FROM TAIL-WIND TO HEAD-WIND
4.4 F IGHTING A TREND
Ensuring a high employment rate is crucial for the financing of the welfare state. This is particularly obvious for pay-as-you-go (PAYG) pension systems, in which the active population is financing the pensions of those retired out of contributions from current incomes. Such a system works well when the dependency ratio is decreas- ing, but it is problematic when the dependency ratio is increasing. Ageing poses an obvious financial threat, because more people live longer and because the employment ratio is likely to fall. One way of counteracting this would be for the retirement age to increase in parallel with increases in longevity (implying that the shares of life spent in and outside the labour market remain constant).
2010 15 20 25 30 35 40 45 50 -5 -4 -3 -2 -1 0 1 -5 -4 -3 -2 -1 0 1 % of GDP % of GDP Figure 4.7
Primary balance projection for 2010–2050
Historically, however, the share of life spent in the labour market has (until recently) been decreasing both due to later entry into the labour market and due to earlier withdrawal from the labour market, typically via early retirement schemes. This trend is sooner or later bound to resume if retirement ages remain unchanged while longevity is increasing. Preventing this from happening is clearly one of the steps needed to ensure the financial sustainability of the welfare state.
Much has been done in the Nordic countries to meet the pension challenge. In particular, the Swedish pension reform, introducing a “notionally defined contribution system”, is widely considered a benchmark. It promises a system that will remain financially sustainable without any increase in pension contribu- tions from their present level. Denmark has recently taken steps to increase statutory ages for early retirement and public pensions. Once these changes have been implemented, the statutory ages will be tied to longevity. These measures address a large part but do not solve the sustainability problem driven by changing de- mographics. Finland is not as advanced in solving the problems; notably the earnings-related pension system of the private sector is unsustainable in the sense that it is likely to call for significant increases in the contribution rate in coming decades.
In recent years Finland has undertaken some reforms that affect pensions and retirement, though these reforms are not suf- ficient to solve the problems. The recent pension reform abolished some early retirement schemes and improved the incentives for prolonging work careers beyond the age of 63. It also introduced an adjustment mechanism linking pensions to longevity to the effect that pensions to be paid to a given age cohort are reduced if longevity increases. The latter is very important and implies that an increase in longevity combined with an unchanged retirement age would leave the individual with a lower annual benefit. In other words, the individual would have either to accept a lower (mate- rial) living standard or postpone retirement alongside the increase in longevity. If the individual postpones retirement in parallel with the increase in longevity, the benefits received will be unchanged. Although this contributes towards solving the problems arising from ageing, these measures are not sufficient. Moreover, from a
The Nordic countries have done much to meet the pension challenge – but more needs to be done, no- tably in Finland
Demographics: from tail-wind to head-wind
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long-run perspective it is an anomaly that the statutory retirement ages (62, 63 and 68) are kept fixed while longevity increases.There are several reasons why retirement may take place too early as seen from the perspective of society. First, taxation (in combination with various forms of means testing and supplements) implies that the return for continued work and later retirement is smaller for the individual than for the society even if the benefits are actuarially fair. The reason is that the labour income earned by postponing retirement is taxed (while leisure is not).
Second, even though indexation of benefits to longevity provides incentives for individuals to retire later when longev- ity increases, the system does not automatically ensure that this takes place. This is so since the statutory ages that apply to the various schemes are not indexed, and because individuals may underestimate longevity. Finally, with rising incomes there may be a preference shift with an increasing focus on leisure in the “third phase” of life.
Ageing is often perceived as an issue of pensions and retire- ment only. While these issues are important, one should stress that there are other financing concerns related to ageing. These include welfare provisions such as health and old age care. Financ- ing the latter is also strongly dependent on the age composition of the population. More people – both relatively and absolutely (and particularly the very old) – will be in need of old age care and health services in the future. While increasing longevity is associated with more healthy ageing, there will nevertheless be an increasing pressure on health and old-age care if the old are in the future to have the same access to welfare services as currently. This requires more resources and raises financing issues beyond that of pensions.