EUROPEAN PAPERS ON THE NEW WELFARE

5. Are pension promises affordable?

The promises that countries make to their future pensioners may be adequate to prevent pensioner poverty and maintain standards of living. But are they also affordable?
To answer this question, the OECD study uses an indicator of so-called ‘pension wealth’. This indicator is the most comprehensive measure of pension promises. It is calculated as the present value of the future stream of pension payments and it takes into account the level at which pensions are paid, the age at which people become eligible to receive a pension, people’s life expectancy and how pensions are adjusted after retirement to reflect growth in wages or prices. It is the lump-sum equivalent to all the pension income someone can expect to receive.
Luxembourg has the highest pension wealth for a worker who earned average earnings: it is worth 18 times average earnings for men and nearly 22 times for women (due to higher female life expectancy). This means that if, instead of paying a regular income, the government gave each pensioner a single payment worth exactly the same, it would have to come up with an average lump sum of $587,000 at the time of retirement. Pension wealth for Luxembourg is nearly treble the average for OECD countries. The lowest pension wealth for someone of average earnings is found in Ireland, Mexico, New Zealand, the United Kingdom and the United States, where it is less than six times average earnings.
Countries can more easily afford to promise a higher replacement rate at retirement if the pension eligibility age is higher and so the benefit is paid for a shorter period. The pension eligibility age in most OECD countries is 65. Iceland and Norway already have (and the United States will have) a normal pension age of 67. Pension eligibility ages are less than 65 in the Czech Republic, France, Hungary, Korea, the Slovak Republic and Turkey.
The impact of differences in life expectancy on pension wealth is quite large. Other things being equal, the countries with lower life expectancy — Hungary, Mexico, Poland, the Slovak Republic and Turkey — could afford to pay men a pension that is 10% higher than a country with OECD average mortality rates (Germany, Italy and the United Kingdom, for example). In contrast, longer life expectancies increase the burden on the pension system. For men, pension wealth is nearly 8% higher than the OECD average in the five countries with the longest life expectancies — Japan, Iceland, Norway, Sweden and Switzerland.
The impact of the combination of these elements on pension wealth can be illustrated using country examples: French gross replacement rates are below the OECD average, for workers earning between 75% and 200% of the French economy-wide average. Pension wealth in France, however, exceeds the OECD average because the pension eligibility age of 60 is relatively low and life expectancy is relatively long. In countries with shorter life expectancies, such as Hungary, Poland and Turkey, benefits are paid for a shorter retirement period and so the pension promise becomes more affordable. The effect is the reverse in Switzerland and the Nordic countries, where life expectancies are high.

6. Do people understand their pension systems?

One clear message emerging from the evidence collected by the OECD is that many OECD countries have pension systems that are very complex. This lack of clarity in the pension system makes it difficult even for experts, let alone the average contributor, to know what future entitlements will be. In Sweden, for example, a full-career, white-collar worker on around average earnings would receive five different pensions: an income-tested public pension, an earnings-related public pension, a defined-contribution personal pension, a defined-benefit occupational pension and a defined-contribution occupational pension.
Sweden, to its great credit, has recognised the problems caused by having such a complex system, and has taken steps to improve the information given to pensioners about the future value of their entitlement. Elsewhere, Germany and the United Kingdom, for example, are providing statements to pension system members to inform them of their current and projected pension entitlements. Other countries need to consider a similar strategy.
The need to have younger generations understand pension systems is important partly because governments increasingly rely on them to make financial decisions (about how much to save, in what form, etc) in order to have a decent pension upon retirement. People also need to be able to understand their pension systems in order to have a reasoned discussion about pension reform.

7. Box: How do workers’ living standards evolve in retirement?

Two pension policies have a particularly strong impact on income levels: indexation and valorisation. Indexation refers to the adjustment of payments to pensioners to reflect changes in costs or standards of living; this feature of pension systems has long been central to the debate on the financial sustainability of pensions. In the past, many countries adjusted pensions to wages. Now nearly all OECD countries link pensions to consumer prices. Under the baseline assumptions used by the OECD, this may result in savings of more than 20% compared to indexing pension benefits to wages.
A related feature of earnings-related schemes is valorisation: the adjustment of past earnings to account for changes in living standards between the time when pension rights are earned and when they are claimed. Until very recently, valorisation has received much less attention than indexation despite its powerful impact on pension benefits. Most OECD countries revalue past earnings in line with economy-wide earnings growth. But there are several exceptions — Belgium, France, Korea, and Spain — where past earnings are valorised in line with prices. Wages usually grow faster than prices, so price valorisation leads to substantially lower replacement rates than earnings valorisation. Price valorisation for a full-career could result in a pension 40% lower than under earnings valorisation.

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