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Impact Investing

IPE special report May 2018


Caught between labour and capital

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In the coming decades, the Dutch population will age. Ageing will increase the ratio between pension liabilities and the premium (contribution) base for pension funds. This makes these funds more susceptible to investment and longevity risks: small premium increases will no longer suffice to absorb these risks. Moreover, an ageing population will make labour scarce relative to capital.
This is bad news for pension funds because these funds have closely tied their liabilities to the price of labour while the value of their assets is linked to the price of capital. They thus can expect income from their investments to fall, while at the same time their obligations increase. To make matters even worse, a larger demand for non-tradable goods and services (such as care for elderly people) can be expected to tighten the labour market in an ageing society, thereby increasing wage inflation. This too will harm the financial health of pension funds.
Accordingly, not only pay-as-you-go pension schemes but also funded systems are vulnerable to ageing. This article assesses the extent of the vulnerability and discusses how the finances of pension funds can become more robust with respect to various risks.
We employ the Image model, an applied general equilibrium model of the Dutch economy with overlapping generations, to assess the macroeconomic links between ageing, risks and pension funds. In every generation, we distinguish multiple income groups. The behaviour of households and firms is derived from standard microeconomic theory, as these agents maximise intertemporal objective functions. The model is based on recent data and incorporates the major Dutch institutions that are vulnerable to ageing: the government (including the public pay-as-you-go pension scheme, the ‘AOW’), the health sector and the funded pension sector.
We explore three scenarios, starting with the base path in which the pension funds and the government respond to an ageing population. To investigate the risks of ageing, we subsequently analyse the effects of a decrease in the international rate of return on capital. Finally, we investigate the sensitivity of our results to a decrease in the tradability of goods and services.

The base path
In the base path, the assets of pension funds are not sufficient to cover their obligations (including the indexation of benefits to the level of wages) at the assumed real rate of return of 4%. Also, the contribution (premium) rate is below the long run equilibrium level.
This starting point reflects the present situation, in which the coverage ratios of many pension funds in the Netherlands are below the level that is required to finance fully wage-indexed pension benefits. Additionally, the current tax rates are insufficient to finance the public costs of ageing in the long run. If the government-run pay-as-you-go scheme continues to tie its benefits to the level of net wages, while keeping its contribution rate constant, the government will have to shoulder a growing part of the costs through an increase in taxes.
In the base case, pension funds employ the contribution instrument to combat deficiencies in their coverage ratio. The pension premium rate (this is the percentage of gross income above the so-called franchise threshold that is paid into the pension fund) goes up or down, according to the coverage ratio; however, the premium rate can never change more than two percentage points per annum and cannot exceed 25%.
The shortages in the base year, combined with a relatively low initial level of the premium rate, result in a substantial increase in the years directly following the base year. The government keeps the level of debt (as a percentage of GDP) constant by adjusting the rate of income taxation on a yearly basis. Because of the costs associated with an ageing society, the rate of taxation increases markedly. The rate of income taxation and the pension premium percentage are in table 1.
On the base path, the level of employment decreases as the large baby boom cohorts retire. The share of people over 65 years of age increases from 13% to almost 23% in 2040. This leads to a period of scarce labour and thus high wages on the labour market, which considerably worsens the plight of the pension funds because their liabilities are indexed to the level of wages in the economy. The net- and gross wages are in figure 1.
This figure reveals that net wages (corrected for technological progress) decrease, as opposed to gross wages. This downward pressure is caused by the higher rates of taxation and pension premiums. Although gross pensions, which are tied to gross wages, increase, net pensions are also on a downward path due to the higher rate of income taxation. Despite the upward wage pressure on a tight labour market, the purchasing power of workers lags behind that of pensioners because workers face higher pension contributions, from which pensioners are exempt.

Shock in returns
To illustrate the resilience of the Dutch economy to macroeconomic shocks, we simulate a negative shock on the rate of return to capital. This shock can be the result of changes in the relative supply of labour and capital, due to population ageing worldwide. Indeed, the supply of capital is expected to increase in the coming years, as the baby boom generation in the OECD countries saves increasing sums for retirement.
In contrast, demand for capital will probably be lower, because the need to create additional jobs diminishes when the size of the working age population is about to decrease. Several studies predict that demographical developments in the next decades will depress the rate of return on capital. In our simulations, we use a recent projection in which the real worldwide return to capital falls from 4% to 3.4% in 2030. In the long run, the rate of return is 50 basis points below the initial level of 4%.
We explore the effects of this fall in the rate of return, which immediately affects the coverage ratio of pension funds, under various rules of behaviour of pension funds. In the first two simulations, the funds use a final-wage system, in which the size of a person’s pension benefits is directly related to his or her final wage. The fall in the rate of return is absorbed by either increasing the contribution rate, or by suspending the indexation of the current pensioners’ benefits. In practice, funds will probably use a combination of these two instruments, but we present these extreme simulations to indicate the outer ends of the playing field.
We also investigate the effectiveness of a premium- or indexation-based policy if the pension funds switch to an (indexed) average-wage system in the base year. In an average-wage system, the size of a person’s benefits is related to the wage that has been earned, on average, throughout his or her career. This average is indexed to grow, on a yearly basis, with the level of wages in the economy.
If indexation is suspended under this system, we assume that the pension rights of not only pensioners (as under the final-wage scheme) but also current workers will be adversely affected.

Final pay system
If pension funds fully rely on a higher contribution rate to cover shortages in their coverage ratio, premiums shoot up to their maximum level of 25%. Rates stay at this level for about 20 years, after which they return to their long run level of just under 20%. This exceeds the long run level on the base path, which was 16.4%, due to the lower rate of return on the funds’ assets in the long run.
Pension funds also have the option to set their premium rate at the long run level of 19.6% immediately and to cover any remaining shortages by suspending benefit indexation for pensioners. This will cause the level of pension benefits to fall behind gross wages at a steady rate of 4% for eight years. This reduction in benefits is enough to restore the funds’ solvancy, and indexation slowly resumes afterwards. Table 2 contains the path of the contribution rate under both regimes.
Figures 2 and 3 show the path of net and gross wages and net pensions under both regimes. The lower rate of return on the international capital market boosts investments in the Netherlands. This augments labour productivity and increases gross wages. Employment increases by 0.7% in the long-run, and GDP goes up by 2.5%. If the indexation instrument is used, changes in net wages are small because the increase in gross wages is just about cancelled by the higher pension premiums.
If the premium rate instrument is used, the premiums are much higher initially (see table 2), causing net wages and labour supply and thus employment to go down. Use of the indexation instrument, instead of the premium instrument, avoids sizeable negative short run effects on net wage and employment, but does depress net pension benefits in the initial years (compare figs 2 and 3).
Figure 4 shows the effects of the adverse shock in the rate of return on the welfare of different generations under the two regimes. In both cases, the fall in the rate of return hurts the welfare of future generations: lower revenues from investments outweigh the (slightly) higher net wages in the long run. In the short run, the decisions of pension funds determine how the burden is shared among generations. If the premium rate is used as an instrument, those born around 1980 suffer most; if benefit indexation is suspended, these generations are spared but those born in the 1930s pay the price.

Average pay system
If pension funds respond to a fall in the rate of return by switching to an average-wage system (using a transition regime in which current pension rights are maintained), the contribution rate turns out to be more stable than it was under the final wage system. While net wages are under pressure from higher pension premiums for the first 20 years, net pension benefits are higher initially due to the transition regime and due to an increase in gross wages, to which benefits are tied (see figure 5).
The scenario in which the switch to an average pay system is followed by the use of the indexation instrument shows that the average pay system makes the indexation instrument much more effective in absorbing the adverse shock in investment returns. Indeed, under the average pay system, suspension of indexation affects existing pension rights of both current retirees and those in the labour force.
The increased effectiveness of the indexation instrument causes the period of reduced indexation to become much shorter than under the final pay system. The paths of net wages and net pensions do not diverge as much in this scenario (compare figure 6 to figure 3).
Higher net wages under the indexation rule (compared to those on the base path) stimulate the supply of labour and boost employment in both the run and long run.

Non-tradable goods
The supply of labour in the Netherlands will decrease when the baby boom generation retires. This reduces the ability to produce goods and services locally. At the same time, pensioners have accumulated enough savings through their funded pensions to maintain their consumption demand.
Although their savings (which have in part been kept in the form of foreign assets) can be used to import consumption goods, not all goods and services can be traded internationally. The sustained demand for non-tradable goods, combined with a diminished ability to produce these goods locally, appreciates the real exchange rate (ie, the price of non- tradables relative to that of tradables).
This price signal will cause factors of production to shift from exporting sectors to sectors that serve the local market. In this way, the production of non-tradable goods and services can meet the local demand despite the reduced availability of labour resources. The tighter labour market resulting from the sustained demand for labour from non-tradable producing sectors raises the costs for both pension funds and the government because these sectors offer benefits that are coupled to the general level of wages.
We simulate an economy with two sectors, one producing tradable goods (using 31% of employment in the base year) and one producing non-tradables (using 44% of employment). After 40 years, the real exchange rate has increased by 4% as the economy shifts its resources from the production of tradable goods to the production of nontradables. By then, the share of workers that is active in the nontradable sector has increased by about 10 percentage points.
These developments accelerate the increase in gross wages, compared to the base path (figure 7). Higher wage inflation raises the costs of pension funds, as their benefits are coupled to the level of wages. We assume that the funds use their contribution rate as an instrument; premiums rise to their maximum level of 25% almost immediately.
The above scenarios illustrate the macroeconomic connections between ageing, gross and net wages, the pension contribution rate and employment. Ageing results in a tighter labour market, higher costs of wages and a higher collective burden.
Furthermore, developments related to ageing can put pressure on the rate of return to capital on international capital markets. When ageing is at its peak the tight labour market exacerbates the financial problems of pension funds because increases in wages serve to increase the costs of pension funds. If goods and services cannot all be traded internationally, the pressure on wages rises even further. The ripe, aged pension funds make the Dutch economy vulnerable to developments on the international capital market and the local labour market.
Alternative regimes for the sharing of risks substantially affect the welfare of various generations. Risks are spread more evenly across generations if the rights of both workers and pensioners are decreased if pension funds face a deficient coverage ratio.
Also, the development of incomes of workers and pensioners is more even, compared to the cases in which pension funds use only the premium rate or the benefits of current pensioners as an instrument. The indexation instrument exerts smaller effects on employment, and thus leaves the economy better able to deal with the increasing costs of ageing. This makes the Dutch economy more robust to macroeconomic shocks.

Lans Bovenberg is at Tilburg University and Ocfeb, Erasmus University Rotterdam and Thijs Knapp is with Ocfeb, Erasmus University Rotterdam. This article is based on a research project commissioned by the Dutch Ministry of Social Affairs and Employment (SZW) and Pension Research Fund (SPW)

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