03 June 2018

VoxEU: Population ageing: Pension policies alone will not prevent the decline in the relative size of the labour force

The column argues that, on average in the OECD, stabilising the old-age dependency ratio between 2015 and 2050 requires an increase in retirement age of a stunning 8.4 years. This number far exceeds the projected increase in longevity and increases in retirement age driven by pension reforms alone.

The number of young people for every 100 people of working age will remain stable at about 40 in the upcoming decades, however, unless fertility changes markedly. This means that the total dependency ratio will increase drastically. It is expected to exceed 0.90 by 2050, compared to 0.65 in 2015. If employment rates, especially at older ages, do not rise, these demographic developments will ceteris paribus (in particular, we are ignoring potential rises in productivity) be a substantial drag on standards of living. We should ask whether this alone will be sufficient to avoid a future lack of labour in OECD and EU economies. By how many years would the upper age boundary of working life – using 65 as a reference – have to increase to keep dependency ratios constant over time?

We computed the shift in the age boundary between 1980 and 2015 which would have maintained old-age dependency ratios at their 1980 levels, starting from age 65 in 1980. On average in the OECD, this was 3.4 years, or an upper age boundary of 68.4 years, by 2015. Over the same period, life expectancy at age 65 grew by 4.4 years. A rise of the retirement age of about three-quarters of the number of years we could expect to live at age 65 would therefore have been sufficient to avoid an increase in the OADR. By contrast, the average total dependency ratio would have stabilised at its 1980 level by loweringthe age boundary by 4.5 years, from 65 in 1980 to 60.5 in 2015.

Policymakers who want to preserve retirement income adequacy will be under financial pressure. The effective old-age support ratio (number of employed people relative to the number of retirees) is the inverse of the effective old-age dependency ratio. It combines demographics and employment rates across age groups, and so is a useful indicator to illustrate what is at stake. 

In a financially balanced pay-as-you-go pension system, a decrease of 1% in the effective old-age support ratio would lead to a fall of 1% in the average pension relative to the average wage, or would require an increase of 1% in the contribution rate.6 This is a mathematical identity, so there is no escape. Avoiding a fall in relative pension levels when the population ages can thus only be achieved by:

• higher contribution rates,
• higher employment, perhaps through later retirement or more female employment, or 
• a financial deficit in pension accounts that would eventually need to be covered by taxation.

Within defined contribution schemes, the pension replacement rate for a given career is proportional to the contribution rate, and mainly determined by the rates of return on accumulated assets. These rates of return ultimately depend on the productive capacity of the economies in which those assets, either financial or notional, are invested. Whatever the structure of pension systems, any labour scarcity induced by population ageing is likely to reduce pension benefit levels. 

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