Ignazio Visco: An ageing population - solutions from financial markets
Keynote speech by Mr Ignazio Visco, Deputy Director General of the Bank of Italy, at the
Conference "Pension Planning in Italy and the Netherlands - Challenges for Public Policy
and Financial Markets", Rome, 25 October 2007.
In part this speech reflects views advanced in Visco (2006) and in a report prepared for the Deputies of the Group
of Ten in September 2005 by a group of experts that I chaired (Group of Ten, 2005). I have received useful
suggestions from Daniele Franco and Fabio Panetta and I would especially like to thank Pietro Tommasino for his
assistance and comments.
* * *
1. Introduction
Italy is an ancient country, rich in history, art and culture. It also has one of the most rapidly
ageing populations in the world. We have all heard about the Medici family, whose most
illustrious member, Lorenzo the Magnificent, was not only a great politician and statesman,
but also a patron of the arts and a poet. To Italians of my generation he is best known for
bella giovinezza, che si fugge tuttavia! Chi vuol esser lieto, sia: di
these verses: "Quant'è
doman non c'è certezza", that is, in a charming English translation, "Youth is sweet and well,
but doth speed away! Let who will be gay, tomorrow, none can tell".1 Lorenzo was only
twenty years old when he succeeded his father as the dominant force in Florence, embarking
on a remarkable political career that would make him the arbiter of the balance of power in
Italy. And he was just forty-three when he died, the same year that Columbus discovered
America.
Today we live much longer lives, but no less uncertain ones: indeed, "tomorrow, none can
tell". Living longer, especially if we are in good health and have the resources to enjoy it, is
certainly a positive development. Since in all probability we are not descended from the
Medici family, or one of similar wealth, we cannot afford Lorenzo's hyperbolic discounting,
which borders on moral hazard. We must, instead, plan for our future. This is especially so
as the demographic changes we are experiencing pose serious challenges for our public
finances and the working of labour markets. These certainly include the need for the reform
and adaptation of our pension systems. Indeed, the "pay-as-you-go" (PAYG) public pension
system that still covers most of the Italian population was devised at a time when life
expectancy was lower and fertility rates were higher. While a major reform of the public pillar
was made in 1995 and refined over the last decade, the development of private pension
saving is now particularly important. The percentage of people enrolled in private pension
plans is still low, and the pool of assets managed by pension funds is still very small.
2. Demographic trends
The last hundred years or so have seen a spectacular rise in average life expectancy in
today's high-income countries. Very considerable, if less spectacular, progress has also
been observed in the rest of the world. For a large part this can be ascribed to the
exceptional fall in infant mortality. However, in the last half a century there has also been a
remarkable increase in life expectancy at old age. This secular rise in longevity has been
accompanied more recently by lower fertility rates, with the result that the world population is
now ageing very rapidly. This is not only the case for the OECD countries but for several
emerging economies as well, most notably China.
The unprecedented rise in longevity has affected Italy perhaps even more than other
countries and mortality rates at older ages have dropped very sharply. Between the early
1930s and 2004, life expectancy for males has increased by 6.2 years at the age of 60, 4.7
years at the age of 70 and 2.9 years at the age of 80; for women, it has improved even more,
by 9.7, 7.6 and 4.6 years. Life expectancy has increased more in absolute terms for the
relatively younger ages, so that the shape of the population pyramid is progressively and
significantly becoming more "rectangular". These changes have occurred extremely rapidly in
recent decades: about two thirds of the increase in life expectancy of males and about one
half that of females took place after 1980.
There are reasons to believe that even these striking figures may underestimate the true
improvements. For example, life expectancy is usually calculated using the age-specific
mortality rates observed today, instead of estimating them on a cohort-by-cohort basis.2 This
may be one of the reasons for the systematic under-prediction of the number of the elderly,
especially the oldest old. New and more sophisticated projection methods have been
proposed recently. They appear to have produced significant improvements in projection, but
life expectancy gains still seem to be somewhat under-predicted.3
Even if there is consensus that life expectancy will continue to rise in the future (most likely
by one to two years per decade), we must therefore acknowledge that there is still a high
degree of uncertainty about future longevity. Moreover, lags occur in the production, adoption
and disclosure of mortality tables. In particular, cross-country variations in mortality
assumptions used by company pension schemes appear at times far larger than the profiles
of their members warrant.4 Indeed, as the 2005 G10 report concluded: "Regulators should
promote transparent disclosure of mortality and disability projections and pension actuaries
should determine the extent to which these projections reflect actual plan experience and
how they model and allow for the uncertainty surrounding these estimates in their funding
strategies" (p. 66).
Demographic changes may cause systematic deviations in the number of deaths from their
expected values. Unlike random variations around a fixed known mortality probability, this is
a collective longevity risk that cannot be diversified across the individuals of a given cohort
as it affects all of them in the same way. More sophisticated hedging mechanisms are
therefore needed, possibly involving the public sector. Indeed, longevity risks are faced not
only by company pension schemes but by public programmes as well.
In Visco (2006) a rough estimate of the risk facing the Italian pension system was computed
by considering the extra pension payments that individuals aged 50 years and older would
receive if they lived longer than expected (assuming that most of the cost of reforms to
correct this effect would be borne by younger individuals). The same percentage
improvements observed in life expectancy between 1990 and 2002 were projected from
2005 forward, with the result that the cost of such a shock would be about 10 per cent of the
present value of pension liabilities under the current system. This would amount to 22 per
cent of 2005 GDP, with an average annual flow of about half a percentage point of GDP for
the next decade, and one percentage point in the 2020s and 2030s.
All this clearly points to a need for better and more timely projections. At the same time,
because projections are surrounded by a high degree of uncertainty, pension systems should
be designed to be robust to uncertainty. They should also be resilient to the economic and
political pressures that demographic changes are likely to engender.
As far as public pensions are concerned, the introduction of notional defined contribution
(NDC) pension systems in a number of countries, including Italy, goes in this direction. In
principle, NDC systems can be designed to calculate pension benefits taking macroeconomic
and demographic developments automatically into account. However, regardless of the very
long transition period, the Italian pension scheme, in the form it was introduced, differs in
some important respects from the prototype of an NDC system. The benefit rules were not
designed to be frequently and automatically updated to account for demographic
developments and the rate of return on workers' contributions (equal to the rate of growth of
nominal GDP) apparently does not grant the actuarial balance of the system at least in the
short-to-medium run.5
Several changes have been agreed recently between the government and the social
partners. While some of the new rules are in line with the NDC philosophy (for example,
parameters should be updated every three years instead of every ten and preliminary
negotiations with social partners will no longer be needed), others are more difficult to
understand (for instance, granting some categories of workers a specific pension
benefit-towage ratio).
3. Demographic change and pension systems
All pension systems imply a redistribution of real resources from active workers to retirees.
While in PAYG systems this is implemented through taxes and social security contributions,
in funded systems it is achieved through capital markets, as pensioners use the assets
accumulated in their working years to provide for their needs once retired.6 In both cases, the
goods and services consumed by both active workers and retirees are produced by the
labour of the former. In a funded system, however, saving and accumulated assets should be
greater, leading in principle to a larger amount of resources available.
An expected increase in longevity results in higher old age dependency ratios and narrows
the range of possible changes to pension system designs, regardless of the institutional
arrangements for intergenerational redistribution. Possible measures include: (i) increasing
payroll contributions; (ii) reducing pension payments relative to per capita GDP; (iii) raising
the retirement age; and (iv) increasing current saving in order to pre-fund greater future
pension expenditures. This last would require both an increase in public saving (reducing
budget deficits and raising the share of capital expenditure) and an expansion of the private
pillar.
Some of these options have the normative appeal that the current workforce shares part of
the burden with future taxpayers. In particular, policies to raise the age at retirement and
increase current savings seem preferable, at least for Italy, given that in the future people will
not only live longer but will also be active and healthy longer.7 Moreover, such policies are
likely to increase potential GDP and this will help to alleviate the financial consequences of
ageing.
All in all, there is a growing consensus among experts and policy-makers that lengthening
the average working life and increasing pre-funding are essential to any credible strategy to
meet the challenges of ageing.
To increase the effective age of retirement, it is important to reduce the disincentives to work
embedded in social security rules. PAYG systems are often not neutral with respect to the
retirement decision. Indeed, in many social security systems workers' pension wealth (i.e. the
discounted value of future pension payments) decreases with age at retirement, generally
because of the weak linkage of benefits to lifetime contributions. The NDC system introduced
in Italy in 1995 should offset this distortion, as benefits depend on past contributions and on
expected longevity at retirement. However, the new system is being phased-in very slowly.
Other potential interventions relate to the labour market, for example offering broader training
opportunities to older employees, increasing flexibility in age-earnings profiles and improving
on employment arrangements.
If we enlarge our framework to account for uncertainty and move beyond the distinction
between funded and unfunded pension schemes, a second distinction comes to the fore,
namely that between defined contribution (DC) and defined benefit (DB) systems. The two
distinctions are independent of one another: unfunded schemes, such as that introduced in
Italy in 1995, may well place longevity or even market risks directly on workers; and funded
systems may shield workers from risks, placing them on the employer.
These two alternative institutional arrangements allocate the risk of unexpected changes in
longevity in very different ways, although upon closer examination the differences appear
less pronounced. Under a DC system, workers bear the risk that, prior to retirement, an
upward revision in the expected longevity of their generation would increase the cost of
purchasing an annuity at the moment of retirement.8 The risk that an individual's
postretirement longevity will turn out to have been underestimated is instead left on those who
sell annuities. This risk can be decomposed in two components: (i) the risk that the insured
will live longer than the rest of her/his cohort (this is a proper insurance risk, which by its very
nature cancels out if the pool of policies is big enough); and (ii) the risk that the average
longevity of an entire cohort will prove to have been underestimated (this is an aggregate risk
that cannot be easily diversified away). Of course, a large part of the aggregate longevity risk
is likely to be shifted back from insurers to workers via (possibly excessively) high annuity
prices, and in practice these high prices are a key reason why many people prefer not to
annuitize. The result is that, in a fully DC system, the insured must cope with longevity risk
on their own. While, in principle, farsighted agents should respond to risk by working longer
and/or by saving more, such virtuous responses are often impeded by institutional obstacles
(labour market rigidities, financial market incompleteness) and by bounded rationality or
myopia.9 Indeed, the existing private DC schemes are often perceived by households
(especially those of slender means) as too risky and too complex (and perhaps too costly).
DB schemes, by contrast, are meant to protect workers against aggregate longevity risk, but
uncertainty about future improvements in life expectancy would affect these systems too. In
fact, an unexpected increase in longevity would necessitate either increasing payroll
contributions or the public debt. And in either case the burden would be borne entirely by the
younger generations. In other words, high longevity risk would translate into high "political"
risk: pension promises might not be honoured, as the intergenerational pact on which they
rest might prove socially and economically unsustainable, as well as intrinsically unfair.
Occupational DB pension plans are designed to protect employees from longevity (and
investment) risks, placing the consequences of any actuarial imbalance on the employer. In
this case too, however, workers would be ultimately exposed to longevity risk. The difficulties
of recent years are instructive as to possible future developments: questionable investment
decisions and adverse financial market developments have opened up a worrisome "funding
gap", increasing the present value of liabilities more than total assets. As a result, many
sponsors have closed DB funds to new workers or ceased accepting further contributions
from those already enrolled. In some cases, workers have suffered from the default of the
plans.
To sum up, the great uncertainty surrounding longevity projections creates problems both in
DC systems (where individuals and households are left alone to bear longevity as well as
market risks) and in DB systems (where entitlements guaranteed by the state and by
corporate sponsors might prove unsustainable).
The demand for some form of DB pension schemes is nonetheless very strong.10 This
presumably reflects investors' reluctance to bear longevity risk and investment risk, and
suggests that, while it may not be possible to avoid transferring at least part of these risks
from the public pension system or employers to workers and households, some form of
capital or performance guarantee could significantly stimulate investors' demand for private
pension products - provided that more accurate asset/liability management practices are
introduced and supervisory oversight is strengthened.
On the supply side, longevity bonds should definitely be encouraged, recent failures
notwithstanding. The market for long-dated bonds is also too small relative to the potential
demand from institutional investors. The duration of public debt in most countries is quite
short (at about 5 years) and the lack of public benchmarks discourages potential private
issuers. There is also a shortage of long-term and inflation-linked bonds: the potential
demand exceeds supply at least threefold.11 One could also think of macro-swaps between
the pension fund and the health care industries, to exchange their exposure to longevity.
Finally, as asymmetric information and market incompleteness cannot be completely
eliminated, governments could step in, acting as insurers of last resort at least for the risk of
very large unexpected increases in aggregate longevity. This is a further reason for reducing
their role as providers of insurance that could be readily purchased in financial markets.
4. The development of private pensions in Italy
Since the mid-1990s in Italy the PAYG system has been in a lengthy phase of transition from
a standard DB system to a new NDC system.12 From the very start of the reform process it
was clear to policy-makers and experts alike that, in order to achieve an adequate level of
retirement benefits, the new public pillar had to be supplemented by a well developed private
pillar. The latter consists in two components, occupational and personal pension plans, both
voluntary and of the DC type.
The development of the private pension pillar witnessed an acceleration in recent years. One
of the goals of the system has been to induce workers to divert contributions from the
socalled TFR (a severance payment scheme where worker's contributions are retained by the
employer and earn a rate of return of 1.5% plus 75% of the inflation rate) towards private
pensions. In order to achieve this objective, the new system includes an automatic enrolment
provision, whereby workers are enrolled in the pension scheme 6 months after they are
hired, unless they explicitly choose to remain in the TFR scheme. It also significantly reduces
the tax burden on private pension savings.
Starting from January 2007, the end-of-period capital accumulated over contributors' working
lives is subject to a proportional tax rate that is equal to 15 per cent but can go down to 9 per
cent depending on the length of the investment period;13 in comparison, the lowest personal
income marginal tax rate is 23 per cent. Our calculations show that the new Italian ETT
system (Exempt, Taxed, Taxed) is considerably more favourable than the EET system
prevailing abroad.14
The tax benefits of the new system are particularly valuable for high-income workers - with
high marginal personal income tax rates - and for young workers, who can benefit from the
favourable tax regime for a longer accumulation period. For example, over a 30-year
accumulation period the new tax treatment would allow a low-income worker to increase the
value of his/her end-of-period capital by about 24 per cent relative to an otherwise
comparable portfolio of financial assets; for high-income workers, the tax benefit would rise
to a hefty 70 per cent.15
Of course, these tax benefits should not be offset by high costs and fees charged to
investors. In Italy, these costs vary substantially across funds, but on average they are still
-
relatively high. Recent analyses show that the total yearly costs of occupational funds
which include management fees, administrative costs and the fees paid to the custodian
-
bank average about 0.60 per cent. For open pension funds and insurance products the
total costs and fees are even higher - 1.4 and 2.6 per cent on average, respectively. The
expansion of the net asset value of pension funds may well reduce these costs, due to
economies of scale. However, the process is likely to be slow and could be insufficient to
lower the level of fees significantly. To speed up and reinforce the process, an increase in
competition in the asset management industry, fostered by domestic and international
competitors, will be necessary.
In order to enhance competition, full transparency about fees and other product
characteristics is also crucial. This would allow workers to choose the funds and products
best matching their needs. In this respect, the fact that employers' contributions cannot be
transferred out of occupational funds limits workers' mobility and restrains competition in the
asset management industry, with potentially significant adverse effects on workers' welfare.
Moreover, to improve governance and reduce agency problems between investors and fund
managers, the separation between asset management, auxiliary services, and consulting
services should be pursued.
The results achieved so far by the new system in terms of participation in private pension
funds are fairly encouraging. According to COVIP (the supervisory authority for pension
funds), excluding the workers who have adhered to pension plans via tacit consent, in the
first six months of 2007 the number of workers participating in some form of supplementary
pension scheme rose from 3.3 to 4.3 million. In the same period, the number of participating
private sector employees rose from 1.8 to 2.7 million.
There is nonetheless ample room for improvement, as the percentage of enrolled workers
remains relatively low. In fact, at the end of June membership rates were equal to only 22 per
cent for private sector employees and 28 per cent for occupational funds. As a result of the
low membership rates and the short life of the system, the pool of assets managed by
pension funds is still very small: in 2005 it amounted to 3 per cent of GDP, against an OECD
average of 88 per cent. Since then it is likely to have increased by only a few percentage
points. In the Netherlands, the leading country in Europe, pension fund assets are 125 per
cent of GDP.16
The lag that distinguishes our country primarily reflects insufficient information and
awareness about the need to supplement public pensions with private schemes, but it is also
due to workers' low levels of financial education. The lack of solid trust in the functioning of
financial markets is also a factor. But how can we stimulate the growth of this sector?
One critical issue is information. Despite the efforts recently made by the government,
surveys show that Italian workers are still not adequately informed on their future pensions. It
is therefore crucial to provide workers with additional information about their accrued and
perspective pension rights, both in the public and in the private pillar. An example of the
benefits of transparent and clear information on the individual rights stemming from the
public system is offered by the Swedish experience, where every year workers receive
information on their past contributions and the rates of return granted by the system on such
contributions. Valuable additional information could include estimates of the final pension
benefits under various macroeconomic and demographic scenarios.
Another issue that deserves closer examination is the potential benefit, in a phase of
transition of the public pillar towards a DC system, of expanding the different types of
guarantees offered on the performance of pension funds. In the current framework, pension
funds are required by COVIP to offer an investment line that guarantees the nominal value of
invested capital in order to be eligible to collect the contributions of those who have enrolled
tacitly. Simulations and developments in the markets show that the costs of offering a
broader range of guarantees would not be prohibitive: for example, even with conservative
assumptions on market volatility, a capital guarantee in real terms over a 10-year investment
horizon would cost 0.7 per cent on a yearly basis.17 Guarantees that are conditional on
particular events (such as long-term unemployment or illness) would imply a significantly
lower cost. A low-volatility regime such as the one that has prevailed in recent years would
further reduce the cost of guarantees.18
Yet another way to reduce the costs that workers attach to the shift from the TFR scheme to
pension funds would be to allow them to go back to TFR if they changed their mind, although
there should be limits on the exercise of such an exit option. Empirical evidence shows that
workers' choices are often backward-looking and are affected by herding behaviour. These
two factors could determine excessive movements in and out of different investment vehicles
and might lead to an unjustified increase in the costs borne by investors.
Customers should not be overloaded with difficult investment choices: the timing and size of
contributions and the allocation of assets could be fixed by default rules, allowing a limited
menu of options; life-cycle products should be developed to allow portfolio rebalances in line
with the changing risk profile of workers as they age.19 Simplicity and cost-effectiveness are
crucial if we want to increase retirement savings among those who most need them. At
present, enrolment is particularly low among younger workers, women, and small business
employees. In 2005, the membership ratio of younger workers (aged from 14 to 34) was
below 8 per cent; that of women was 11 per cent; that of employees of small businesses
(fewer 50 employees) was less than 5 per cent.
It is also well known that adverse selection on annuity markets plays a possibly important
role in limiting their development. In Italy the fraction of pension capital that is mandatorily
transformed into an annuity at retirement is at present equal to 50 per cent of the total
capital. An increase in this fraction could perhaps be considered.
Finally, we should not overlook the fact that annuities are the classic answer to longevity risk,
but by no means the only one. In reality, they make sense for people whose financial wealth
is sufficient to buy them a significant income. As it may take time to accumulate sufficient
levels of financial wealth until private pension schemes reach maturity, we should remember
that real estate is often for households both a currently consumed asset and a major savings
vehicle. Since housing wealth constitutes 60 per cent of Italian households total wealth,
which is quite high compared with other high-income countries, instruments which help
elderly people to extract liquidity from real estate in an efficient manner, such as reverse
mortgage contracts, should become more widespread than they are today.
5. Conclusions
Several thousands of years after the Age of the Patriarchs and the Bible saying that God had
put a limit of 120 years to human lives, we still do not know whether that will be the biological
limit to the human life-span. It is clear, however, that we are now approaching it at a very fast
pace. It is also clear that in the last decades longevity projections have been systematically
downward biased. This has produced an aggregate longevity risk, one that we will most likely
continue to live with.
Ageing populations require reform efforts at all levels. In Italy, not only has there been a
major reform of the dominant public pension system, with a long transition period and many
adjustments, but important steps have been taken towards developing an efficient private
pension pillar. It will take time for a private system to be an adequate complement to the
public system, but the road is clearly indicated and we must continue looking for
improvements in information, competition, asset management and supervision. To cope with
individual and aggregate longevity risks, it seems inevitable to me that we must aim for a
better balance between these two pillars of our pension system.
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