Why and How to prolong working life: a labour market perspective

Using the Italian case as a learning example, this short note will discuss the issues raised by the goal of working life prolongment. Firstly, it will be argued that such a goal is of paramount relevance vis-à-vis the increase in life expectancy as a way-out from the apparent trade-off between financial sustainability and social adequacy of pensions systems. The difficulties of fulfilling such a goal, taking account of the interactions between demand and supply factors and of the inheritance of past rules and habits, will then be discussed with reference to the Italian case.
Section 1 will summarize the rationale behind working life prolongment. Section 2 will introduce the more difficult issue of how to realize it, showing the differences existing between cohorts and contexts as differentiated by labour market environmental conditions, normative rules inherited by the history and different chances of adjusting to possibly new rules. The need to look at the interaction between demand and supply factors will be stressed. Using the Italian case as an example, the following four sections will provide detailed arguments relating to these supply and demand interactions.

1. Why prolong working life

The basic arithmetics of life expectancy lengthening are quite simple. Faced with it, any society whatsoever has either to allow more resources to be spent upon retired persons — maintaining both historical retirement patterns and unitary pensions benefits — or to trade-off actual retirement age increases with cuts in unitary benefits in order to limit such an increased burden.
Such a basic fact remains true, although the details of these arithmetical realities may differ according to the pension system under consideration and the timing of these hard choices may differ according to detailed demographic factors.
Re. the latter, it is clear that countries which are going to experience a swelling in the numbers of the elderly because of a previous baby boom — such as Italy in the next 20-30 years as a result of the baby-boom of the late 1950s and early 1960s and the subsequent fertility fall — have more problems than others, particularly if migratory inflows are subdued and incapable of alleviating that temporary bulge. However, migratory inflows may not prevent the longer term implications of life expectancy lengthening1. In addition, relinquishing fertility in order to acquire a more balanced population2 evolution may not avoid the basic fact that, for any given individual, the lengthened life expectancy implies a longer retirement to working years ratio (for given retirement patterns).
Similarly, differences arise according to the details of the pension system. A pay-as-you-go (PAYG) system would require an increased contributory and tax burden. Some leeway may come from the possibility of depleting reserve funds accumulated in the past or from accumulating deficit for some years when a temporary swelling of the numbers of the elderly actually appears. However, the longer term arithmetical realities remain untouched by these financial tinkering exercises. In addition, a system based upon the financial returns of accumulated savings would still require more savings being accumulated and invested, amounting to an increased contributory burden. What differs is the possibility of investing those resources abroad, at the given international rate of return, so that the resources currently consumed by the elderly may actually be the counterpart of a trade deficit rather than claims upon the GDP.
In such a framework, paralleling the lengthened life expectancy with prolonging the working life provides a way out from the above-stated dilemmas. There would be less need to increase the burden upon current youths (or to accumulate funds for the future) and unitary benefits would not need to be reduced too much. Basically, financial sustainability and social adequacy of pensions entitlements (during retirement) would both be preserved.
It is impossible to state an optimal rule linking retirement and life expectancy since the optimal response of a (hypothetical) individual having to plan consumption and work over the whole life cycle would depend upon many details, including health related considerations, the amount of uncertainty (associated to the lengthened life expectancy), the access to financial markets and so on. Broadly speaking, it is likely that the increase in life expectancy would be used both to postpone retirement (i.e. an increase in life-time labour supply) and to spread consumption over the lengthened expected life (i.e. saving more while working, the equivalent of a rise in contributions, and consuming less while retired, the equivalent of a cut in benefits). However, even an apparently simple rule maintaining a constant working to retirement years ratio cannot be taken for granted, though as already said an optimal response to an increase in life expectancy would include a postponement in retirement. Therefore, a well designed pensions system should include mechanisms leading towards that: avoiding perverse incentives to early retirement as well as providing explicit obligations to work longer (obligations quite natural to the extent that some mandatory aspects are present in the system as a whole3). Managing such a system over time, therefore, involves mechanisms designed to progressively shift the retirement patterns over time.
In the Italian case, the above-stated arguments are directly visible through the lenses of the Notional Defined Contribution (NDC) system gradually phased in in accordance with the reform of the mid 1990s. In such a system4, pension unitary benefits are a function of total life time contributions5 multiplied by a transformation coefficient which is a decreasing function of age at retirement. These transformation coefficients are themselves periodically adjusted6 in order to take account of the actual changes in life expectancy7. Taking into account the likely evolution of these transformation coefficients, the NDC system would thus imply a declining trend in the replacement rate at given retirement patterns (see Figure 1). The only way-out from such a decline would be a sizable postponement of actual retirement, so that people would accumulate more contributions and so avoid the decline in the transformation coefficients applied to those accumulated contributions.

Fig. 1: Rates of replacement for public services with and without the effects of demographic correction

Paolo Sestito: Ministry of Labour and social Policies, Rome
1 At least insofar as migrants acquire natives’ demographic characteristics as far as life expectancy is concerned, social evolution is a gradual process and some actual ‘exploitation’ of their initially lower life expectancy may actually occur even if migrants rapidly acquire the same legal rights of the natives. However, such a ‘solution’ would be unfair and a signal of social and health policies’ failure.
2 Besides fertility rises have only very gradual effects against the prospect of a swelling in the numbers of the elderly.
3 The mandatory aspects of a pension system are relevant also in the case of a system based upon the financial returns of individually accumulated savings. The need to accumulate funds and the investment in annuities from the returns accruing from them should be mandatory, the justification for this being the need to tackle the risk of imprudent behaviour. For very similar reasons, minimum age eligibility standards may also be fixed when the individual would bear the financial costs associated with early retirement using actuarial adjustment rules. In a defined benefit system, these minimum age eligibility standards may also be necessary in order to prevent individuals from exploiting the system because of the lack of actuarial adjustment rules. Note that the relevant issue refers to the rules governing benefits determination, i.e. whether the system is of a defined contribution (DC) or of a defined benefit (DB) type, regardless of its fully funded versus PAYG nature.
4 For a succint description of its features, see Marano and Sestito (2005).
5 It would amount to a given percentage of total earnings and accumulated over time according to a notional rate of return which is a function of a moving average of nominal GDP growth rates.
6 It is envisaged that the adjustment would take place at ten-year intervals. The distinct steps implied by this are a source of inequities — as adjacent cohorts are treated in rather different ways — and inefficiencies — as retirement decisions may be affected by the anticipation of the distinct adjustments to come. Moreover, the adjustment itself, while being required by law, is not automatic, as a consensual procedure is envisaged for it and an explicit political endorsement has to be given, meaning that there is a risk that the adjustment could be either postponed or held back. Actually, a very important political test is going to take place in 2005, as the first of these adjustments should be made then.
7 It is the average life expectancy which matters regardless of sex, and the risk of leaving survivors is also taken into account. The lack of differentiation gives an advantage to the healthier and the longer-living. This favours women and, to the extent that they are more long-living, the rich as well. The possible perverse distribution implications have not been well studied so far. However, it should be noted that the previous defined benefit system, besides giving an implied advantage to more long-lived people, also favoured those with steeper earnings careers, who are on average those with higher incomes. On the issue of longevity risk and benefits design, see Diamond (2005) and Fornero and Sestito (2005).

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