PROJECT M
 
Jack VanDerhei
Pablo Antolín-Nicolas
Renate Finke

Conference Call: Adequacy

The question of adequacy is gaining relevance as policy makers focus on redesigning social systems. The notion of adequacy itself, however, lends itself to debate. In this conference call, Jack VanDerhei of the EBRI, Pablo Antolin-Nicolás of the OECD and Renate Finke of Allianz discuss how to treat this elusive concept

Conference Call: Adequacy

The question of adequacy is gaining relevance as policy makers focus on redesigning social systems. The notion of adequacy itself, however, lends itself to debate. In this conference call, Jack VanDerhei of the EBRI, Pablo Antolin-Nicolás of the OECD and Renate Finke of Allianz discuss how to treat this elusive concept


Renate Finke

Adequacy is a topic that has gained in importance after recent pension reforms. These aimed to regain sustainability in the first pillar and often fostered funded pensions. The idea was right, but the financial crisis has brought new challenges. Now, we must address the topic again and rethink the approach.

Jack VanDerhei

The question is whether pay-as-you- go (PAYG) public pensions are sustainable. If we are going to pay less in pensions, are we going to increase the private pensions component? And, if we are going to do this, by how much? This “how much” needs to be defined as a target retirement income individuals should aim to achieve. The next step in defining adequacy is to see how much people have and to see how big is the gap. This is the analysis we are undertaking at the OECD.

Renate Finke

Jack, discussion has been quite intense in Europe. Is it similar in the US?

Jack VanDerhei

Yes, very intense. Within the last two years, EBRI has testified at three Senate hearings and a Ways and Means hearing on this issue.

Jack VanDerhei

What definition of adequacy do you or EBRI work from?

Jack VanDerhei

For me, adequacy can be defined as anything from being able to replicate some stated percentage of pre-retirement income, to retaining one’s pre-retirement standard of living, to having enough to cover basic expenses plus uninsured medical costs in retirement.
For public policy analysis, EBRI defines adequate retirement income as having enough financial resources to cover basic expenses plus uninsured medical costs in retirement at least X% of the time. X can take several values. We start at 50% in large part because that is what an individual implicitly assumes if he or she uses average longevity, average rate of return assumptions, average retiree expenditures, etc., when using some of the more rudimentary retirement planning models.
However, since most individuals would not be comfortable coming up short half the time, we also provide projections with 75-90% probabilities of success.

Renate Finke

Has there been a tendency to focus on sustainability and to miss adequacy?

Jack VanDerhei

I don’t think so. Most countries that have undertaken reforms have introduced incentives to join occupational DC pension plans or have implemented such plans, like the Riester Rente in Germany. So, there has been a recognition that making PAYG systems sustainable requires increasing savings in other sources to finance retirement.

Renate Finke

Pablo, in a way, that is correct, but in a number of countries this was done on a voluntary basis and people were hesitant to take up the schemes, although, as in Germany, the results were directly integrated into calculations showing the benefits the “standard retiree” could achieve. But in a transition from where people did not have to think much about pensions to a system where additional saving is necessary, this can lead to a huge gap. People are realizing they have to adjust their behavior and policy-makers should monitor this more closely.

Renate Finke

On a slightly different topic, it’s commonly said that a 70% replacement rate is sufficient for retirement needs. I know that is an average and it depends on many parameters whether it is appropriate, but, Pablo, I was wondering if you feel that was roughly correct?

Jack VanDerhei

This is difficult. Is it 70%, or better said two-thirds, of your final salary? I don’t think this is a correct measure. There are problems with replacement rates depending on whether the person was in full or part-time employment before retiring. Also, replacement rates are fixed in time. As you go forward in retirement, even though your pension benefit compared to your final salary is still constant, your position in the income scale might change. It then becomes important whether your benefits are inflation-indexed or not, or indexed to incomes. The point is that just looking at final salary can be misleading.
But then there is another complication. It is not the same for a person at the lower end of the income scale as for an individual at the upper end. An individual at the lower end of the scale may need more benefits to substitute past salaries than a person at the higher end. One can say that someone with a lower income needs 100%, a middle income two-thirds and a higher income 50%.

Jack VanDerhei

A general question is, do you think we should consider other sources to finance retirement when we take into account whether income is adequate or not?

Renate Finke

Yes, we should, as the reform process was precisely set in this direction. If governments foster additional pension schemes and focus on complementary savings, we should include them in the analysis, otherwise governments may as well redirect subsidies to other, possibly more productive, investments.

Jack VanDerhei

Yes. In our analysis, we include Social Security – both status quo and several reform scenarios, defined benefit and/or defined contribution plans, IRAs (regular, Roth and rollover) and net housing equity. We also include non-tax-advantaged savings in some scenarios and any salary that may be earned beyond the age of 65.

Renate Finke

Avoiding poverty is the primary goal and that is a right target. But that doesn’t mean that it is an adequate retirement income Pablo Antolin-NicolasIt has been suggested that to motivate people to develop adequate savings, there has to be some kind of ‘specter.’ Is avoiding poverty the right approach?

Jack VanDerhei

No, I think that is too limited. I believe it is important that we define adequacy, because as a question it comes down to will you have ‘enough’ financial resources available to sustain yourself throughout your post-working life? It would be helpful to those attempting to rely on definitions of adequacy, if the individuals and organizations making claims about their results would be clearer about the assumptions they make in defining their inputs, and the projected outcomes.
At EBRI we developed a Retirement Security Projection Model with a stochastic decumulation model in addition to an accumulation model to simulate adequacy. Any other approach means generally relying on a target based on deterministic assumptions and a likelihood of failure that most people would likely find unacceptable.

Jack VanDerhei

Avoiding poverty is one goal, but pensions have traditionally had three. One is avoiding poverty, the second is redistribution, and the third, which is the most important part from our point of view, is saving for retirement Obviously, PAYG systems try to fulfill the role of avoiding poverty and some redistribution – as well as pushing people to save for retirement. The funded concentrate more on saving for retirement. So, yes, avoiding poverty is the primary goal, and that is a right target. But that doesn’t mean that this is an adequate retirement income. If everyone is at the poverty level, then fine – people have enough to eat and live, but they haven’t saved to maintain their living standard.

One way to get a handle on adequacy is a general measure by different socio-economic characteristics – income, gender – and then look at the consumption patterns. Unfortunately, focusing only on consumption patterns has the problem that some retirees don’t consume more because they don’t have more money.

Jack VanDerhei

If people save for retirement from wage contributions, the aim should be more than poverty prevention Renate FinkeSo, is consumption based on actual desire or on constrained income?

Renate Finke

I agree. Targeting “avoiding poverty” is really the lowest approach as it leaves out schemes which are earnings-related. If people save for retirement from wage contributions, the aim should be more than poverty prevention – especially compared with people who do not have a comparable working career or no working career at all. To avoid poverty, governments have instituted welfare programs – and that should be the basis. Earnings-related retirement schemes should reach further and aim at higher levels.

In all, defining adequacy is not an easy task. There is a wide variety of definitions and approaches and personal perceptions. Governments need to clearly define what is adequate because they design, redesign and adjust pension systems as they set the framework and give incentives for people to reach the targets.

Jack VanDerhei

Adequacy is complicated. The answer will be different for different income groups, and it will be different for genders and various economic statuses. At the OECD we understand that governments and policy-makers want just one number, but one number is wrong. Low-income people may need more income as a share of their final salary than high-income people.

Jack VanDerhei

I beg to disagree. I think it is a simple concept, just extremely difficult to model accurately. If you mean that it can be subject to many different definitions, depending upon the definer’s point of reference, then it will have wide variations.

Renate Finke

Thanks to you both for your time. Without doubt, this is far from the last word on the subject.

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