Increased life expectancy is one cause of this demographic shift. According to a recently released
Green Paper by the European Commission on pensions, life expectancy in Europe has risen by five years in the last half century – and a further rise of seven years could occur by 2060.
Combined with low fertility rates, this age of aging will affect almost every aspect of society. In economic terms, its impact will be felt from growth and productivity to demand structures, innovation and labor markets. It will also strain public finances as increasing numbers of retirees rely on the public purse for a large portion or even all of their retirement income.
As chairman of the Pensions Commission (2003-2006), Lord Turner oversaw a report that ignited intense discussion on retirement income in the United Kingdom. Now chairman of the Financial Services Authority, he notes that indexation rule changes have been a dominant feature in European reforms. It can deliver significant long-term savings, he argues. “But, I suggest that the way the reforms have occurred have involved doing things, such as changing indexation, that people don’t really understand. As they begin to realize what has occurred, tensions will arise within the political process. Turner concludes, “The challenge will be to see if politicians will stick to it when the consequences slowly become more apparent to people.”
Yet, this aging need no longer fuel the “apocalyptic demography” headlines common at the end of last century.
Lord Adair Turner, chairman of the Financial Services Authority in the United Kingdom, says notions of a crisis are overstated now. According to Lord Turner, “The argument is that Europe is facing a crisis of aging and that it is failing to deal with it. I believe more has happened in the way of reform than we sometimes think and, at least in terms of the figures, a lot of progress has been made.”
He refers to a decade of reforms that have altered retirement systems across Europe. Traditionally, most countries were textbook examples of the dominance of public pay-as-you-go (PAYG) pension systems. This has changed. In an effort to spread retirement income of citizens across a wider base, governments initiated far-reaching reforms to create a multi-tiered structure for retirement provision.
These ranged from parametric changes, which redefined pension eligibility and indexation, to fundamental systemic changes, such as the introduction of funded schemes in Latvia, Poland and Sweden. In addition, almost every European country has increased the age of retirement (on average 61 years in the EU-27). France and Greece are the most recent, although this has galvanized opposition in France (see
The New Age of Retirement) and has the potential to cause further political tension across Europe.
Yet, despite the furor, as the EU Green Paper states, unless people, as they live longer, also stay longer in employment, either pension adequacy is likely to suffer or an unsustainable rise in pension expenditure may occur.
“I personally don’t believe that increasing the retirement age should be controversial, as it is obviously needed,” says Turner. “I think it is quite possible that life expectancy at birth could soon be over 100. I think the idea that you come out of university at the age of 25, that you work until you are 60 or 65 and then spend 35 years in retirement is a bizarre way to construct a society. We simply have to get used to the idea of how long people will live.”
European Old-Age Provision at a glance
Pre-tax public pensions range from a replacement rate as low as 30% for today’s average earners in the United Kingdom, to a high of 96% in Greece.
On average, nearly 50% of an average earner’s pay is covered by public pensions. Mandatory private pensions bring the average replacement rates closer to 65%.
In comparison, US workers with an average income receive a replacement rate of 40% from Social Security.
Nine of the EU-17 countries have established reserve funds to partially fund the public pillar; these are crucial players in the financial markets.
Pension reserve funds are driving and strengthening a trend toward socially responsible investing (SRI).
DC is often mandatory. In central and eastern Europe, in particular, privately managed retirement savings similar to 401(k)s are a standard feature.
Italy and the United Kingdom are both introducing auto-enrollment.
60 million workers (25%) participate in a DC plan.
European DC accounts hold over a trillion US dollars in assets.
Even though costs may be more sustainable in many countries, age-related public expenditure is still projected by the EU to increase by almost five percentage points of GDP by 2060. According to estimates, half of this is due to pension spending.
Further changes can be expected to continue the shift away from state provision toward retirement savings. Across the continent, public pension replacement rates (the ratio of post- to pre-retirement income) have been rolled back. To compensate, governments have stimulated capital-funded solutions. Private and occupational retirement savings have been encouraged either through tax incentives or through the introduction of new retirement savings schemes.
This is reflected in the shift toward defined contribution (DC) and away from traditional defined benefit (DB) schemes. Since 2002, Austria, France, Greece, Norway and the United Kingdom have all introduced second-pillar DC plans, adding to those that already existed. For some observers, the trend toward greater individual responsibility for retirement provision is another indication of the demise of the welfare state, the system that nannied Europeans from the cradle to grave. Yet, even if one paradigm may be passing, it does not mean that, in their search for a new one, Europeans are prepared to jettison their beloved ideal.
The European Dream (Penguin, 2005), Jeremy Rifkin, founder and president of the Foundation of Economic Trends, contrasted the unbridled opportunity provided for individuals to pursue success that lies at the heart of the American Dream with what he called the “European Dream.” He believes Europe has articulated a new vision, one that emphasizes “collective responsibility and global consciousness.” It is a dream focused not on amassing individual wealth, but “a sustainable civilization, based on quality of life.”
For organizations such as the
European Trade Union Confederation, the core of this dream is a social model where postwar social progress has matched economic growth. In their view, this distinguishes Europe from the US model, where small numbers of individuals are seen to have benefited at the expense of the majority.
The fallout from the financial crisis and the mood of austerity reigning after Greece’s near bankruptcy is challenging the European model. However, “social inclusion and justice” remain goals of the European Union, Elemér Terták, the director for the European Commission on Internal Markets and Services, reminded an audience of representatives of the asset management industry recently. Discussing funded plan design during the 2010 EFAMA (European Fund and Asset Management Association) Forum, he commented: If plan design proves inadequate and people save insufficiently, then “society is under a moral and social pressure to ensure people receive a monthly pension. We [society] do not accept that people can be left in penury in old age.”
Talking about “Europe” as if it were one entity is misleading. The continent stretches from Portugal to Bulgaria in the east, and from Scandinavia down to Malta in the south. Along the way, it embraces more than 500 million people, an estimated 230 languages (Source: Ethnologue) and an array of different cultures and levels of wealth.
Yet, a degree of convergence is happening, particularly in terms of DC. While a strong trend is noticeable across Europe, Europeans have not firmly embraced a DC approach that places 100% of all risk and responsibility on individual workers, such as the 401(k) plans of the United States. Instead, nations have tempered the rigors of DC to local cultural and social concerns. For example, a feature of the European approach is an emphasis on guarantees. Workers who watched the value of their 401(k) plans plummet during the financial crisis may be surprised that counterparts in a number of European countries can bank on at least receiving their contributions back when they retire.
In countries such as Belgium, Denmark and Switzerland, plans must even provide a minimum annual return (see
Secure Future). In the Netherlands, DC plans have a collective approach, so risks are balanced out between members. Such features blur the line between pure DC and DB plans. The results are hybrid plans that merge the features of both.
For Annamaria Lusardi, one of the strengths of DC in many European countries is that it doesn’t leave individual workers isolated when it comes to investment decisions. Denmark and Sweden have significant universal coverage through collective labor bargaining. “It is one of the things not really being done yet in the United States, but workers in the Netherlands, for example, are quite vocal about not wanting to be left alone,” explains
Lusardi, the Denit Trust Chair of Economics and Accountancy at George Washington University.
For Lusardi, who studied in Italy before moving to the United States, the collective bargaining approach recognizes the difficulties individuals can have when it comes to complex investment decisions. “It makes sense to mimic defined benefits so that, although the money goes to a private account, decisions are made centrally. Individuals are no longer confronted with intimidating decisions; such an approach can help enhance returns and provide bargaining power when it comes to fees.”
Europe has also innovated in terms of applying DC to the first pillar. Many countries have established a strong link between contributions and benefits in the public pillar by introducing a notional defined contribution (NDC) system. Under this, contributions are recorded in notional individual accounts. Contributions are often credited with a rate of return in line with average earnings growth, and later benefits depend on the accumulated sum. The final monthly benefit may also be calculated based on the life expectancy of that age cohort.
Although old-age provision within Europe has undergone dramatic change, it cannot be said reforms are finished – far from it. The changes have ramifications for public policy and the finance industry. For example, the regulation of funded schemes, the effectiveness of plan design, the risk management of investments, the design of the payout phase and the quality of financial products become questions that will shape the financial security of many future retirees.
There is also the question of adequacy. In a period when replacement rates are falling, people in countries like France and Germany, where contributions to private retirement savings arrangements are not high, could find old-age income inadequate to meet their needs. Regulators need to complement cuts by tackling the hard issue of pushing back the retirement date and encouraging retirement savings to compensate for replacement losses from the first pillar. “Mandatory” and “auto-enrollment” are likely to be phrases commonly heard in discussions on reforms as voluntary methods of saving appear to have limited results.
Then there is the vexed issue of national borders, which pose obstacles to the mobility of workers across Europe. Fabio Galli, director general of Assogestioni, the Italian association of asset management companies, says each nation believes its system is the one that best fits its own circumstances, but this attitude does create problems for pan-European approaches.
“Americans were perhaps fortunate to have developed a DC scheme almost by mistake through a small tax provision that developed into a fully fledged second pillar. If Europeans stick to their approach of allowing national systems to evolve into a common model, it will take about a hundred years.” While plan providers will increasingly try to promote similar DC plans across Europe, national tax incentives, social and labor laws, and investment restrictions imply that pan-European DC products are unlikely to emerge any time soon.
The EU Green Paper addresses the complexity of retirement issues confronting public authorities, social partners, industry and civil society at national and EU levels. Adequate, sustainable and safe retirement is seen as a key for the EU to maintain its social cohesion, while the impact of public finances in one nation can have a serious repercussion on the financial health of another, as was seen during the crisis in Greece.
Yet, even if they address all of these issues and salvage the welfare state in a new form, noted scholar Gøsta Esping-Andersen believes there is one unknown variable in the retirement equation: That is the hiring and firing policy of the private sector.
“If the private sector continues, as it has done in past decades, to lay off workers at ever earlier ages in the name of profitability, then attempts to reform pension systems are in trouble. The average citizen needs a guarantee that, by prolonging their working life and taking fewer retirement years, they will not be at risk due to the employment strategy of firms.”