The effects of longevity on financial vulnerability, Think Forward Initiative Summit 2018

Many people think that they are cautious and taking proper care of their future. They make precautionary savings and employ various strategies to try to make sure they are not out of money if they cannot work because of illness, or when they retire. Choices differ between people, depending on their financial situation, degree of optimism and attitude towards risk, but many are not saving enough for their old age.

A large fraction of elderly individuals cannot afford necessary out-of-pocket health expenses – those not covered by the public health system – towards the end of their life. As argued by Marshal et al. (2011), the elderly from the bottom quartile of income spend roughly 30% less on out-of-pocket healthcare expenses than the median. Out-of-pocket expenditure covers items such as prescription drugs, home health care and helpers and physiotherapy, all of which have been shown to have a substantial positive effect on life expectancy (Hemmelgarn et al. 2007,  Mohile et al. 2015, Lilley et al. 2016).

So, how can people make the right decisions about how to save? One way to think about it is to take into account life expectancy: how much longer is my individual birth cohort expected to live? The increasing life expectancy as observed among current elderly individuals substantially understates the life expectancy of the  current young and middle-aged. Within 20 years, an average 65 year old can expect to live for five to seven years longer than a person turning 65 now. This impressive increase in life expectancy also comes with improved health and thus potentially brings about quality years of life. Unless we are able to fully internalise the consequences of increased longevity, we are all running the risk of saving too little. Consequently, longevity increases the financial vulnerability of the elderly: if savings are insufficient to supplement consumption after leaving the labour market, as we age, we run a greater risk of old age poverty.

This risk will be more acute in countries which have implemented a defined contribution (DC) pension system. DC pensions pay out what was contributed during the working years, as opposed to defined benefit (DB) schemes, where a fixed share of pre-retirement earnings is paid out. In the late 1990s and early 2000s, many Central and Eastern European countries implemented DC pension systems, which yield substantially lower pension benefits relative to those paid to retirees at present. The generations currently working in those countries are therefore likely to experience two negative surprises at once. First, their pension benefits will be lower than currently observed. Second, their own savings will have to last over a longer life expectancy. As a consequence, we should expect increasing financial vulnerability among pensioners, and high poverty rates among the elderly. The changing proportions between working years and years in retirement imply that those in a DC pension system, contributing about 20% of wages for old age benefits can expect a replacement rate of no more than roughly 30% of their average monthly earnings. That is, pension benefits will be no more than a half of what we see currently (60%), relative to earnings. 

For high-earning professionals, effectively holding a well-paid job all their lives, 30% of their average annual earnings can still be enough to support a satisfactory lifestyle, even if it that lifestyle is substantially lower than during the years of their active professional career. But for medium or low-earners,  paying for out-of-pocket health care expenditure of several thousand euros per month may be impossible, thus limiting their life expectancy, let alone quality of life towards the old age. Making ends meet for a greater part of old age may appear feasible, but for many individuals the 30 years of career may comprise some periods of career interruptions (such as job-seeking or inactivity) as well as periods of relatively lower earnings. Many individuals will become at risk of poverty.

Once we account for this heterogeneity, we can simulate the future evolution of poverty and old age poverty in the decades to come, as longevity progresses. We do that for six Central European economies, because at the turn of the Millennium they all replaced a DB system with a DC one. This means that all Millennials will collect pensions from a DC system.

If life expectancies were not increasing, income inequality could decline, as all individuals would be subjected to the stronger incentives of the DC system. This appears to be the case for Poland, Bulgaria and to a lesser extent, Hungary. The heterogeneous reaction to the labour market incentives under DC pension systems contributes to larger income inequality in the Czech Republic, Slovakia and Romania. These diverse paths of income inequality reflect the fact that the ability to adjust labour supply across these countries differs.

Longevity leads universally to a substantial increase in income inequality. The Gini ratio – a commonly used measure of income inequality − will increase by at least four percentage points and in some countries by much as 14 percentage points. This rise is substantially bigger than experienced by those countries when transitioning from central planning to a market economy. These large income effects contribute to higher poverty for those individuals who chose not to, or were unable, to increase the amount they worked,in reaction to the reform. Hence, the overall rise in poverty rates after replacing DB with DC systems stems from two sources: lowering pension benefits under longevity in the DC scheme and growing income inequality.

The scope and direction of changes in savings patterns will depend on the extent to which one is willing to give up current consumption in exchange for a lower decline in consumption at old age. Some individuals particularly value a smooth lifetime path of living standards and are thus willing to accumulate more savings. Some other individuals prefer to take out substantial loans to smooth consumption over lifetime. For others, low consumption in the future is not enough of a driver for current decision making. Expecting a decline in pensions due to an increase in life expectancy, some households accumulate more private, voluntary savings, but for others it is optimal to continue with some level of indebtedness. The net effect of these changes depends on the population structure and country-specific distribution of preferences. In all six countries, the majority of social groups will substantially increase their savings. However, in Bulgaria and especially in Poland, debt-taking intensifies as well.

Our simulation finds that wealth inequality − accumulated assets such as housing, stocks, savings − rather than income inequality, increases in Poland, remains stable in Bulgaria and declines in the remaining four countries: Czech Republic, Hungary, Romania and Slovakia. Behind the growth in inequality lies the persistent indebtedness of some social groups in Poland and to a smaller extent in Bulgaria. Noticeably, individual debt levels in the four countries is low already with current life expectancy and will further decline with longevity. Meanwhile, in Poland it is high and will increase with longevity. Consumption inequality increases in the six analysed countries by roughly three to five percentage points when measured by the Gini ratio, i.e. more than in Spain and Greece during the global financial crisis and fiscal crisis.

An increase in indebtedness and persistently low consumption paths show that with longevity, the position of the vulnerable groups worsens relative to what is observed currently. A further decline in voluntary savings and high indebtedness further increases  the relevance of social as well as macroprudential risks. Meanwhile, further increases in wealth accumulation is bound to increase liquidity in the financial system, ushering in the risk of excessively lax regulation on credit.

In the six analysed economies, individuals have a heterogeneous ability to save due to unequal access to financial instruments. Prior to the reform of the pension system, we assumed that some individuals were able to consistently put aside a higher fraction of their income. Pension system reform provides incentives to both increase the hours worked and raise the share of earned income set aside for old age consumption. These incentives interact with longevity, changing the optimal set of decisions.

We checked what would happen if access to financial instruments was made universal for everyone. This was analysed alongside demographic trends.

Fostering equal access to saving instruments reduces (old age) poverty in all six of the countries analysed. Equal access does not need to imply that everybody saves the same amount - quite the opposite: savings can continue to reflect preferences for smooth lifetime consumption as well as expected longevity and macroeconomic tendencies. A reduction in poverty is large enough to counterweight otherwise dominant trends related to longevity. The fact that equal access to financial instruments outweighs the effects of demographic processes shows the scope for potential policy to mitigate old age poverty. The report discusses empirical evidence related to financial instruments which address the problems raised by longevity. We show how they could be expanded to encompass a large share of populations across Europe, as we age.