Global Aging

I have blogged before about the problems that demographics pose for European countries. Within Europe, the only three countries that have a supplementary funded pension system are the United Kingdom, the Netherlands and Switzerland. All the others are in deep trouble one way or the other. But that's just looking at the pensions side. I only just discovered The Aging Vulnerability Index (pdf) published as part of the Center for Strategic and International Studies' Global Aging Initiative. The aim of the Aging Vulnerability Index is to measure how vulnerable countries are to the problem of an aging population. The index consists of four main areas of investigation, in the words of the authors:

• public-burden indicators, which track the sheer magnitude of the public spending burden
• fiscal-room indicators, which track each country?s ability to accommodate the growth in old-age benefits via higher taxes, cuts in other spending, or public borrowing
• benefit-dependence indicators, which track how dependent the elderly are on public benefits and thus how politically difficult it may be to reduce their generosity
• elder-affluence indicators, which track the relative affluence of the old versus the young?another trend that could critically affect the future politics of benefit reform

This analysis goes a step beyond looking at the demographics of each countries, and actually tries to calculate how expensive the pension commitments are. Modeling future developments, especially as far ahead as 2040 is fraught with difficulties. I think we should look at the results not so much as predictions of what will happen, but a what-if analysis of what might happen if no major changes occur. That's the key point to bear in mind in all of this, but it is a valid starting point as doing nothing is the comfortable default.

There are two sides to this kind of modeling: the liabilities and the economic development. Modeling the liabilities is usually very complex to do, especially if you want to integrate the finer details of current pension systems into the mix. You need a demographic model, with birth rate assumptions and mortality tables. Then, once you have the population development, you need to calculate how much in pension rights everyone gets. If it were an analysis of a pension fund, you'd also have to calculate the present value of these rights. So while all of this is very complex, this is something that can be done quite accurately in general. It's just a lot of painstaking work. In the kinds of broad-brush analysis like this one, you can make simplifying assumptions which reduce the amount of work considerably. It's the economic development side that's usually easier to understand in its parameters, but also much more contentious. The impact of taking a slightly higher GDP growth rate on overall results is enormous if you look at periods as long as 40 years. So again I come back to my earlier point: don't look at this as a forecast, but more as a what-if.

The results of the study are somewhat surprising. The report groups the countries into three tiers: Low, Medium and High vulnerability countries.

Rank	Country	Index Score
1	Australia	-1
2	United Kingdom	+7
3	United States	+18
4	Canada	+42
5	Sweden	+48
6	Japan	+50
7	Germany	+52
8	Netherlands	+62
9	Belgium	+63
10	France	+83
11	Italy	+84
12	Spain	+93

The scores are scaled such that 50 is the average, and 0 and 100 represent respectively scores of minus and plus one standard deviation from the average in each score.

The trio of Australia, UK and US are the Low Vulnerability countries, which have their house in reasonable order and can face the future with some confidence. The Medium tier countries are Canada through Belgium, who all face substantial challenges. Lastly, the High Vulnerability countries are France, Italy and Spain, who will end up in deep trouble unless they take drastic action. But the scope for taking action is part of the analysis, which in part has pushed these countries to the bottom of the list. How likely is real reform in France? Not very.

The only country that can lay claim to having sorted out its pensions problem is Australia. Although it has favorable demographics to help, the key to its excellent score is the Superannuation Guarantee that was introduced in the early 1990's. This is a mandatory, private and funded retirement account, which by 2040 will reach 11% of GDP. With the "Super" contributing more and more over time to Australians' pensions, the current pay-as-you-go system is being reduced. The privatization of retirement provision is going to be a boon to the Australian economy and Australians themselves. The key feature is that the system is mandatory, so it does resemble a tax since you have no choice in paying it or not. But it's not really a tax since the money is still yours, except it's being put in an investment account, and you'll be using your own money for your own old age. This is a necessary feature if the government is to provide a fallback guarantee. Once you have a safety net, then the temptation will be great for some to skip their contributions entirely in the knowledge that the state will bail them out. The socialization of these costs necessitates an act of compulsion for the system to work.

The UK and US are doing relatively well, as both have supplementary funded pensions systems. The biggest problem for the US is the large increase in socialized heath care costs for the elderly in the form of Medicare. Perhaps surprisingly, it is Sweden that is the highest-scoring European country. Sweden is best known for its gargantuan public sector and high taxes, but on the pension front they are doing something right. They've set up a number of nationwide funded pensions systems (known as the AP Funds, numbered 1 to 5), and Swedes can decide to which they want to contribute. If they don't want to make a choice, the government does it for them. Still, the situation in Sweden is still far less favorable than in either of the top three countries The reason Japan scores so well (relatively) is simply because its pension system is extremely stingy.

The Netherlands scores poorly, coming in at 8th place with a score of 62. Given its large funded supplementary pension system, this comes as a bit of a surprise. The report authors explain it as follows (page 29):

its public pension benefits are so generous, its retirement age so early, and its family ties so weak that elders in the Netherlands are left just as vulnerable?and dependent on public benefits?as elsewhere.

The situation in France, Italy and Spain is pretty serious. Poor demographics, very generous public pension systems, no funded pensions at all and the prospects for reform are remote.

The conclusions are clear. Sticking with the current pay-as-you-go systems is going to cause very serious problems in many countries. Remember that the scores for the countries also include the ability to implement reforms. This means for Medium Vulnerability countries that doing nothing is not an option. For High Vulnerability countries, taking action is urgently required. Australia's Superannuation Guarantee is a good starting point for other countries to follow. The most obvious candidate here is Social Security in the US, which is long overdue a change to a funded system from its current pay-as-you-go format.