Chapter 12: Public Pensions

Historically, families cared for the elderly, In modern society, elderly care has fallen on

societyRetirement income is broken into 3 categories:

1) Old Age Security Program ($29 billion in 05-06, financed out of government revenue)

2) Pension Plans ($32.8 billion in 05-06, financed by payroll taxes on employees and employers)

3) RPP and RRSP ($57.7 billion, covered in Econ 353 - Economics of Taxation)

Chapter 12: Public Pensions

Why Public PensionsEffects of Public PensionsOld Age Security ProgramCanada Pension PlanConclusion

Theory - Why Public Pensions?

The justification for publicly provided retirement income include the “usual suspects”:

1) Paternalism

2) Redistribution

3) Adverse selection

And Public Pensions Carry 2 additional considerations:

4) Inflation and Timing

5) The Samaritan’s dilemma

1) Paternalism

Public retirement income due to a sense of paternalism comes from 2 sources:

a) People who don’t plan for the future (due to nearsightedness or high discount factors)

b) People who inaccurately plan for the future (not considering future costs or inflation)

Is it right for the government to force saving for old age?

2) Redistribution

Old Age Security Program has redistributive elements because:

a) It is funded out of taxes, which are redistributive

b) Old Age Pension has a clawback

c) The Guaranteed Income Supplement (Low income add-on to the Old Age Security) is a NIT

2) Redistribution

This setup is preferable to welfare because:

i) The elderly have unique characteristics which are best met by a unique plan

ii) Income support through a “pension” is less stigmatic than collecting welfare

iii) Intergenerational redistribution is allowed for (if one generation is in a recession and the next is well off)

3) Adverse SelectionRetirement could be funded through a life

ANNUITY, where an individual pays an upfront cost for a yearly income until they pass.

This suffers from ADVERSE SELECTION• some (healthy women) live longer and want an annuity

more than others (unhealthy men) who live shorter

The private market would result in high costs, low participation, and higher costs for women

Through mandatory government pensions, adverse selection is avoided and statistical discrimination is also avoided

4) Inflation

Private annuities are unable to guarantee a yearly income that increases with inflation

Government pensions, however, automatically adjust to inflation as taxes automatically adjust with inflation

4) Funding TimingPrivate pensions have to be funded by a

pensioner’s past contributions (grows with r)

Public pensions can be pay-as-you-go, funded by current payments (grows with growth of wages and salaries)This is better if wages grow faster than interest rate,

which occurred in 1960’s and 1970’sSince 1980’s wage rates have grown slower than

the interest rateThis financing caused huge problems, resulting in

major changes in 1998

5) The Samaritan’s DilemmaSociety wants to take care of the elderly, BUT, if

a young person knows he will be taken care, of, he has an incentive NOT to save for the future.

The Canada Pension Plan, RPP, and RRSP portion of Retirement Income, through required payroll contributions, forces individuals to work towards their retirement income somewhat.

Perhaps the Old Age Security Program still suffers slightly from this attitude

Theory - Public Pensions and Economic Behavior

Pensions may have an impact on two areas of economic behavior:

1) private savings

2) work effort (through retirement age)

PRIVATE SAVINGS are influenced through public pensions through 3 effects:a) Wealth substitution effect

b) Retirement Effect

c) Bequest Effect

1a) Wealth Substitution EffectTo analyze the wealth substitution effect, one

needs to examine the LIFETIME BUDGET CONSTRAINT and LIFETIME UTILITY:

-A person’s lifetime is summarized in two periods:

1) Now (when you work) with income I0 and consumption c0

2) Future (retirement) with income I1 and consumption c1

1a) Wealth Substitution Effect-A person’s consumption can:

1) Occur entirely in the period income is made (THE ENDOWMENT POINT)

2) Increase in the future. Sacrificing savings S now produces extra consumption S(1+r) in the future

3) Increase now. Borrowing B now reduces consumption by B(1+r) in the future

This gives us the INTERTEMPORAL BUDGET CONSTRAINT:

INTERTEMPORAL BUDGET CONSTRAINT

Lifetime UtilityUsing a lifetime

indifference curve and tangency, we can see how much a person will save or borrow

In this case someone saves

1a) Wealth Substitution EffectA public pension plan forces savings for a

benefit in the future, moving the endowment point up on the budget constraint

An individual therefore DECREASES private savings to reach their optimal lifetime consumption

WEALTH SUBSTITUTION EFFECT – Individuals save less in anticipation of the fact that they will receive public pension benefits after retirement, ceteris paribus

1bc) Retirement and Bequest Effects

RETIREMENT EFFECT – Pensions induce people to retire earlier, resulting in fewer working years and more retired years, INCREASING savings during working years

BEQUEST EFFECT – Public pensions shift income from children (workers) to parents (retired). People therefore INCREASE savings to make up for this and leave an inheritance to their children

Savings resultsWhy Do We Care?

-Because Canadian pensions are funded in a pay-as-you-go fashion, their savings don’t result in investment, whereas PRIVATE savings does lead to investment (and therefore economic growth)

Empirical Results?

-Studies have shown pensions both increasing and decreasing savings (often calculated through the increase or decrease to consumption)

2) Work Effort/ Retirement AgePensions give an incentive to retire early:

They enable early retirementTheir “clawback” makes work less attractiveFrom 1960 to 1999, age 55-64 men in the

labor force fell from 87% to 61%BUT other factors also affect retirement age

(rising incomes, changing life expectancy, changing occupation demands, inflation, wealth accumulation)

Public Pension ImplicationsPublic pensions MAY:

Encourage early retirementReduce private savings

BUT

Is the loss in efficiency may be worth income security for the elderly?

Old Age Security Program History

1927- Old Age Pension Act let the federal government pay half (75% in 1931) of provincial pensions

1952- Old Age Security Act gave $40 a month to Canadians over 70

1952-2006 – Benefits increased

(dip in benefits after 1967 due to only partial indexing to inflation)

1970 – eligibility age reaches 65 (slow reduction to this point)

Old Age Security Pension Benefits (2006 Dollars)

Old Age Security (OAS) & GIS

OAS is taxed as an income, and clawed back $15/$100 above a threshold ($63,511 in 2007)The full pension requires living in Canada for

40 years after age 18, and was $492 per month in June 2007

The Guaranteed Income Supplement (GIS) started in 1967 as a NIT with G=$621 for a single person and $410 for a married person, with a clawback (t) of 50% (excluding OAS)

OAS & GIS & The Allowance

OAS and GIS guaranteed $1113 in June 2007GIS equals zero at yearly income of $14, 904

(June 2007)The Allowance (started in 1975) is paid to the

spouse of an OAS recipient, widow, or widower between age 60 and 64 (lived in Can 10 yrs)$907 allowance in June 2007, with 75% clawback

(excluding OAS)

OAS & GIS & The Allowance

In 2005-06:4.2 million people received OAS1.6 million people received GIS97,000 people received the Allowance

In 2005-06, $29 billion in payments where divided as follows:76% for OAS22% for GIS2% for the Allowance

OAS & GIS & The Allowance

The Old Age Security Program and Canada Pension Plan has reduced senior poverty greatly :

Senior headed families in poverty has decreased from 41.1% (1969) to 7.1% (1994)

Senior individuals in poverty have decreased from 69.1% (1969) to 47.6% (1994)

But OAS may have problems…

Universal or Targeted Transfer

Originally (1952), OAS was a universal benefit for seniors (they all built this country, they should all benefit)Some argue this is inequitable, as some taxes will

come from low incomes and be transferred to highThey argue that this transfer is only equitable if

funded by a tax that highly focuses on the richAnd is therefore even more distortionary

In 1989, the clawback was introduced (but 15% is a very weak clawback)

Percentage of Population over 65

Some studies expect OAS/GIS expenditures to triple from 2001 to 2030

-Others claim the burden MAY not be severe, depending on future economic growth and elderly taxes

History - Canada Pension Plan

The Canadian Pension Plan (CPP) and Quebec Pension Plan (QPP) started in 1966CPP is financed in a pay-as-you-go fashion through

a mandatory payroll tax6.3 Canadians received $32.8 billion in 2005-06

The CPP includes disability benefits75% of their age 65 CPP payment until they turn 65Additional benefits if caring for children below age

18 or 18 to 25 and attending an educational institution

The Canada Pension Plan

The CPP has a one-time death benefit payment (maximum $2500)

CPP also has a survivor benefitFixed rate plus 37.5% of deceased CPP payment

for survivor 45-65 or below 45 with dependent children (max $482.30 per month in 2007)

This increases to 60% at age 65

CPP’s orphan benefit is paid to children under 18 or 18-25 and attending an educational institution full-time

CPP Benefits CalculationCPP Pension = [(average YMPE for last 5 years)

+(average ratio of pensionable earnings to YMPE)]/4

YMPE =yearly maximum pensionable earnings =average industrial wage

The ratio is calculated (omitting some years) to a maximum of 1, resulting in maximum pension:

(average YMPE for last 5 years)/ 4

Contribution IncreasesCPP is pay-as-you-go, and contribution was

3.6% from 1966 to 1982, resulting in a surplus put in an invested emergency fund

After 1983, 3.6% caused a shortfallContributions increased 0.2% from 1987 to

1996In 1996 the contribution rate of 5.6% was less

than the needed rate of 7.85%In 1966, the needed 2030 rate was expected to

be 5.5%, but many factors increased that expected needed rate to 14.2%:

Contribution Increases

Demographics=birth decrease and life expectancy increase

Economics = productivity (wage) growth is lower than expected

1998 ReformsTo avoid 14.2% contributions, sweeping

changes were made in 1998:

1)Financial: Exemption to paying CPP contributions frozen at $3500 yearly income and emergency fund invested better (stocks vs. government bonds)

2)Benefit changes: (see chart)These changes result in a 9.9% contribution

rate in 2003, lasting until 2099

(Note: the overview earlier takes all of these changes into account)

1998 Reforms ResultsThese reforms may work, or unforeseen

(demographic?) shocks may require higher contributions

Many argue for a higher retirement age (US retirement is 67), and criticize the reforms for not starting this trend

The reforms trade higher contribution rates for higher political viability of the CPP in the future

ConclusionOAS acts as income redistribution for elderlyCPP is an earnings-related public pension

schemeCPP (but not the pay-as-you-go format) is

justified by paternalism, redistribution, the Samaritan’s dilemma, adverse selection, inflation and timing

These programs have severely decreased poverty among the elderly

Great reforms had to be made to adjust for a pay-as-you-go funding scenario

Important Note

Pension programs tend to be more popular than welfare programs, because everyone will grow old, while not everyone will require welfare.

Chapter 12 Conclusion

Canada’s Retirement System consists of OAS, CPP, and tax-assisted savings

CPP is justified by paternalism, redistribution the Samaritan’s dilemma, adverse selection, inflation, and timing

Pay-as-you go is better than a funded plan when real wage growth exceeds real interest rates (which hasn’t been the case lately)

Chapter 12 Conclusion

Public Pensions reduce savings (Wealth Substitution Effect) and increase savings (Retirement and Bequest effects)The net result is unclear

CPP tends to encourage earlier retirementCPP contribution rates have soared over

the years, and were held back to 9.9% only due to extreme 1998 reforms