Erkki Liikanen: Population ageing, pension savings and the financial markets
Speech by Mr Erkki Liikanen, Governor of the Bank of Finland, at the International Conference of
Social Security Actuaries and Statisticians, Helsinki, 23-25 May 2007.
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Population ageing has become an integral part of international debate on economic policy and has
attracted a lot of attention in recent years. I joined the Bank of Finland in July 2004. The first major
international event I participated in was a symposium on global demographic change. This was
organised in Jackson Hole, Wyoming, USA. The opening remarks were made by Alan Greenspan. All
the prominent central bankers from all over the world were present together with leading economists.
So it became clear to me from my first days as a governor that ageing is a major issue also for the
financial markets.
As you all know so well, when we look at current projections of population trends in the future, the
scale of the problem is staggering. This is an issue that affects every country in the world. In its latest
population projection, the UN forecast the median age of Europe's population will rise by almost 10
years between 2000 and 2050. In Asia and South America, the increase will be even faster. The
increase will be smallest in North America, only around 6 years. The median age of the world as a
whole is at present rising by around 8 days every month.
Everybody understands that this degree of change in population structure must affect the economy in
many ways. A harder question is to determine precisely what these effects will be. We have very little
empirical data on changes in the age structure of the population. This means that, when we study this
issue, we have to rely to a great extent on theoretical analysis and models.
Today, I'd like to discuss the importance of pension savings as a source of finance on the international
financial markets. I will also take a look at the impact of changing population structure and pension
reforms on the determination of real interest rates internationally. In that context, I shall also present
estimation results of the Bank of Finland Dynamic General Equilibrium Model, which analyses the
consequences of ageing for overall economic dynamics.
Pension savings and the financial markets
Preparing for old age is one of the most important reasons why people save and is also a key source
of market finance. The pension funds are major players on the financial markets. Still, this is just one
of the financial market impacts of ageing. Besides the pension funds' own investments, a large
proportion of private share-ownership, unit trust investment, bank deposits etc. reflect people's
preparation for old age. How large a proportion is impossible to assess. There are many reasons why
people save, and there is no simple way to quantify their relative shares.
Financial markets play an important and increasing role in the management of ageing-related risk. But
it is clear that it is possible to hedge only a certain part of ageing-related risks on the financial markets.
A little imagination can illustrate the magnitude of savings needed to fully fund pension liabilities. Let's
first imagine a country with a developed economy in which the birth rate, retirement age and life
expectancy are such that the elderly dependency ratio (the ratio of over-65s to the working-age
population) is 23%, the present average for the developed economies. Imagine, next, that all the
over65s have retired and all those of working age are actually working. Imagine, further, that the country
has a fully funded pension scheme that provides a pension equal to 60% of the average wage in the
economy at any given moment. If we then add a few typical assumptions regarding productivity
growth, real interest rates and production technology, we can estimate how large the pension funds
would become in the long term. The answer this calculation yields is approximately 340% of the
country's gross domestic product! This is an enormous amount. As a comparison we could take
Finland's national assets, which, depending on the definition we choose, are worth 4-5 times the value
of GDP.
Next we can add in the effect of population ageing. The UN estimates that the elderly dependency
ratio of the developed economies will increase to 44% by the year 2050. If we repeat the above
calculation with an assumed elderly dependency ratio of 44% instead of 23%, the result is an
enormous increase in the required value of the pension funds. In the long term, the funds would grow
to around 640% of GDP! Different assumptions would yield slightly different results, but the general
magnitude would be similar.
What do such highly categorised calculations tell us? They do perhaps tell us two things. In the first
place, they tell us that it is hard to provide pension security of the assumed level solely through a
funded pension scheme. It is not possible to maintain funds worth six times the value of GDP, not
nationally, and particularly not globally. The supply of productive investments would quite simply run
out. An economy with real assets worth more than six times the value of GDP would be strongly
overcapitalised, and its return on capital insignificant. Thus, it is clear that a large part of the funds
needed to pay our future pensions will inevitably have to be covered through pay-as-you-go schemes.
The second thing we can take from these calculations is that, even if pension provision is covered
primarily through pay-as-you-go schemes and only a small proportion is funded, the volume of the
pension funds would still be very large. From this we can conclude that the way in which pension
provision is divided between funded and pay-as-you-go schemes will be one of the key factors
shaping the future of the financial and capital markets.
The baby-boomers and financial market meltdown
A few years ago, a new concept, "financial market meltdown", began to gain currency in the debate
over the future of the financial markets. It refers to some calculations on the retirement of the
babyboom generation. When they retire, the baby-boomers will stop saving towards their pensions and
begin to consume the assets they have already accrued. According to the meltdown concept this
would destroy the balance of the financial markets: buyers would disappear when the pension funds
begin to realise their assets. The price of the assets would then collapse and the value of pension
savings be wiped out - or so the argument goes.
Most recent research paints a less dramatic picture of the future. I already mentioned the Jackson
Hole symposium in 2004. It concluded that the change in population structure is more likely to be
reflected on the financial markets as fluctuations in demand for different types of financial instrument
than as a general collapse in prices. One development that was considered particularly likely was
growth in demand for insurance-type instruments.
The impact that the retirement of the baby-boomers will have on the financial markets will be softened
by at least three factors. In the first place, some commentators have drawn attention to the fact that
pensioners' actual consumption behaviour does not seem to be the same as assumed in the models:
pensioners do not realise their assets with anything like the speed the theoretical models would lead
us to believe. Financial assets certainly decline during retirement, but it's a slow process, and a
considerable proportion remains intact until death. When this is taken into account in the calculations,
the result is a considerable reduction in the forecast financial market impact of ageing.
Another factor that will serve to prevent sudden price movements is the fact that the retirement of the
baby-boomers can be anticipated. Events that can be anticipated are not going to cause a collapse on
the rationally based financial markets. Thus, if the retirement of the baby-boom generation is seen to
change the balance of supply and demand for financial instruments, the markets will already take this
into account in their pricing years before the baby-boomers actually retire.
The resistance of the financial markets will also be improved by a third factor. At least in those
countries where pension cover is based to a considerable degree on private savings, there will be a
mutual self-correcting interaction between the retirement of the baby-boomers and asset prices. If the
approaching retirement of the baby-boom generation began to build up sales pressures on the asset
markets and push down the prices of stocks, bonds and houses, this would reduce the value of the
baby-boomers' own assets. Many pension savers would then face a situation in which their pension
assets would no longer allow them to maintain the standard of living they had hoped for in their
retirement. Some of those who had already planned to retire would then find themselves forced to stay
on at work longer than they had intended. This would increase the level of pension savings and
reduce the number of pensioners, improving the balance on the financial markets and preventing a
price collapse.
A study at the Bank of Finland by Tuomas Saarenheimo1 on the financial market impact of ageing
introduces another point of view that has received less attention in international discussion: the
change in people's lifespan. This means higher life expectancy and, especially, longer retirement.
From 1950 until the present day, the additional life expectancy of a person aged 60 has grown by
around 5 years. It now stands at 22 years. By the year 2050 it is forecast to grow again by
approximately another 5 years. The trend is more or less the same everywhere apart from those
African countries that are suffering most from the AIDS epidemic.
For the sustainability of public pension schemes it would be good if part of this longer lifespan could be
devoted to remaining longer at work before retiring. So far, there exists only weak evidence of such a
trend. The most likely outcome is that, in the future, most of these extra years will be spent in
retirement. In the next few decades we can expect the time spent in retirement to increase by about a
quarter.
It is clear that an increase of this size in life expectancy increases the need to prepare for the funding
of retirement pensions. Retirement lasting over 20 years costs more than 15 years. Some of the
increased costs will be covered by publicly funded pay-as-you-go schemes (particularly in Continental
Europe), but the need and desire for private pension savings will also increase.
According to a study conducted at the Bank of Finland, the increase in savings will be considerable.
The study anticipates a large increase in the saving ratio of a typical European 62-year-old
approaching the end of his working life. According to the model used, the ratio is at present a good
30% of disposable income. As a result of increased life expectancy this is anticipated to grow to
around 40% by the year 2050. This is despite the fact that public pension schemes will cover most of
the costs of living in retirement. If public pension benefits are cut, the increase in the saving ratio could
be much stronger.
Thus, global savings will in future be shaped by two opposing factors. On one hand, declining age
cohorts will reduce the number of pension savers relative to the number of retired persons consuming
previous savings. On the other hand, lengthening lifespans will make people of working age keener to
save. The calculations conducted at the Bank of Finland suggest that this latter trend will be stronger,
at least over the next couple of decades. Only around the year 2030 will the impact of declining age
cohorts begin to dominate and depress the level of savings. Even then, the impact will be gradual and
visible mainly as slower growth in new investment funds entering the financial markets, not a collapse
in investment.
Of course, we should not see these types of calculations as forecasts. Predicting economic trends for
decades ahead is not realistic, and that is not the intention. The idea has been to apply a mainstream
economic research model to analyse the likely economic impact of certain demographic trends that
can already be relatively well anticipated.
To the list of factors increasing pension savings we can add another, more speculative motive.
Attitudes towards retirement would appear to be changing. At one time people stopped working when
their working capacity had declined so much that they could no longer work productively. But
expectations have changed. People can increasingly look forward to many years of healthy life after
retirement. Many now see their retirement years as an opportunity to enjoy their leisure time in a way
that was impossible while they were at work. There appear to be rising expectations about
consumption levels during retirement. An increasing readiness to consume in retirement also means
an increasing need for pension savings. How large an impact this change in attitude will have on the
financial markets is hard to assess, but the direction of the impact is surely clear.
We can, then, sum up our discussion with the observation that ageing, and particularly the retirement
of the baby-boom generation, will slow volume growth of the financial markets, but current estimates
suggest growth will nevertheless continue, and there is no reason to fear sudden or strong price
disturbances.
Ageing, real interest rates and public pension schemes
Although there is no immediate prospect of a collapse in global asset prices, population ageing will still
impact on the economy and the financial markets in a number of ways. In the developed world, there
will be slower growth in the labour force, and without large-scale immigration the labour force will in
fact begin to contract. The resulting contraction in labour supply will weaken the profitability of
investments and hence reduce the overall volume of investment. This will mean slower growth in the
capital stock. Coupled with the smaller labour force, this, in turn, will produce sluggish growth in GDP.
All these factors will affect the formation of the equilibrium interest rate - in other words, the level of
real interest that balances investment and savings and is in harmony with price stability and balanced
growth.
The scale of these of interest rate effects has been estimated in a number of studies. Almost every
one of these studies has observed that ageing reduces both willingness to save and willingness to
invest. With regard to the formation of real interest rates the key question is which of the two reacts
more strongly, savings or investment. Generally speaking, the most comprehensive calculations
suggest the change will be more marked in investment, resulting in a decline in the equilibrium interest
rate. For example, the research literature suggests the results of the Bank of Finland calculations are
fairly typical, with the demographic changes reducing global real interest rates - other things being
equal - by around 0.7 percentage points over the next quarter of a century.
In these projections, the role of public pension schemes is both central and very interesting. As I said
at the outset, the extent to which provision is made for paying pensions by funding (through pillars
one, two or three), and the extent to which we rely on public pay-as-you-go schemes, is of central
importance to the supply of finance. At the present moment, public pay-as-you-go schemes
predominate, particularly in Europe. Their future is, however, uncertain. What is certain is that, if
pension systems are not radically reformed, there will be a dramatic rise in the scale of the pension
contributions levied to finance pay-as-you-go schemes. The Bank of Finland's calculations indicate
that pension contributions in Europe would rise from their present level of around 16% of aggregate
wages to around 28% by the year 2040. Japan, which starts out from a lower base, would end up at
approximately the same level. Even in the United States, where population ageing is slower, the
pension contribution percentage would rise from 11% to almost 20%.
Economic policy and macroeconomic consequences of ageing
The above calculations treat economic growth as exogenous: public pension systems, financed by
taxlike pension contributions, redistribute income but do not affect economic activity. This is, of course,
unrealistic. We know, on the basis of both theoretical and empirical literature, that higher taxes do
affect behaviour, and in a manner that makes maintaining fiscal sustainability in an ageing society
even more challenging. When a government, responding to the rising fiscal cost of ageing, raises
taxes or tax-like pension contributions, people will adapt their behaviour, economic growth will slow
down, and slower growth will generate less tax revenues. (This is a manifestation of the infamous
Laffer curve.) Hence, taxes will need to be raised even more than the calculations with the global
savings/investment framework would suggest.
To quantify these effects, I'd like to refer to another study conducted at the Bank of Finland. It
analyses the economic implications of ageing when the economic costs resulting from tax distortions
are also systematically taken into account. In that study, the economic costs of ageing for the Finnish
economy were estimated in a general equilibrium macroeconomic model2.
According to this study, even with retirement age increasing by 2-3 years, income taxes and tax-like
pension contribution rates would need to rise substantially to bring public finances on to a sustainable
path3. On the other hand, the analysis indicates that if, instead of increasing pension contributions,
pension replacement rates were reduced, households would respond by increasing their labour
supply, and the loss in economic activity would remain far smaller. The required reduction in pensions
would, however, be drastic, and so would its social and political costs.
If it were to materialise, the large global increase in public pension contributions would not only mean
an intergenerational income transfer, but could also entail losses in employment. At the same time, the
growing fiscal cost of elderly care would increase pressure to raise taxes. It is doubtful whether
pension contributions could really rise this much, particularly at a time when the increasing mobility of
both labour and capital is reducing national governments' room for manoeuvre in taxation.
The effort to achieve a more sustainable base for our pension systems has in recent years been a key
plank of economic policy throughout the developed world. The sustainability of pension systems can,
of course, also be improved by postponing retirement. This, would increase the number of people
paying in and reduce the number of people receiving benefits. Postponing retirement would slow the
growth in pension expenditure, increase the supply of labour, improve the return on investments and
accelerate economic growth.
For the financial markets, the most important feature the various pension reforms all have in common
has been the attempt to reduce the role of pay-as-you-go schemes in providing an income for the
elderly. This does not necessarily mean the increased use of funded schemes within public pension
systems. Macroeconomically, the same result could be achieved simply by reducing or restricting
access to the benefits of pay-as-you-go schemes. These types of reform would mean a reduction in
the transfer of income from future age cohorts to present cohorts. As a result, the present generation's
expected income flow would be reduced, people would become keener to take out private pension
insurance to bridge the gap, and the saving ratio of the economy as a whole would rise. We all know
how difficult such reforms would be politically.
It is interesting to note that the impact on financial market balance if the retirement age is raised is
precisely opposite to the impact of cutting pension benefits. In the end, the fall in real interest would be
either small or non-existent. In this calculation, an extra four years at the end of working life
(worldwide) would be enough to neutralise the downward pressure of population ageing on real
interest rates.
These calculations are essentially a mental exercise and should not be taken literally. It is, however,
clear that developments in pension savings and public pension systems are among the key factors
that will shape the macroeconomics, supply of finance and the future of the financial markets.
Transparency and credibility of pension systems
Irrespective of how much future pensions end up being funded, balanced economic development
requires two vital qualities of any pension scheme: transparency and credibility.
Transparency means that those covered by the scheme understand what sort of security it provides
them and what it will cost them. Pension schemes should be understandable - they should not
mislead their customers to over- or under-estimate their pension security. This is, of course, obvious
from a human and social perspective, but it is also important macroeconomically: misunderstandings
will sooner or later come to light, and the result then could be sudden changes in people's savings and
investment behaviour that could destabilise the financial markets.
Another important perspective, one regarding the credibility of the pension system, relates to the
nature of contributions and incentive effects. In a credible, actuarily fair system, pension contributions
accrue in full to augment the beneficiary's personal pension assets. They are in this respect equivalent
to personal savings. This type of contribution does not have the unfavourable incentive effect of
taxation. Pension contributions only begin to take on the nature of tax when the system begins to
move away from this ideal. The further a system departs from the credible, actuarily fair ideal, the
more pension contributions become just another tax.
The message for policymakers preparing the reform of pension systems is clear: the goal has to be a
clear and sustainable system. Thus, on one hand the reform must guarantee the long-term
sustainability of the system, while on the other hand providing people with a clear and unvarnished
picture of their public pension security so they can plan properly for their personal future needs.
In conclusion,
we can draw a number of different conclusions from the calculations that have been done on the
effects of population ageing. One thing is, however, clear: the world is facing demographic changes
that will have considerable implications for the economy and the financial markets. On one hand, the
end of labour force growth, and in many countries its reversal, will lead to lower investment demand.
On the other hand, the change in population structure will tend to reduce the flow of savings and the
supply of finance. At the same time, lengthening lifespans, and especially more years spent in
retirement, will increase the need to finance private pension security.
Management of the economic and social consequences of population ageing will require three
mutually supportive elements. In the first place, the volumes needed for financing pensions mean the
system will always have to be based on a public pay-as-you-go scheme. On top of this there will also
be a need for a solid funded element to balance out disturbances, spread the burden between
generations and thus help the economy adapt to the demographic changes. As a third pillar, we will
also need to provide a clear framework for private pension savings that will provide scope for personal
planning and fill any gaps that may remain in the public system.