Technological Changes, the Reversal of Age Pyramids and the Future of Retirement Systems

5. Retirement, Saving and the Economy

In the agrarian economies, all risks were handled by the extended family and there was little need for social security. The industrial revolution created the need for another form of protection, in the form of government managed social security arrangements, which were supported by other work-related arrangements (labour unions pension funds etc.). The post-industrial revolution creates new challenges, and calls for re-evaluation of the old schemes, and for the foundation of new forms of protection.
Catering for the new needs must be done in a careful and thoughtful way, insofar as the retirement system is strongly interconnected to major parameters of the economy. There are strong relationships between the retirement system and population patterns, the national savings, the income distribution, the fiscal system, the labour and capital market and the economic growth of the country. The broad implications on such key parameters must be kept in mind in the creation of new solutions.
We have examined above the effects of technological waves on population growth and its age distribution (the population pyramid), as well as the different problems of the developing countries and the post-industrial countries simply due to their being at different points in the same developmental process. The countries that are now entering the industrialisation process have the advantage that they can examine the validity of the solutions that were tried years ago by the developed countries, and can learn from their experience, and avoid repeating the mistakes.
The impressive population growth (baby boom) of a country in the first stage of industrialisation brings with it several huge, tough and pressing problems: a quickly growing number of mouths to feed, fast growing educational needs, rapid movement from the farms to fast-growing cities, and a practically non-existent infrastructure (roads, trains, communication, energy, water, sanitation, capital market).
Other problems, like the retirement system, seem to be currently less pressing and their treatment is typically deferred. The experience of the developed countries shows that this could later prove to be a serious mistake, even if the baby boomers will only need an appropriate retirement system to take care of their needs in the far future (say, 60 years’ time).
Early treatment of retirement needs can help solve two major problems: the seemingly less pressing retirement problem and the huge financial needs that are unmet due to the underdeveloped (often non-existent) capital market. The developed countries that dealt with the issue a century or so ago while they were in the industrialisation stage, have developed their capital markets with tools that were appropriate at that time: They introduced national social security plans and additional work-related pension plans (that were typically run by labour unions).
The social security systems in the West European countries, which were based on partial funding, and the pension funds of the labour unions managed to accumulate huge funds, in some countries equivalent to substantial parts of the entire national wealth. Even in the U.S.A., where pension schemes are less developed than in Western Europe, pension funds have become a major source of capital and represent about a quarter of all U.S. equity holdings. Thus, the social security systems and unions became important players in the capital markets and in the investment and growth of their countries, and acquired substantial economic and political power.
The important connections between social security systems and the national savings was already being broadly discussed in the literature 40 years ago, and were the subject of a heated debate sparked by a famous article by Feldstein (1974) arguing that the governmental social security system reduces the total saving in the economy: social security has become a major source of income for retired people, and caused a reduction of their private savings, though the social security tax has not been used for increasing the public saving. Others (for example Schulz 1991) argue that the social security does not reduce the savings, since in the absence of social security people will tend to save only a little.
Most countries have selected partially funded social security systems. A few, and the U.S.A. is the leading one, have selected a ‘pay-as-you-go’ system, with but little accumulation of funds (designed to mitigate slight short-run deviations from the expected values of premiums and payments). In such a plan the financial burden is shifted from one generation to another. In a country undergoing the industrial revolution a pay-as-you-go system is expected to bear an enormous burden when it matures some 60-70 years after its establishment. It is no wonder that the U.S. system introduced in 1934 is currently facing this problem, and that U.S. economists are its loud opponents (see Diamond, 2003; Feldstein, 1998; Mitchell et al., 2002, 2004). With the U.S. experience in mind, Feldstein presents a forceful case for a radical shift from the existing pay as you go social security system to a mandatory funded program with individual savings accounts. Note, that the current U.S. problem is far smaller than the problems expected by newly industrial countries: the U.S. has mitigated the problem by allowing a huge wave of immigration to enter the country over the years, and this has kept the dependency ratios under control.
Today, the developing countries are simultaneously undergoing both the industrial and post-industrial revolutions, and they should, therefore, develop retirement systems that fit the post-industrial stage. The nature of the retirement schemes will be slightly different, but the old idea will prevail: simultaneously creating a solution for both the retirement and the missing capital market problem.
The nature of the new retirement systems must be slightly different from the old one. If in the past, the government played a major part in running the social security system, it can be privatised to a large extent, with the government just needing to create the general framework for the operation of private facilities. The additional solutions provided in the past by the labour unions, through the establishment of union pension plans, also need to be revised. The labour unions have lost much of their power in the post-industrial developed countries, and their ability to offer work-related pension plans has declined. The same is true for the currently developing countries: the unions there are unable to attain the same power that their counterparts in the developed countries had in the past.
Government intervention is still needed, though. In order to expedite the solution, governments have to make the retirement saving mandatory, setting the rules, but leaving the establishment of the retirement programs to private institutions. Young people, especially in less developed countries do not typically think about retirement as a pressing issue; they prefer to spend their money on other current needs, and they lack recognition of and trust in financial institution as a possible vehicle to treat the problems of retirement. Therefore, it is not recommended to wait for the slow and gradual natural development and penetration of private financial instruments into the retirement market. Government intervention will enable the country to start treating both the retirement and capital market problems within a short period of time. This approach is somewhat patrimonial, but making the retirement plans mandatory is essential, given the unsecured nature of developed labour markets, and due to the need to start treating the retirement issue at an early stage in order to enable the savings to be accumulated over a long as possible period.
Another difference from the old social security or labour union systems is in the way retirement systems can be run today. The old systems were the result of the basic way of thinking and basic tools that were available in the past. Designed for mass production and mass marketing, like the industrial revolution, the old retirement systems were fairly uniform and rigid plans that did not leave much room for adjustments to the individual’s particular needs. In addition, as computers did not exist at the time and those introduced in the 1960s were quite primitive. Therefore, the plans were predetermined to a large extent (most plans were based on a ‘defined benefits’ approach). The same was true for the commercial insurance policies of those days: life insurance policies (the most popular at that time were the whole life policies and endowment policies) were designed so that all the parameters of the program (premiums, sum insured, surrender values, etc.) were calculated and predetermined from the inception of the policy.
The development of computers and communication that allow insurers to process and store large databases quickly and at low cost has opened the way for a huge variety of policies: variable premiums, variable coverage conditions, various portfolios in which the premiums can be invested, profit-sharing schemes, investment in a variety of options, etc. The same tools can be used for the new retirement system, allowing the insured to enjoy a free choice of investments (stocks, bonds, mortgages, options, foreign investments, etc.), and letting the premium fluctuate according to the ability, needs and desires of the person, as long as certain obligatory targets are met. This could stimulate private savings and help finance the needed growth of the economy.
The government will have to set the general framework of the system, so that the mandatory savings are a substantial part of the income (probably around 25% of the income). It will have to set the rules for employer-employee participation, and government subsidies could be included (through tax incentives, for example). It will have to set the rules to assure proper governance, transparency and honest management of the system in order to make sure that the huge amounts involved are not stolen or mismanaged. Much flexibility could be given to the selection of investments (subsidies could be given in special cases, for example in order to encourage the local capital market). The managers of the private funds will have a high degree of responsibility, and they will have to find prudent ways to invest the funds. In order to immunise against some of the risks, a maturity matching will be needed. This will probably encourage the creation of a long-term mortgage market (to back up the long-term obligations of the fund), and this in turn will encourage the development and growth of the country’s economy.
We believe that the optimal system will be mixed. It must preserve certain elements of the nationalised social security system, possibly in the form of some sort of welfare program that will be responsible for the treatment of disabilities (both disabilities from birth and from uninsurable events), and for the handling of the (growing) number of people who will be unemployed over long periods as a result of the changing nature of the economy. This is a very complicated issue that has to be handled with much care, sensitivity and wisdom.
One last critical point has to be made. The traditional solutions (social security and union pension plans) were driven by the desire to relieve the people of many risks, especially investment risks, which led to a very conservative investment policy (mainly in governmental bonds). In addition, the so-called ‘defined benefit’ plans, which tended to be the norm, are hard to maintain over long periods, especially when the environment is changing at an accelerated rate. It is quite clear that the main future vehicles will be based on a ‘defined contributions’ approach, meaning that retirement plans will be run like a saving program. The insured will know the amounts that are being saved, but the future value of these savings will depend on the realised return on investment. In other words, the burden of interest risks is entirely shifted to the shoulders of the individual.
The main difficulty with a defined contribution approach goes beyond the fact that the future amount of accumulated savings remains uncertain. Even if it is known, it is not clear how much protection it will be able to buy in the future, as this will depend on a large number of uncertain elements: the prevailing interest rate, the mortality table, the level of the medical costs, and many other unknowns. It is most probable that countries will have to supply some sort of protection against such risks when they come about. There is no way to calculate the actuarial cost of such a program.
In other words, the post-industrial society has to dispense with the illusion of freedom from all financial, demographic and economic risks.

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