Ageing and the Payout Phase of Pensions, Annuities and Financial Markets
While the immediate concern is the current financial market crisis, the key challenges for pension systems over the medium and long-term are dealing with the implications of population ageing, the design of the payout phase of pensions, in particular the type of products to channel assets accumulated in defined contribution (DC) pension plans (e.g. life annuities), as well as examining the role that financial markets can play in providing adequate private pensions.
Population ageing is the result of steady increases in life expectancy and of fertility rates falling back from the high level reached in the 1950s and 1960s.1 This hump-shaped profile of fertility rates has created the so-called the “baby boom”, that is, a generation or cohorts that are larger than the preceding and subsequent cohorts.
Consequently, the impact of the “baby boom” is temporary as the cohorts born during the high fertility years pass away. The impact of increases in life expectancy, on the other hand, is of a more permanent nature, bar wars or pandemics.
The implication of population ageing is an increase in the number of people of retirement age as a share of the working age population. The retirement of the baby boom generations will increase this share as those cohorts retiring will be followed by smaller cohorts. Similarly,improvements in life expectancy directly increase the number of people in retirement, ceteris paribus, as people live longer.
The increase in the number of people in retirement relative to the number of people of working age creates serious financial troubles to PAYG-financed pensions (generally public pensions) as well as to funded pensions (generally, private pensions). Public pensions would see the number of people contributing dwindle relative to those withdrawing benefits, increasing public expenditure on pensions. Moreover, the manner in which public pension systems are designed creates incentives for people to retire early, compounding the demographic impact on public pension expenditures (Duval, 2003).
Population ageing will also affect private pensions through its impact on financial markets, in particular, on portfolio allocation and returns on investment. Portfolios based on life-cycle considerations may increase their share of bonds as the average age of the working-age population increases. Consequently, returns on investment may fall slightly while risk decreases. Additionally, increasing life expectancy also directly raises the amount of savings needed to maintain a certain standard of living at retirement.