Pension reforms don’t consider human nature

Change the rules and you change behavior. What may seem obvious is being overlooked by a number of European governments

Richard Wolf

The almost tautological relationship that lies at the core of Sam Peltzman’s argument of unintended consequences is almost as old as the discipline of economics itself. In 1850 Frédéric Bastiat distinguished between the “seen” and “unseen” effects of policy. To him, foreseeing the unseen was the aim of economic thinking.

Although psychologists and behavioral economists have since dissected how people form decisions, the implications of new regulations on human actions are often hard to analyze. This is particularly true of pension policy as it potentially embraces almost every aspect of an individual’s life: how long they will work, how much they consume or save, their development of skills and even family planning.

However, 125 years of pension policy has yielded vast experience as to how people react to, for example, changes in retirement age or disincentives to insure against longevity risk. Yet, it appears as if many recent pension reforms are aimed at seen short-term benefits and fail to consider the unseen but known long-term effects.

AN EARLY-EXIT HABIT

Germany’s recent introduction of early retirement at 63 for people who contributed to the system for 45 years is an example of reform with foreseeable consequences. In, Germany’s Federal Ministry of Labor and Social Affairs calculated the costs to be €900 million ($977 million) for the remainder of, and that 200,000 people would take the option in the first year.

But the number of new early retirees was reached within six months and costs ballooned out to €1.5 billion. The depressing aspect was that it was predictable. It is highly rational for people to respond to such incentives and, once introduced, early retirement quickly becomes the standard.

In, half of all eligible men in France, Italy and the Netherlands retired before the age of 60, and even today 90% of the working population in Austria retires well before the official age of 65. Early exit is popular because benefits are often granted without actuarial adjustment. This means that not only can you stop working earlier but you actually penalize yourself if you do work longer.

In Germany, working two additional years compared with using the new early retirement option reduces a retiree’s pension wealth by around 5%, so it was obvious what eligible workers would do. Even worse, the recent policy represented a retrograde step, as reforms of the early had closed early retirement loopholes and incentivized people to work longer, reversing a long-term sinking effective retirement age.

Lamborghini effect

Another foreseeable consequence will occur due to the UK decision to allow retirees to cash out their DC pension pots in a lump sum instead of an annuity without a tax penalty. As experience in Australia, New Zealand and elsewhere shows, this will lead to a collapse of the annuity market leaving retirees without longevity coverage (see “How to avoid the UK pension blues”).

Short-term political success over the long-term good appears to dominate pension policy in EuropeThis can also create incentives for retirees to game the system. “Double dipping” is seen in Australia where workers can access Superannuation savings at age 55 – ten years before the eligible age for pension benefits. So, retirees can spend their savings for a decade and then obtain state benefits. This is a profit maximizing strategy for the individual.

Similarly, the UK government decision will increase tax revenues with people splurging retirement savings on cars, housing and holiday. Known in the media as the “Lamborghini effect,” this could even provide a short-term boost to economic growth. However, the tab will be paid by future generations who may face higher taxes to address higher rates of old age poverty.

Paved with bad intentions

At the turn of the century, eastern European countries realized that their inherited soviet-style retirement systems were not capable of handling the challenges of an aging society. Most countries introduced multi-pillar pension systems, which included a mandatory occupational pillar that would provide citizens with adequate retirement income once generous first pillar benefits phased out.

The region is now experiencing a dramatic roll back of these reforms. During the height of the financial crisis, Hungary tapped into the honey-pot of funded pensions to finance excessive budget deficits. Accumulated assets were exchanged into first pillar pension entitlements, which simply shifts painful austerity measures into the future.

In, the Polish government followed by taking 51.5% of the pension fund’s assets in exchange for a credit in the countries NDC system. In addition, the capital-funded system is no longer mandatory and new entrants have to actively opt-in.

In this instance, the government is exploiting inertia, the tendency to stick with the status quo. This is one of the most hardwired biases in human behavior to overcome and means that all social security contributions will be channeled to the statutory system where they will likely stay as the window to voluntarily opt-in to the second pillar only opens every four years.

According to calculations by Allianz, the ability of the Polish retirement system to generate adequate retirement income for individuals will deteriorate. Today, an average income earner who started working from 24 birthday and will retire in the near future can expect about 70% of his last salary in retirement benefits. Until, this could drop to about 35%, which will increase the already high risk of widespread old-age poverty.

This akrasia of preferring short-term political success over the long-term good appears to dominate pension policy in Europe. Whether it is campaign goodies offered at the expense of pension sustainability, tax revenue instead of a life-long retirement income or easy fiscal consolidation in preference to long-term pension adequacy, rule makers seem happy to leave known long-term consequences unseen.

Pension reforms don’t consider human nature

Change the rules and you change behavior. What may seem obvious is being overlooked by a number of European governments

Richard Wolf

Pension reforms don’t consider human nature

Change the rules and you change behavior. What may seem obvious is being overlooked by a number of European governments

Richard Wolf

Thinking beyond 65

Greybeard workforce prevents wealth loss

Pension savings under pressure

Living in a world of 11 billion