02 June 2005

The Demographic Impact: Is the Pensions Crisis Mortality or Fertility?

The demographic impact: is the pensions crisis mortality or fertility?

Joining the Challenge Europe debate on the future of the European welfare state model, Graham Bishop discussed the looming pension crisis. While longevity and earlier retirement impact on the long-term sustainability of traditional pension systems, falling fertility rates jeopardize the existing model. Without a recovery in fertility rates or increased migration, the outlook for economic sustainability is bleak.

A “pension crisis” is at hand in the EU. By 2050, life expectancy will soar to 85 for a 65 year–old man; the old age dependency ratio is set to rocket (pensioners rising from 40% of the working age population today to 70% by that time); and the population of several major states will have declined by more than 10%. Such statistics can be seen everyday in many newspaper articles and they raise disconcerting questions about the long-term sustainability of economic growth.

Many interpret the ageing society as being the driver of this crisis and increasing longevity will certainly create problems for the age structure - but is it the whole of the story? Are middle-aged policy-makers looking at their own future and allowing personal concerns to cloud a review of the totality of the problem? At least they do not have grandchildren distracting them from this important work!

What is the pension crisis?

Forty years ago, Europeans retired at age 65 but the effective age has been falling ever since and is now fluctuating around 60. The Heads of Government may have set a target of reversing that decline but it will be some years before it happens. In the meantime, the improvement in health care has lengthened the life span of the elderly, and continues to do so at a rate that is rising and may now be about 1.5 extra years per decade.

The combination of earlier retirement and increasing longevity is having a dramatic effect on the length of retirement — the “term” to be funded by savings. That term has risen from 12.8 years in 1960 to more than 20 years today. However, this does not yet reflect the (perhaps alarming) improvements in longevity that are now the reality.

Using data from the UK — which has slightly lower longevity than the Eurozone — the 60- to 64-year-old age group is now experiencing a rapid improvement in longevity. In the 1960s, the improvement seemed to have stalled but nowadays it is accelerating — to a 2.5% annual improvement, and life expectancy for this group may rise by two years in the next decade, versus the 1.5-year improvement in the last decade.

Whatever the future may hold, the present already exists and is quite different from the past. Social mores shape legal structures and even in the mid 1980s German government bonds did not have a maturity longer than 10 years — originally stemming from legal concepts about the prevention of usury. But these laws permitted assets that would comfortably last most retired people for their life span during the 1950s and 1960s.

Today, the retirees would be seriously exposed to “roll-over risk” when a 10-year bond is redeemed about halfway through their retirement when they may be less able to cope with difficult economic problems. Roll-over risk is the possibility that they may find that interest rates at the time of the redemption of their bond are significantly lower, thus cutting their actual income. In the past, they may have welcomed such a mismatch as it offered the possibility of recovering from “surprise inflation.” Today, the inflation risk seems much reduced and more attention is likely to be paid to the possibility of a cut in income. This is the problem that has faced European savers, and their intermediaries, for the past decade.

In practice, most citizens will not hold financial assets themselves but will use a financial intermediary such as a pension fund or life insurance company. The new retiree is likely to look for some form of guarantee from the intermediary that they will continue to pay the income throughout their remaining life. After a string of shocks about the stability of life companies, the EU has embarked on a major re-assessment of capital adequacy and a directive is likely to be proposed by year-end called Solvency II.

At the same time, the world’s accountancy profession is looking at the appropriate accounting treatment – for both insurance and pensions. A key element is that any mismatch between the term of the liabilities – the length of the promises to pensioners or insured lives – and the assets should be backed by adequate capital. For a capital-constrained industry, this proposal will create a major incentive to match the term structure of promises/liabilities with assets more closely.

That turns out to be a difficult task. Analysing the Citigroup index of “tradable” bonds, the average time for redemption of all bonds in the Eurozone is only seven years – about a third of the life span of the average retiree. Importantly, the non-central government sector is only five years – and constitutes only a third of outstanding bonds. Thus, the important sector is that of bonds issued by central governments – where the average life is nearly eight years.

It turns out that decisions by central governments are crucial to the ability of financial intermediaries to give real certainty to the promises to retirees. Will governments recognise their responsibility to issue bonds that will provide that type of certainty, even if it costs more? Or will they continue to insist that their debt managers minimise the interest cost – which inexorably leads to shorter maturity bonds? The recent decision by the UK Government to consult about the need for 50-year maturities is a welcome step in dealing with the unfolding pension crisis.

The real problem: the fertility crisis

However, the truly intractable problem may be the fertility crisis, which is the key problem in determining the population size. The spirit of the age is that women should achieve equality with men. Thus social policies are designed to permit/encourage greater participation in the labour force by women – of all ages. So young women are choosing to look for a career that is the equivalent to that of their male counterparts. Equality of activity has obvious merits but the logical consequences of these cumulative forces are now becoming inescapably apparent: birth rates have fallen dramatically and are now well below “replacement” rates.

The fertility rate (the number of children per woman of child-bearing age) is the ultimate driver of the old-age dependency ratio. If people are living longer, then the ratio of older to younger age groups is set by the size of the younger group of workers, which will be determined by the birth-rate – unless there is an offsetting amount of immigration. But discussion of this potentially highly significant element of the pension crisis seems to be frozen by two taboo subjects: the role of women in society and immigration.

The impact of immigration

In the decade 1993/2003, the EU-25 population was officially estimated to have risen by 10.4 million people. But only 3.0 million can be attributed to an excess of births over deaths. Demographers expect the working age population to begin declining around 2010, but this assumes continued, significant immigration. A glance at newspaper headlines suggests that this assumption could turn out to be optimistic. For example, the UK official forecasts assume that immigration will decline from 200,000 in 2001 to about 125,000 annually and continue at that rate. But that would be five times the rate of the early 1990s. If immigration were to fall short of current expectations, then fertility would revert to being the dominant driver of population dynamics.

The arithmetical facts are stark: the EU-12 total fertility rate was about 2.5 in the early 1970’s and has fallen – in a straight line – to 1.5 in the late 1990s, crossing the 2.1 replacement ratio in about 1976. However, demographers noted a marginal rise around the turn of the century. Amongst the major states, the 2001 rate in France and the UK was 1.7; Germany was 1.4; whilst Italy and Spain both recorded dramatically low rates of 1.2.

Will there be a substantial recovery in fertility rates?

The social pressures to remain an active part of the labour force continue to be officially encouraged, thus further raising the economic cost of a career break to have children. One possible response is to postpone starting a family – which seems to have happened. In the UK, for example, the average age of the mother when bearing the first child (within marriage – which applied to only 60% of births in 2003) has now risen to 30. For the daughters-in-law of today’s policy-makers, that age is nearly 32![1]

For society, the critical factor is the “completed family size” (CFS). The risk is that excessive postponement of childbirth may lead to a CFS that turns out to be lower than intended/hoped by an individual. At that stage, the aggregate fertility rate cannot recover and a natural shrinkage of the population will be well underway, creating problems that are the mirror image of those of the “baby-boomers” of today. The next five to ten years will bring the answer to this question.

Without a dramatic recovery in fertility rates that goes well beyond demographers current expectations, the outlook for economic sustainability is bleak. A shrinking workforce will be expected to support an increasing population of retirees – even if the age of retirement is raised significantly. The public finance implications are profound. Yet policymakers seem locked into focussing largely on the problems and costs of increasing longevity – which are seen as being increasingly serious, taking a 15-20 year view. But the fertility question will have been settled decisively long before then. Without sufficient new entrants into the population, new efforts on pension policies may look increasingly like shifting deckchairs on the Titanic.

[1] Only daughters-in-law are referenced here as only these statistics are recorded.

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