Adequacy of savings for old-age in Europe

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Adequacy of savings for old-age in Europe

• Elsa Fornero, University of Turin and CeRP
• Annamaria Lusardi, Dartmouth College and NBER
• Chiara Monticone, University of Turin and CeRP
• CeRP Conference 2008
• "Financial security in retirement"
• September 18-19th 2008, Collegio Carlo Alberto

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An American prologue the worrisome baby
boomers

• A lively US debate on the adequacy of retirement
  provisions of the large baby boom generation
• fears of inadequate savings are echoed in the
  press and in the political discussion
• Research has produced mixed results
• more than 43 of American households are
  considered at risk according to the National
  Retirement Risk Index (CRR at Boston College)
• financial illiteracy is widespread (i.e.,
  according to a survey, 60 of Americans do not
  understand the difference between social
  security, a company pension and a 401 (K) plan)
• Yet models based on (enriched versions of) the
  life cycle model find less than 20 of households
  have inadequate resources

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1. Motivation and relevance for Europe

• Dramatic changes in the European population
  structure declining fertility rates and
  increasing longevity are expected to hamper
  economic growth, and to challenge the welfare
  state

Old-age dependency ratios (Visco 2006)
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2. Definition and measurement of retirement
saving adequacy

• The concept of retirement saving adequacy should
  combine two closely related dimensions
• Individual dimension
• has to do with a sensible intertemporal
  allocation of resources in a given market and
  institutional context (e.g. generosity of public
  provision and presence of saving instruments)
• the life cycle model is the natural normative
  benchmark
• a household is said to be saving adequately if
  it is accumulating enough wealth to be able to
  smooth its marginal utility of consumption over
  time in accordance with the optimizing model of
  consumption (Engen et al. 1999, p. 70)
• Pension system dimension
• refers to a well structured institutional design
  for an efficient sharing and diversification of
  risks, given individual preferences and financial
  sustainability, and requires
• intergenerational and intragenerational risk
  sharing (Shiller, 1998)
• a mixed system (Lindbeck and Persson, 2003),
  combining PAYGO and funding
• an appropriate combination of DB and DC formulae
  (Gomes and Michaelides, 2003)
• enhancement of individual responsibility, through
  information and financial education (Lusardi
  2007)
• an appropriate design of workers choice
  situations, e.g. pension schemes default options
  (Madrian and Shea, 2001 Holzmann et al, 2005)

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Elements of realism and difficulties in
computation

• All measures can be made more realistic by
  considering
• (a) Real life complications
• Taxes
• Imperfect indexation of social security benefits
• Risks of too early retirement because of health
  shocks, firms restructuring or other
  contingencies
• Imperfect annuity markets
• Illiquidity of retirement wealth (housing wealth,
  in particular)
• Risks of catastrophic health expenditure in
  retirement
• Risk of divorce (typically for a woman)
• (b) and facilitations
• Public health, subsidies and care
• Changes in the family composition (couples are
  normally better situated than singles because of
  their greater moderation)
• Changes in consumption/leisure mix at retirement
  and opportunities to economize
• (c) Heterogeneity of individual situations
• Typically poor individuals have higher pension RR
  because of progressivity in both the pension and
  the tax system
• Cohort and gender aspects (womens longer
  longevity)

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Measures

W/Y
W
Y
Cr/Ca
P/Y
C
P
Age
Retirement
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A more realistic life-cycle
Imperf annuity mkt Illiquidity (house)
Investment risk Longevity risk

W
Smoothing of mg ut/cons Bad health outcomes
Economies of scale in hh Home production
Work-related expenses
Y
C

• Household composition
• Children in out
• Divorce

P
Imperf indexation Progressivity
Early ret (health or job shock)
Age
Ret
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Greater income and pension uncertainty have made
P/Y more elusive

• While retirement planning is difficult in a
  stable environment, pension reforms greatly
  complicate the task by downsizing past promises
  and limiting both guarantees and indexation
  mechanisms
• the PAYGO pillar as a source of retirement income
  has been retrenched
• retirement ages have been raised
• replacement rates have been reduced
• benefits have been de-indexed from wages to
  prices
• occupational and personal pension plans, where
  workers have greater choice but also greater
  responsibility and risks, have been strengthened
• DB schemes are being replaced with DC schemes
  based on financial accumulation and actuarial
  principles