Lecture I: Pension Institutions, History and Theoretical Rationales

I. Overview of the 4 lectures:

A. Professional caveat: Not an expert in pension systems. There are many people who know much more
about this that I and have spent lifetimes studying it. Have benefitted tremendously from summaries
of the huge literature by various authors, enabling a newcomer like myself to learn a lot, quickly.
Challenge of the area: combine knowledge of 1) institutions, 2) politics, 3) economic theory, 4) data, 5)
economometrics to obtain an overall understanding of how pension policy affects behavior. Importance
of area in the future: the large fraction of GNP devoted to pensions, the aging of society, and the huge
potential costs of inefficiencies. This is an area where I definitely think economists and econometricians
can make a contribution. Rewards to doing so are very high. My comparative advantage: using dynamic
programming models to analyze individual responses to pension incentives. Necessary condition for
economists to have much of a role in pension policy issues is first demonstrating that people respond
rationally to these incentives, otherwise retirement behavior might be better left to sociologists and
psychologists. Going to argue in these lectures that people are quite rational, selfish optimizers who
will take advantage of the system if it is to their advantage. Moral scruples to claiming DI, cheating the
system, or working becuase one “ought” to work for character reasons may be operative, but effects are
dominated by economic incentives. People “play the system” to make themselves as well off as possible,
and there is good evidence that they know the ins and the outs of the system and the various pension
rules extremely well. This is opposed to the “paternalistic” “irrational” view that people are myopic,
stupid, and retire primarily for non-economic reasons and that details of pension policy therefore has
little impact on behavior. Course will attempt to compare both points of view, especially since the
paternalistic view is often quoted as one of the motivating reasons for the establishment of private
pensions.

B. Political caveat: Issues of retirement, disability, etc. are highly politically charged. Even in the
economic literature one see’s highly value-laden terminology e.g. “actuarially fair/unfair”, “prema-
ture/early retirement”, and potentially judgmental concepts such as pensions as device to rid the firm of
“unproductive older workers”, or individuals “feigning ill health” to obtain DI benefits or “rationalize”
fact that they are not working. With the potential that benefits to elderly may have to be cut in many
OECD countries, can expect huge political battles.1 In US AARP is a huge lobby with extreme amount

1 Also, please lert me to language differences in terminology. E.g. Social security vs. public pension, fully-funded vs. capital reserve, private pension
vs. occuppational scheme or superannuation scheme, etc.

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of political power very sensitive to any suggestion of cutting benefits “owed” to America’s old. So
important to approach the issue with a certain amount of sensitivity. Also recent conservative doctrines
have appeared questioning whether government ought to be in the pension business: why not let the
free market do it if as economists we believe in “free trade” and the superiority of market solutions to
private solutions. Feldstein’s program on privatisation of social security systems starting in Chile and
elsewhere. My own position: political liberal who favors redistribution from rich to poor, insurance to
unhealthy or disabled, and concern for the well-being of our elderly and the recognition and preservation
of respect for their independence and human dignity. Don’t believe that the private market can provide a
total solution: indeed will be arguing that one of the most compelling ways to understand the origin and
economic effects of public pension systems is due to the government stepping in to correct failures of
the private market, particularly in annuities and health insurance and disability insurance markets where
there are good economic reasons why private markets should be weak or non-existent. Fundamentally,
I have in mind the same ideal of the tolerant, humane society that European social democracies have
tried to attain. But I am also a realist and realize that it is human nature to try to make oneself as well
off as possible, optimizing relative to the rules that are in force, in some cases even taking advantage
of the benevolence of the government and society. Without realism, and a proper understanding of
individuals’ strategic responses to public and private pension/DI/health insurance policies, (as opposed
to the assumption of perfectly moral behavior), the benevolent policies enacted over the last half century
are threatened. Need to design incentive schemes that are as “strategy proof” as possible in order to
direct as much possible aid/insurance to those really in need, and also to preserve political consensus to
continue these remarkable “social institutions”.

II. Overview of Institutions

A. Pensions are delayed compensation schemes ( often involving forced savings) that “tax” wage earnings
when young in exchange for a stream of retirement benefits when old. Pension systems are widespread
in industrialized societies, offered to 1) employees of private firms, 2) public employees military, and 3)
(virtually) all individuals via universal public pension schemes, also known as social security systems.

B. Why do pensions exist? I will review more detailed reasons later, but basic reason is to provide
an adequate stream of consumption in old age. Basic life-cycle model in figure 1 shows problem:
individuals work while young but for various reasons (age related declines in health productivity, and
age-related changes in marginal utility of income/leisure) people’s earning capacity slows down at end
of their life and they withdraw from labor market. They want, however, to maintain a reasonably smooth
level of consumption, so pensions provide one way to obtain a relatively smooth lifetime consumption
stream, taxing wage earnings when young in exchange for wage earnings when old.
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C. Why don’t individuals just save instead of using pensions? A major reason is that people have random
lifespans: expected lifespan for males may be 75 years, but they could live to age 99. Should one save
for the worst case, assuming one will live to age 99? If so, accumulating sufficient savings will involve
major sacrifices early in life, especially if it turns out that one dies early, say at age 55. ON the other
hand if save only enough to live to 75, what happens if live to 99? Will one be reduced to living on
handouts or on welfare?

D. Why don’t individuals purchase annuities to insure against mortality risk? In practice, annuity markets
are very thin or non-existent in most countries around the world. When they do exist they are often
very expensive relative to the annuity payments one actually receives. High “load” factors. Why are
they so expensive and so few exist? Reason 1): the classic adverse selection argument: there is a great
deal of individual heterogeneity in health and longevity, which is private information to individuals.
Insurance company only knows aggregate, average mortality rates. Individuals know whether there is
a family history of cancer, heart attack, stoke, etc. If annuity is set on average mortality rates, those
who are “good risks” from the insurance company’s standpoint (i.e. those who are likely to have cancer,
heart attacks, strokes, etc. and die off early) are less likely to apply and those who come from strong,
healthy Scandanavian backgrounds (the “clean livers” who don’t smoke, exercise, and may have at
most 1 drink per day) are more likely to apply, forcing the insurance company to raise its premiums or
reduce its benefits, causing still more good risks to leave, etc. In extreme circumstances this process of
adverse selection can completely drive the annuity market out of existence (see Rothschild and Stiglitz,
1976, QJE, “Equilibrium in Competitive Insurance Markets: An Essay in the Economics of Imperfect
Information”). Is the lack of annuities due to this adverse selection problem? Not completely clear.
Adverse selection is also operative in other kinds of insurance markets such as for health and life
insurance and we see such markets existing around the world. Why did it just “kill off” the annuity
markets? Some argue that annuity markets don’t exist not becuase of adverse selection but because
Social Security and pension plans have taken their place. No really good information on who strong
annuity markets were prior to the advent of Social Security and pensions, but more on that later. Also,
problem with private annuities markets providing fixed real annuity in presence of inflation, and risks
associated with annuity companies going out of business, makes them still relatively risky investments.

E. “Informal” alternatives to Social Security and pensions: the extended family/community as a risk-pooling
Social Security system. Estelle James, in a forthcoming book, claims that approximately 60% of the world’s
population receives no significant retirement benefits from a “formal” pension or security system, but rather
is supported by the family and community transfers. Example: in a sample of Indian widows: 90% were
supported primarily by their sons. This systems is mostly used in LDC’s in Asia, India, Africa and Latin
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America. Even Korea (both north and south) have a relatively miniscule Social Security systems, and in these
socieities (similar to China) one’s children, and specifically one’s son, is the primary “Social Security system”.
(Anecdote: Korean grad student at Wisconsin, Chong-Bum An, had good job offer at a US university, his father
came to attend his graduation and contracted stomach cancer, and his stomach was immediately removed. After
that requiring feeding every few hours and continuous care. Chong-Bum quit his position, returned to Korea
to take care of his father, living together with him, his wife and children in a small apartment in Seoul. Recent
paper by Namkee Ahn showed that incentive to have son is so strong in Korea that new technology allowing
selective abortions have increased male/female birth ratios from 1.04 in 1980 to 1.13 in 1989. These are the
kinds of perverse effects (in addition to the incentive in India, Mexico, etc. for having too many children)
of not having an adequate formal Social Security system). Remaining 40% of world population, primarily in
developed OECD countries have “multiple pillar” formal pension/retirement systems. Informal systems are
now starting to break down for the same reasons they broke down historically in Europe in the 19th century:
(Harrie Verbon, the Evolution of Public Pension Systems) industrialization, the move from primarily agricultural
to urbanize society, the emergence of nuclear family and highly mobile labor with relatively weak community
bonds. Predict that ultimately all societies around the globe will ultimately move to formal systems, although
family transfers will always be an important source of flows they seem to decrease in importance in modern
societies. (defer to Borsch-Supan, see Kotlikoff study, etc.) In U.S. there has been a marked decline in the
extended family. Fraction of aged living with children declined from 31% in 1950 to 9% in 1950. By 1983,
fewer than 3% of elderly households received income from their children, and overall the fraction of elderly
income from children amounted to less than 1%. So in practice, informal systems relatively small in U.S.: is
this cause or effect of expanded formal systems, i.e. social security and pensions?

F. “Multiple pillar” formal systems (in order of importance as a source of retirement income):

1. Social Security/public pension: mandatory, universal coverage

2. private/occupational pensions: usually mandated by firm for its employee but not firms not mandated
by government to provide pensions (except for France) coverage not universal but a large fraction in
some countries such as U.S., Netherlands, etc.

3. individual personal savings accounts, tax-deferred annuitites: IRA’s (Canada and U.S., France, Switzer-
land, UK)

4. Family transfers

G. Summary of Social Security systems: main features, details of systems in U.S. and Netherlands.

H. Summary of Pension plans: main features, details of systems in U.S. and Netherlands
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1. Source on European pensions: J.A. Turner and L.M. Dailey (1991) Pension Policy: An International
Perspective Covers 9 countries with substantial private pension systems: U.S. Canada, Japan, Nether-
lands, UK, Australia, France and West Germany. Contains a specific summary of pension system in
Netherlands by Kees Zweekhorst and Piet Kiezer.

2. Source on U.S. pensions: O. Mitchell “Trends in Pension Benefit Formulas and Retirement Provisions”
in J.A. Turner and D.A. Beller (1992) Trends in Pensions also Kotlikoff and Smith, (1983) Pensions in
the American Economy.

3. Two main types of pensions: defined benefit vs. defined contribution. DB plans specify a benefit rule
as a function of wage history and years of service: firm bears residual risk of cost of providing pension
benefits. DC plans specify a fixed contribution rate (possibly augmented with matching employer
contribution) and funds are invested in securities (stocks and bonds) whose ultimate accumulated value
is uncertain. Upon retirement employee can either collect value as a lump-sum (in some cases, e.g.
Japan) or the value of the portfolio is converted to an annuity and paid out over the person’s remaining
lifetime (e.g. TIAA/CREF) Thus, under DC employee bears residual risk of investment portfolio
performance over his working years. In reality, DB plans aren’t riskless either, since often benefits (in
the U.S. but less often in Netherlands) are specified in nominal terms rather than being automatically
inflation-adjusted. Employee also bears risk that firm could go out of business, or be taken over by
another company that would cash in its pension fund and reduce pension benefits ex post. In U.S. 1974
ERISA legislation (described below) is designed to reduce some of these risks.

3. Start with U.S. pensions system, then look at Europe, and Netherlands. Great diversity: huge number
of alternative plans. My impression is that there is more uniformity in pension terms in Netherlands.

H-USA Pensions in U.S. can be traced back to 19th century (American Express, 1975, first formal pension plan) but
really took off after 1942 tax act granted special tax breaks to firms that created pensions, and 1949 Supreme
Court decision making pensions a mandatory negotiating topic in collective bargaining agreements. Number
of plans increased from 9,370 in 1946 to 616,642 in 1980. Fraction of working population covered by pensions
increased from 17% in 1940 to 52% in 1970, but coverage has remained fairly flat since 1970, with a recent
tendency towards decline. Bloom and Freeman (1992) “The Fall in Private Pension Coverage in the U.S.”
showed that decline in unionization and weakening economic position of less skilled American men during
1980’s (Reagan and Bush years) was associated in a fall in coverage rates, document a 10 percentage point
drop from 1979 to 1988 in the proportion of workers eligible for pension coverage in BLS data on medium
and large establishments, from 91% in 1979 to 81% in 1988. After the 1974 Employee Retirement Security
Act (ERISA, a landmark pension legislation designed to increase equity and reduce risks of failure of private
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pension systems requiring minimum vesting and participation standards, imposed minimum funding standards,
rquired plan termination insurance for DB plans) we see a big increase in defined contribution vs. defined
benefit, (DB increased by 6,725 plans per year vs. DC of 35,118, so by 1980 65% of all plans were DC vs. 35%
DB. However in terms of number of participants, DB is still predominant: in 1977 74% of particpants were
covered by DB, 25% by DC, by 1980 65% DB, 35% DC, and by 1987 68% of covered workers were enrolled
in a DB plan vs. 68% in a DC plan (39% of workers were enrolled in at least 2 plans, 13% were enrolled in 3
or more plans. Overall, number of people covered by DB decreased from 30 million to 28 million from 1980
to 1987 whereas number covered by DC increased from 18.9 million to 35 million.

I. Specific pension plan rules: IBM and Wisconsin Retirement System

J. Summary of accrual patterns for pensions: incentives to stay with the firm until vesting and early retirement
age, substantial incentives to leave firm after normal retirement age

III. Theoretical explanations for the existence of social security and pensions

K. Theoretical explanations for government provision of public pensions

L. Theoretical explanations for firm provision of private pensions