Life expectancy and pensions:High-class problem or calamity of so long life?

Edward WhitehouseHead of Pension Policy Analysis

OECD

Motivation

• “I’ve often said that this is a high-class problem. It’s the result of something wonderful: the fact that we are living a lot longer.”(Bill Clinton, President of the United States, 1999)

• “What dreams may come when we have shuffled off this mortal coil must give us pause: there’s the respect that makes calamity of so long life.” (Hamlet, Act 3, scene 1)

Definitions

• Longevity risk– Without annuities, people might outlive retirement

capital, because how long individuals live is uncertain

• Life-expectancy risk– The average length of life of a cohort is uncertain

• During retirement, this risk is borne by the pension/annuity provider

• Focus here is on life-expectancy changes in the period between paying pension contributions and drawing benefits

Who bears life-expectancy risk?

• DB and points schemes– Life-expectancy risk borne by pension providers– Government or employers– But ultimately, by taxpayers or shareholders

• DC and notional-accounts schemes– Pre-retirement life-expectancy risk borne by individual

retirees through annuity calculation

How large is life-expectancy risk?

Modelling mortality

• Use extrapolative (rather than biological) methods– Pioneered by Lee and Carter

• Three stages in the process1.Data on past changes over time in mortality by age2.Distribution of past changes in mortality by age 3.Simulation of future mortality changes based on the

data

Changing mortality rates

0

50

100

150

200

250

1945-1949 1950-1954 1955-1959 1960-1964 1965-1969 1970-1974 1975-1979 1980-1984 1985-1989 1990-1994 1995-1999 2000-2002

Men aged 50-54, G7 countries, 1945-2002, relative to Japan in 2002Source: Human mortality database

Mortality-improvement distribution

Mortality improvement for men aged 60-64 over five-year periods,G7 countries, 1945-2002

0

25

50

75

100

-20 -15 -10 -5 0 5 10

Percentiles of distribution

Life-expectancy uncertainty

Baseline 5% 25% Median 75% 95% Life expectancy (years) Men 15.1 20.1 19.1 18.5 18.0 17.1 Women 18.7 23.7 22.8 22.2 21.7 20.9 Change (years) Men 0.0 +5.0 +4.0 +3.4 +2.9 +2.0 Women 0.0 +5.0 +4.1 +3.5 +3.0 +2.2

Note: OECD average. Source: Baseline mortality rates from UN/World Bank database, projections by OECD

Who bears life-expectancy risk?

Allocating life-expectancy risk• Use standard measures of pension entitlements:

– Average pension level and average pension wealth (relative to average not individual earnings)

• With a pure DB pension system:– Pension level constant with changing life expectancy– Pension wealth higher for higher life expectancy

• With a pure DC pension system:– Pension level falls with higher life expectancy– Pension wealth constant with changing life expectancy

Structure of pension systems• Schemes where entitlements change with life

expectancy– DC– Notional accounts– DB with adjustments

• Schemes where entitlements constant with life expectancy

• Schemes where entitlements offset effect of life-expectancy changes on other parts of the system

Impact of recent pension reforms Defined

contribution Notional accounts

Benefit levels

Qualifying conditions

Australia Canada Denmark Finland France Germany Hungary Italy Japan Mexico Norway Poland Portugal Slovak Republic Sweden United Kingdom United States

Structure of pension systems

0 25 50 75 100

United States

United Kingdom

Japan

Canada

Norway

Hungary

Slovak Republic

Australia

France

Sweden

Denmark

Mexico

Portugal

Finland

Germany

Poland

Italy

Offsets link to life expectancy

No link to life expectancy

DC

Notional acs

DB+adjustments

Average pension level

0

25

50

75

High Median Low

FranceUnited States

United Kingdom

Japan

Canada

Norway

Australia

Hungary

0

25

50

75Denmark

Sweden

Slovak Republic

Italy

Mexico

Finland

Portugal

Poland

High Median Low

Weighted average pension, per cent of economy-wide average earningsunder three scenarios for future life expectancy

Average pension wealth

0

2.5

5

7.5

10

12.5

France

Australia

Japan

Hungary

Canada

United Kingdom

United States

Norway

High Median Low0

2.5

5

7.5

10

12.5

PolandPortugal

Finland Italy

Mexico

Sweden

Slovak Republic

Denmark

High Median Low

Weighted average pension wealth, multiple of economy-wide average earningsunder three scenarios for future life expectancy

Poland

United States

Life-expectancy risk on individuals

0 25 50 75 100

United Kingdom

Japan

Canada

France

Norway

Australia

Hungary

Germany

Denmark

Slovak Republic

Mexico

Sweden

Italy

Finland

Portugal

*

Life -expectancy riskborne by individual retireesper cent of total

Conclusions and policy implications

Pension reforms and their motivation

• What did countries do?– 12 out of 18 OECD countries that had major pension

reforms in the last 15 years have introduced some link to life expectancy

– 8 with DC, 3 notional accounts, 3 link DB pension levels to life expectancy, 2 link DB qualifying conditions

• What were the motives?– Privatisation– Justify benefit cuts– Other parametric changes (early retirement etc.)

Sharing life-expectancy risk

• Who now bears life expectancy risk?– Individual retirees bear just 10% in Norway and

30% in Australia– In Poland and Portugal this is 100% or more– No systematic relationship between type of life-expectancy

link and allocation of risk

• How should life-expectancy risk be shared?– Living longer is a ‘good thing’, so difficult to see

why beneficiaries shouldn’t bear some of the associated cost

Future developments

• Which countries next?– 17 OECD countries do not have a life-expectancy link in

mandatory pension system– Case for life-expectancy links is strongest in countries

with large mandatory pensions, e.g. Austria, Greece, Luxembourg and Spain with high public pensions