Pensions, Purchasing-Power Risk, Inflation and Indexation
Pensions are inherently risky because they are long-term contracts, which complicates financial planning for individuals and governments. If things turn out better than expected, who will reap the gains? If things turn out worse, who will bear the cost? No one wants to bear risk, but, in most cases, someone has to. Risks in pension systems have, in the past, been poorly measured or even just ignored.
This paper is part of a series that examines how different kinds of uncertainty affect retirement
incomes. The first of these papers (Whitehouse, 2007) looked at life-expectancy risk: how much of the cost to retirement-income systems of longer lives will be borne by individual retirees, in the form of reduced benefits or later retirement? How should this life-expectancy risk be allocated between generations?
The second and third papers in the series analyse investment risk. Using historical data, the first of these papers measures the degree of uncertainty in investment returns (D’Addio, Seisdedos and Whitehouse, 2009). The second – Whitehouse, D’Addio and Reilly (2009) – looks in detail at the impact of financial-market performance on retirement incomes and government budgets.
This paper, the fourth in the risk and pensions series, looks at inflation and indexation. Most OECD countries have automatic adjustment of pensions in payment, usually to changes in prices, average earnings or a mix of the two. However, these indexation rules have often been overridden, meaning that individuals bear a greater risk in practice than the legal position sets out.
This paper examines indexation policies and actual practices using data for 18 countries for up to 45 years. It examines policy questions, such as: Should pensions be indexed? If so, should they be linked to prices or earnings? How should the index be calculated? What role is there for progressive indexation policies, which give higher increases to lower pensions?