The Geneva Association estimates the worldwide pension gap to be US$41 trillion. The definition of the pension gap is the difference between the present value of the yearly lifetime income needed to sustain a reasonable standard of living and the actual amount saved for retirement plus the present value of pay-as-you-go (PAYG) contributions over a 40-year period.
The main consequence of the pension gap is old-age poverty. Not only does old-age poverty put a drain on government finances, it neglects an important societal value, that people should retire with dignity.
Improving life expectancies, declining fertility rates
Life expectancies at birth have been improving since statistics have been recorded, but it is only during the past few decades that life expectancies at older ages have been improving dramatically. Advances in medical technologies including bypass operations, stent insertions and cancer treatments along with cholesterol-reducing drugs and infectious disease vaccines will add an estimated three years to the life expectancies of 60-year-olds in 2050 in developed countries.
During this period of improving life expectancies, fertility rates have been steadily declining. The fertility rate is defined as the number of children that a woman has during her childbearing years. It would seem logical that a fertility rate of 2.0 would be sufficient to replace the woman and the father of her child. However, due to infant mortality, women not living through their childbearing years and imbalances between male/female percentages in some countries, the average worldwide fertility rate needed to replace the current population is approximately 2.1.
Between 1965 and 2014, the worldwide fertility rate has dropped from 5.1 to about 2.5. In Europe, this trend is even more dramatic with a current rate of about 1.5.
Perfect storm
Low fertility rates put extreme pressure on the old-age-support ratio which is defined as the number of workers divided by the number of retirees. As a proxy for workers, most old-age-support ratio calculations use people aged 15-64, and as a proxy for retirees, ages 65 and older. The current worldwide old-age-support ratio is about 6.9 workers to retirees and is expected to drop to approximately 3.7 by 2050. For developed countries, the old-age support ratio is expected to drop to 2.5 by the year 2050.
Increased life expectancies and low fertility rates are the two main drivers of the pension gap. However, the sustained low interest rate environment is exacerbating the situation by not only decreasing returns on assets, but also by increasing pension liabilities.
Pension liabilities are the present value of future expected payments to retirees. The lower the interest rate, the greater the amount of pension funds that are needed to be able to make future payments.
These three factors, increasing life expectancies, low fertility rates and low interest rates, are causing a perfect storm that will need to be addressed quickly.
The pension gap has caused countries to cut social benefits promised to citizens, local governments to cut benefits promised to municipal workers and companies to cut pension promised to employees.
Japan has world’s highest pension gap
Asia has no less of a pension gap issue than Europe and North America. In fact, some may argue that the situation is even more dire. The one-child policy in China has caused this populous country to have fertility rates below 2 since the mid-1990s. This, in conjunction with improving mortality, will cause the ratio of workers to people over age 65 to decrease from about 7.9 in 2008 to about 2.4 by 2050, according to OECD estimates.
According to a Geneva Association calculation, Japan has the highest current pension gap globally. This is due to Japan having the second longest life expectancy in the world (Monaco is first), according to the World Factbook, coupled with one of the lowest fertility rates in the world (211th of 224 according to the World Factbook).
Japanese government saw this evolution in demographics coming and instituted cuts to retirement benefits and increases to normal retirement ages in the late 1990s.
Then, in 2004, an automatic pension stabiliser was enacted that annually recalibrates benefits according to the number of workers in the workforce and life expectancy development. It is too early to tell if these measures will be socially sustainable, as benefits may need to be reduced during the next 20 years.
Finally, China and Japan have been slow to increase normal retirement age to the levels that we are seeing in European countries, which puts extra pressure on the pension gap.
Addressing the pension gap
There are, however, a number of steps that governments, corporations and the general public can take to reduce the pension gap.
- Employer defined contribution pensions should, at a minimum, automatically enrol workers and at a high enough level to ensure adequate retirement income.
- Governments should further encourage retirement contributions with additional tax-advantaged savings opportunities.
- Governments should strongly encourage or mandate annuitisation of all or a large portion of employer defined contribution plans.
- Retirement ages to receive unreduced social pensions should continue to increase commensurate with the increase in life expectancy.
- Governments and the industry should create more opportunities to allow work past normal retirement age.
- Contribution rates for social pensions should increase for employers and individuals until, in conjunction with other solutions, the national system is sustainable based upon realistic actuarial assumptions. In addition, all defined benefit plans should be funded to the actuarially correct levels.
- Governments should be required to disclose current pension funding gaps and show expected benefits to future retirees under best estimate assumptions.
- Financial literacy should be part of core education systems around the world.
Some of these proposed mitigating solutions are in place or being introduced in many countries. For example, many countries have increased normal retirement ages to receive social pensions. Continuing to increase normal retirement ages could have a huge effect on the pension gap. Based upon The Geneva Association’s calculations, increasing the normal retirement age to 70 could reduce the pension gap by 75%.
Of course, this would assume that people are healthy enough to work until age 70, want to work, that there are jobs available, that their continued work does not affect the employment status of other workers, that their salaries will be unaffected and that these people continue to contribute to social pensions, work pensions and private savings. Even if a fraction of the population continues to work to age 70, the results can be quite beneficial.
Some of the recommended solutions could cause other issues such as placing further demands on younger workers to finance current retirees or what is called inter-generational wealth transfer as well as difficulty for politicians to change policies that reduce current pension benefits with an ageing population that has a high voter turnout.
Conclusion
The insurance industry is in a unique position to mitigate the effects of this epidemic. It has the expertise through its actuaries and underwriters, the tools with its products and services, the appetite to accept risk and the political influence and means to work with governments and society on practical solutions.
Mr Ronald Klein is Director of the Global Ageing research programme at The Geneva Association.