Defusing a demographic time bomb without moving to funded pensions

Longer hours, higher immigration and productivity could be the real solution for governments

One of the industries thriving since the launch of the European single currency is investment management, and the reason is often said to be the ticking of a demographic time bomb driving a switch to funded, private pensions.

One of the industries thriving since the launch of the European single currency is investment management, and the reason is often said to be the ticking of a demographic time bomb driving a switch to funded, private pensions.

Ageing populations across most of the industrialised world will, it is argued, put an intolerable burden on government budgets through increased pension and healthcare costs and a reduced tax base.

Continental Europe, along with Japan, faces the most severe problems of old-age dependency. Not only is the age structure of their populations greying faster, they also have generous pay-as-you-go state pension schemes whereby today's taxpayers fund today's pensions. The number of taxpayers is falling, while the number of pensioners is growing rapidly.

The ratio of retired to working-age population is known as the dependency ratio. It will rise sharply across the industrialised world between now and 2030.

In the UK, the number of 0-14 year olds is expected to fall from 19.3 per cent to 14.7 per cent, and of 15-64 year olds to drop from 65 to 61.8 per cent, of a population that is barely growing in total. The proportion of over-65s is likely to rise from 15.7 to 23.5 per cent of the total. In Italy, which has the lowest birthrate in Europe, the proportion of over-65s is likely to climb from 17.6 to 29.3 per cent of a declining population. The US and Ireland are the only two countries enjoying population growth, and they too will see a rising proportion of retired people as the baby boom ages.

The pressure this places on the public purse depends on the generosity of the pension schemes. The UK's inflation-linked (rather than earnings-linked) scheme means the bite state pension payments will take out of the economy is unlikely to rise very much. But in countries like Germany and Italy the pensions burden is far heavier to start with and poised to increase dramatically.

Most of the analysis of the problem has focused on the funding question, starting from the safe presumption that taxpayers will be unwilling to pay ever-higher contributions in order to finance a growing number of pensioners. One much-mooted solution has been a switch to funded pensions, either state or private. The idea is that the switch can somehow take advantage of the high return on equities.

However, one big catch is that moving to funded pensions solves tomorrow's problem, but people who are working now have to save for their own future pensions at the same time as continuing to pay for current pensioners out of their taxes. Politically, this proposal does not have anything going for it. What's more, according to an article on pension reform in the new issue of the journal Economic Policy, advocates of funded pension schemes ignore the fact that they are risky. Indeed, the world's stock markets could be poised to give this week a demonstration of the potential risk. If one generation of pensioners happened to have suffered a poor return on their investments, a government would come under pressure to step in anyway, so the burden on the public purse would not have been entirely removed.

"The question of funding is a complete red herring," said Kevin Gardiner, an economist at Morgan Stanley. "Pensioners are always paid out of an economy's current output, and pension arrangements involve redistribution between generations."

Two research papers just published by City economists both argue that there is no need for European governments to contemplate a switch to funded pension schemes. One, by Jan Mantel and David Bowers at Merrill Lynch, focuses on raising the retirement age as a solution. They calculate that there would be no problem paying for pensions out of current taxation if the retirement age were to rise to 69 by 2030. With no increase in the retirement age, contributions would have to nearly double from 14 per cent of the average salary in 1990 to 26 per cent in 2030. An alternative would be to raise the retirement age to 67 or 68, raise contributions slightly, and make pensions a little less generous.

Mr Gardiner, in a report for Morgan Stanley, looks at a far wider range of potential adjustments. Although later retirement is one way to reduce the dependency ratio of pensioners to workers, others include increasing the participation rate amongst the working-age population, reducing unemployment, and increasing the average hours worked each week.

There is plenty of scope for such adjustments, especially on the Continent. The US has an employment rate of 78 per cent, the UK 75 per cent, but Germany 68 per cent and Italy only 58 per cent. The UK's participation rate has climbed sharply, mainly because of the numbers of women entering the workforce, but the employment rate for older men has declined due to industrial restructuring and early retirement, so that too could climb again.

And, of course, it makes no sense to worry about a potential labour shortage when unemployment rates in many European countries are in double figures, wasting a valuable resource. Jobs market reforms would make a huge difference to the pension calculations. Europe could also start increasing, rather than reducing, the work week. Shorter working hours are a perverse policy for a country concerned about a potential shortfall in pension contributions paid by employees.

Last but not least, higher immigration can increase the labour supply. Every country in Europe has boosted its labour supply through immigration at some stage in the post-war period. The US still does, which is partly why it has less of a pensions problem to begin with.

Even without any of these adjustments to increase the labour supply, Mr Gardiner points out that it is productivity growth - technology-driven increases in output beyond the increases in labour and capital inputs - that explain more than two-thirds of economic growth. He says: "The likelihood that an aggregate supply constraint will bite on GDP and average living standards is slim." He estimates that potential output could comfortably double by 2030, in which case we can easily afford our pensioners.

Besides, in the very long run, everything in the economy can adjust, and that includes seemingly immutable demographic trends. If Europe's middle-aged populations do start to worry seriously about their retirement provision, the below-replacement birth rate could rise with a late baby boom. Whatever the solution, metaphorical time bombs never explode. Nor does this good news for older people mean bad news for investment managers. The fund management business will thrive anyway; there will be more pensioners in Europe and their pensions will be increasingly invested in equities.