Tarmo Valkonen

Controlling the effects of demographic risks: the role of pension indexation schemes

Within a model featuring demographic uncertainty, this paper studies a pension reform where public pension benefits are indexed to the total wage bill rather than to the average wage level. This implies a decline in the variability of contribution rates and an increase in the variability of replacement rates. While thus shifting some of the adjustment burden following demographic shocks to pensioners, the trade-off in risks is found to be fairly moderate.

Longevity Adjustment of Pension Benefits

In anticipation of future gains in life expectancy, several countries have passed laws that automatically adjust pensions, if life expectancy changes. In this paper we study the effects of longevity adjustment under demographic uncertainty in Finland. If longevity increases, the adjustment decreases the contribution rate, and the reduction is bigger the higher the rate would have been without the reform. On the other hand, longevity adjustment increases the uncertainty in replacement rates. The current middle-aged generations, whose pensions are reduced more than contributions, are likely to experience the largest losses. The full gains are observed far in future. The quantitative results depend on, besides demographic realisations, the specifics of the pension system. Longevity adjustment significantly weakens the defined-benefit nature of the Finnish pension system and brings in a strong defined-contribution flavour.

Population ageing and fiscal sustainability in Finland : a stochastic analysis

This study analyses the fiscal sustainability of the Finnish public sector using stochastic projections to describe uncertain future demographic trends and asset yields. While current tax rates are unlikely to yield sufficient tax revenue to finance public expenditure with an ageing population, if developments are as expected, the problem will not be very large. However, there is a small, but not negligible, probability that taxes will need to be raised dramatically, perhaps by over 5 percentage points. Such outcomes, if realised, could destabilise the entire welfare state. The study also analyses three policy options aimed at improving sustainability. Longevity adjustment of pension benefits and introduction of an NDC pension system would reduce the expected problem and narrow the sustainability gap distribution. Under the third option, pension funds would invest more in equities and expect to get higher returns. This policy also limits the sustainability problem, but only under precondition that policymakers in the future can live with substantially larger variation in the value of the funds without adjusting tax rules or benefits.

Uncertain Demographics and Fiscal Sustainability: Demographic uncertainty and pension projections

Introduction With increasing understanding that populations are ageing and will continue to do so, long-term pension expenditure projections have become essential policy tools for all countries with pure pay-as-you-go or less than fully funded public pension systems. The most important background assumptions in these projections usually concern future demographics. It therefore seems particularly relevant to try to envision the uncertainty caused by future demographics in pension expenditure projections. We summarize quantitative estimates of the uncertainty in long-term pension expenditure projections caused by demographic factors for Belgium, Denmark, Finland, Germany, the Netherlands, Spain and the United Kingdom. The estimates are obtained from model-based country studies. The demographic uncertainties are quantified by stochastic population simulations. The results unequivocally show a great deal of uncertainty in pension projections. There are significant differences between the uncertainty estimates in these countries. The differences partly reflect demographic factors, partly differences in pension systems and partly the properties of the models that were used. We also relate the uncertainty estimates of the country studies to the uncertainty considerations in the recent projections by the Economic Policy Committee (EPC) of the European Commission (EPC, 2006). The EPC uses sensitivity analysis as a method to describe uncertainties. Not surprisingly, the resulting quantifications of deviations from the expected outcomes are small compared with those obtained in the country studies. Finally, we consider the implications of the country studies for the future development of the tools for analysis.

Pension Policies and International Capital Mobility

The effects of pension policies on households’ and firms’ behaviour depend on the international mobility of financial capital. We compare the policy effects between three regimes: a perfect capital mobility regime, a flow equilibrium regime where domestic interest rates react to current account developments, and a portfolio adjustment regime where the net foreign debt affects the domestic interest rate. We consider three different pension policies: an increase in the retirement age, a decrease in the pension benefit level and a temporary variation in the pension fund. The long-run policy effects are equal with perfect capital mobility and the flow equilibrium regime, but the short-run effects are different and the transition period is longer with the latter. In the portfolio adjustment regime even the long-run effects are different when the policy changes are permanent. Thus the degree of international capital mobility is important e.g. for the changes in intergenerational distribution. The effects on the pension contribution rate, on the other hand, are almost independent of the interest rate behaviour.

LONGEVITY, WORKING LIVES, AND PUBLIC FINANCES: LONGEVITY, WORK, AND PUBLIC FINANCES

Can longer working lives bring sufficient tax revenues to pay for the growing public health and care expenditure that longer lifetimes cause? We review studies concerning retirement decisions and pension policies, the role of mortality in health and long-term care costs, and errors in mortality projections. We combine key results into a numerical OLG model where changes in mortality have direct effects both on working careers and on per capita use of health and long-term care services. The model has been calibrated to the Finnish economy and demographics. Although there are huge uncertainties concerning future health and long-term care expenditure when people live longer, our simulations show that without policies directed to disability admission rules and old-age pension eligibility ages, working lives are unlikely to extend sufficiently. But, importantly, with such policies it seems quite possible that generations enjoying longer lifetimes can also pay for the full costs by working longer.

Housing Equity Release, Old-Age Income, and Public Finances

Many elderly people could markedly increase they standard of living by releasing housing equity. Purchase of a life annuity would increase the benefits of this release. Focusing on the Finnish case, we analyze the fiscal implications of different forms of housing equity release. We take into account the fact that most households have most of their wealth in the form of owner housing and that housing enjoys a tax-favoured status relative to most other forms of consumption and savings. We find that even tax free life annuities may well increase aggregate tax revenue relative to a situation where private annuities are not available. This is because the possibility to annuitize financial savings increases the opportunity cost of housing wealth inducing households to increase non-housing consumption relative to (tax-favoured) housing consumption. Reverse mortgages, in contrast, are likely to decrease tax revenue. This is because they make housing consumption all the more attractive.

The Finnish Corporate Income Tax Reform and the Financial Strategy of Firms: A General Equilibrium Approach

This paper simulates the effects of the recent Finnish corporate tax reform with a computable general equilibrium model. It shows that the impact of the reform on the capital stock depends on the reactions of firms. If the financial strategy is changed to prefer dividend distribution and share issues, the cost of capital falls and the capital stock increases. On the other hand, if the criterion of financial policy is to minimise the welfare loss of current shareholders, the earlier financial behaviour should be continued. In that case,the induced higher cost of capital leads to a lower capital stock. The overall welfare evaluation of the tax reform is not sensitive to the regime shift: the reform should not have been implemented. This is because the increase in interest income taxation distorts saving decisions, expands the net foreign debt of the economy and weakens the terms of trade.