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Challenges posed by the ageing EU population for the financial sector - Economic and monetary challenges

Ageing, pensions and financial markets

By Antolín-Nicolás Pablo - Principal Economist, Head Private Pensions Unit, Financial Affairs Division, Organisation for Economic Co-operation and Development (OECD)


Population ageing is an increase in the median age of the population, which results in part from declines in fertility rates from the high levels of the baby boom generations to a lower constant level and partly from increases in life expectancy. Increases in life expectancy are the main driving force behind population ageing, particularly in the long-term. The impact of the baby boom is an important but temporary factor. Once the baby boom cohorts pass away, their impact will fade. In contrast, the impact of increases in life expectancy is more permanent (barring pandemics or wars).As a result, there will be fewer people in the workforce per retiree than today (i.e. higher old-age dependency ratios), which other things equal will put tremendous pressure on economies in general and on pension systems in particular.

Population ageing may lead to lower productivity and thus lower GDP, although its final effect is subject to debate. The workforce may shrink, other things being equal (e.g. participation rates and effective retirement age). Overall savings may also be lower, unless current saving behaviour changes. Its potential impact on financial markets includes the impact on portfolio strategies, the asset price meltdown hypothesis, and the impact on annuity markets. As regard the meltdown hypothesis, a more general equilibrium view taking into account behavioural adjustments suggest much smaller reductions in asset prices.

Population ageing will also affect public finances, especially through health care and pensions. Although population ageing will increase health care expenditure, the main driver of those increases is raising prices. Most of the health care costs of old age occur in the years just prior to death. Living longer just postpones the time when those costs are incurred, and does not necessarily increase them. However, the spread of ailments such as Alzheimer’s may change this outcome.

Population ageing has different impacts on different pension arrangements. It affects (1) the sustainability of defined benefits (DB) PAYG financed pensions public pensions. They may not be financially sustainable in the medium to long-run as a result of pension benefit promises that are out of sync with the new actuarial parameters (e.g. life expectancy); (2) the solvency of DB funded pensions as their assets may fail to cover for their liabilities, as they need to pay pension benefits for a longer retirement period; and the adequacy of DC funded pensions as the assets accumulated may be lower than expected to finance retirement.

The OECD recommends diversifying the sources to finance retirement and encouraging complementary funded private pensions. To address the problems posed on the sustainability of PAYG-financed pensions, the recommendation is to link retirement age to changes in life expectancy. A better option may be to link the number of years contributing or saving for retirement to improvements in life expectancy, specially when improvement in life expectancy differ among different socio-economic groups. Similarly, adjusting actuarial pension parameters regularly and automatically will also help in addressing sustainability and solvency problems.

Addressing adequacy problem on DC pensions requires to contribute and contribute for long periods, combined with making sure that part of the assets accumulated are annuitized. This brings to the forefront the importance of designing the payout phase adequately in order to provide protection from longevity risk. Combining a deferred life annuity that starts paying later in retirement (e.g. at age 80) with programmed withdrawals during the first years in retirement allows to strike a balance between flexibility and liquidity on the one side and protection from longevity risk on the other. However, support for annutization requires better functioning annuity markets. One of the main problem facing annuity providers is how to manage longevity risk (see OECD Mortality Assumptions and Longevity Risk, 2014).