The haves and the have-nots
The retirement-income systems of OECD countries are very diverse and so the link between population ageing, pensions and voluntary retirement savings varies significantly.
Figure 1 shows the average projected pension for people entering the labour market in 2004, including all mandatory pension schemes, both public and private.
The most striking feature is the large variability in the mandatory pension target: from an average of just 30% of average earnings in the UK to nearly 100% in Greece.
The average across the 30 OECD countries is 57.5%. The target mandatory pension tends to be low in English-speaking countries, such as Canada, the UK and the US. However, Germany and Japan also have small mandatory pensions.
Figure 1 also shows differences in the way in which mandatory pensions are provided.
Since 1997, a number of OECD countries - Hungary, Mexico, Poland, the Slovak Republic and Sweden - have introduced individual, defined-contribution (DC) pensions as a substitute for all or part of the public, earnings-related pension.
In DC plans, contributions accrue in an individual account and the accumulated contributions and investment returns are converted into a pension when people retire.
Australia added a mandatory DC pension to its existing public, means-tested pension plan as early as 1992. In Denmark, industrial-relations agreements mean that more than 80% of workers are covered by a DC scheme.
Similarly, workers in the Netherlands and Sweden are generally covered by occupational plans. These plans are quasi-mandatory, meaning that they are negotiated between the social partners and cover more than 90% of the workforce.
In the Netherlands, nearly all of these are of the defined-benefit (DB) type, where benefits depend on years of contributions and some measure of individual earnings.
In Sweden, the chart shows the occupational scheme for white-collar workers, which currently has both DB and DC components. Norway made occupational plans mandatory in late 2005 (not shown in Figure 1). In Iceland and Switzerland, occupational pensions are mandatory. The government imposes complex rules regarding contribution rates, return and annuity conversion on these schemes, which mean that these are best described as DB plans.
Overall, one third of OECD countries involve the private sector in running part of the mandatory retirement-income system.
DC pensions are by definition pre-funded and there is significant pre-funding of the obligations of DB plans, such as the occupational schemes in Iceland, the Netherlands and Switzerland.
Some countries also pre-fund part of their public pension liabilities. The assets of these public pension reserves are shown in Figure 2.
Some of these funds are very large, amounting to nearly 40% of GDP in Japan and over 60% in Norway.
Others are currently small because the policy of pre-funding is a more recent one. However, assets in the reserves of Canada, Ireland and New Zealand, for example, are growing fast.
The involvement of financial markets in this pre-funding of public pension liabilities also varies significantly. In Canada, Ireland and Sweden, for example, equities make up around 70% of total assets of the funds, according to OECD Global Pension Statistics.
In contrast, the reserves of Spain and the US are invested entirely in non-marketable government bonds, meaning that financial markets do not play a role in financing public pensions.
Private mandatory pension plans
also invest in equities to varying degrees. In 2005, around 20% of Swiss and Australian private pension fund assets were in equities while the share was one third in Iceland and Poland and around half in the Netherlands.
2. Voluntary retirement savings
In countries with low mandatory target pensions (Figure 1), voluntary private pensions play an important role, particularly for middle and high earners. Without voluntary retirement savings, these workers could face a substantial drop in living standards in retirement.
Figure 3 shows evidence of take-up of voluntary private pensions - either personal or employer-provided plans - in a range of OECD countries.
Two groups of countries are highlighted. First, there are seven countries with very high pension mandates where private pension coverage is around 10% of the workforce.
This includes Greece, Italy,
Portugal and Spain in southern Europe along with Finland and Luxembourg. The size of the public pension means that people have little or no need to make private provision for retirement, including middle and high earners.
A second highlighted group consists of eight countries where the mandatory public pension is relatively small. Coverage of private pensions in this group averages around 50%. This group includes four English-speaking countries - Canada, Ireland, the UK and the US - where occupational pension plans and small public pension promises have long been the norm.
Germany has also long had broad coverage of occupational pension plans, but these have in the past provided only a small part of retirement income. With the reduction in the public pension for future retirees, the government has encouraged individuals to take up private pensions, a policy which has proved very successful, delivering overall coverage of the workforce of around 60%.
Coverage data, however, gives only part of the picture. In order to assess the importance of private pensions for the total benefit in each country, it is necessary to looks at the level of assets of private pension funds.
Figure 4 shows the assets of private pension funds. The countries with the most mature private pension schemes - Iceland, the Netherlands, Switzerland and the US - have private pension assets as large or nearly as large as annual GDP.
In contrast, countries that introduced private pensions as a substitute for the public pension within the last decade have yet to build up substantial assets.
This group includes Hungary, Mexico, Poland and the Slovak Republic. Similarly, while coverage of the new pension funds in Germany has increased rapidly over recent years, occupational pensions in the past
were financed by ‘book reserves’ on the balance sheet of the sponsoring employer and so there were no measurable assets backing the pension promise.
3. Will voluntary savings be enough?
The target average pension is low in many different OECD countries. Indeed, all of the G7 countries bar Italy have public pensions below the OECD average target replacement rate. In the UK, for example, the target pension is 30% compared with the 57.5% average. The difference between the two can be called the “savings gap”: it shows how much voluntary savings would need to be to reach the same average pension level as the OECD average.
Using standard actuarial techniques, it is possible to work out how much workers would need to save to plug this savings gap.
But more assumptions are needed: the rate of return on investments and how much of their career people actually contribute to pensions.
Following OECD Pensions at a Glance, the results are based on an assumption of 3.5% real annual investment returns.
If British workers contributed to a DC pension scheme each year from age 20 to age 65, then a contribution rate of 6.8% would fill the pension savings gap, delivering a retirement income of 27.5% of average earnings to take the total pension from the 30% provided by the public scheme to the 57.5% OECD average.
The pension savings gap in Japan is smaller than in the UK: the required pension is 23.7% rather than 27.5%. However, because Japanese people live longer than Britons, they need to build up a larger pension pot to provide the same retirement benefit. The required contribution rate to fill the pension savings gap is therefore the same in Japan as it is in the UK.
The gap between the public pension and the OECD average target pension is smallest (among the six countries studied) in France.
However, France has a normal pension age of 60. This compares with 65 in all the other countries, except the US, which will have a normal pension age of 67 for younger workers.
This means a shorter period in France over which contributions can accumulate. Workers who contributed each year from age 20 to 60 would need to pay in 3.3% of earnings each year to generate a pension of 9.4% of average earnings, the size of the gap between the public pension in France and the OECD average pension level.
The problem with voluntary savings is that people might not contribute for their whole careers. Younger workers may have more pressing financial concerns or might procrastinate over making retirement-savings decisions. Figure 5 therefore also shows the contribution rate required to fill the pension savings gap if people skip some years’ payments. UK or Japanese workers who delayed the start of their retirement planning from age 20 to age 30 (a quite likely scenario) would need to save 9.5% rather than 6.8% of earnings to plug the retirement savings gap. With people having children later, the starting point for retirement planning might reasonably even be age 40. In Japan and the UK, the required savings rate is by that point 15%, to make up for the missing years.
Monika Queisser and Edward Whithouseare senior pensions experts at the OECD in Paris.