Individual retirement provision - -motives and instruments -motives and instruments

The sources of private retirement provision are highly diverse. In the fol-lowing I employ a rather simple and straightforward distinetion between individual and collective (occupational) retirement provision. In the former, the individual or the household is the active agent, while occupa-tional pension provision is distinguished by the fact that coverage depends - at least in the first instance - on the behavior of employers and/or unions in deciding whether to let pension provisions of a certain quality form part of the employment conditions in a particular company or a segment of the labor market. The instruments available for individual retirement provision, as thus defined, include the accrual of all kinds of financial wealth and housing equity, and the participation in various forms of individual insurance schernes that prornise to pay out annuities or lump-sums once the insured has reached a certain age (or in case of death, to the surviving spouse and children).

The main part of this section is devoted to general theories about the use of private means for retirement provision. The theoretical discussion takes the pure and simple life-cycle hypothesis from neo-classical eco-nomics as the point of departure. Then I discuss its radical antithesis: the equally simple model of completely myopic individuals. Finally I con-sider various ways to allow for more complexity (read: realism) in terms of behavioral assumptions, and their consequences for the expected rela-tionship between public and individual retirement provision. I conclude the section by turning to more concrete issues about the operation of the specific individual instruments and their implications for the pattern of income distribution in retirement.

Throughout this section I ignore the role of occupational pensions as an alternative to both public and individual/private pension provision.

Occupational pensions are in their turn discussed in Section 3.6.

How-ever, there are obviously important interdepencies between the two forms of private retirement provision, and the theoretical diseussion of individual motives for retirement provision in the present seetion is rele-vant also for understanding the dynamics of oecupational pensions. The behavior of employers and unions on questions about pension provision is likely to be sensitive to pereeptions about a (latent or voiced)

"demand" for additional retirement ineome among the employees to be covered, ¹²⁷ and to the extent that individual savings behavior is driven by the motive of retirement provision, ehanges in the eoverage and quality of oeeupational pensions can be assumed to have eonsequenees for efforts to save on an individual basis. 128

The /ife-cycle hypothesis

In its most simple form, the life-eyde hypothesis holds that individuals alloeate their eonsumption over the life-eyde in a way to maximize an inter-temporal utility funetion of ineome and consumption (for a non-teehnieal introduetion see Aaron, 1982).12⁹ Sinee the eapacity for generat-ing market ineome is unlikely to eoincide with the optimal eonsumption profile over the life-cyde, saving and dissaving beeome neeessary means to aehieve the preferred (presumably relatively flat) time profile of eon-sumption. ^It is a fundamental assumption of the life-eyde hypothesis that the primary motive behind individual savings behavior is to aehieve a preferred eonsumption leve! in retirement, i.e., in the life-phase where the individual must expeet that earnings are (dose to) zero. ^It is an equally fundamental assumption that preferences are well defined and stable over time.¹³⁰ People do not ehange their taste for pensions over time, and thus they never end up in a situation where they regret earlier

127 Y ou could even imagine that employees shop around in the labor market to find the employer/sector with just the right pension-wage package. The differentiation of the extent and quality of pension coverage across the different segments of the labor market could then be a rational (equilibrium) response by employers to a strong dif-ferentiation in preferences about the wage-pension trade-off among members of the labor force (Blinder, 1983).

128 The finding of such a relationship has been reported by Munnell (1982).

129 The specification of the agent is not always clear: is it the individual, the family, or the household that does the planning according to a shared utility function?

130 See Stigler and Becker (1977) for a dedicated (heroic) defense of the presumption un-derlying most economic modeling that preferences and tastes are both invariable across individuals and stable over time, and daring claim that most human behavior can be accounted for within such a paradigm.

savings decisions, unless they have been exposed to external shocks that could not have been foreseen.

In the frictionless neo-classical environment stipulated by the hypothe-sis (at least in its most simple form), the individual has complete informa-tion on all aspects necessary to plan in a lifetime perspective, including information about her own future eamings capacity, interest rates, infla-tion, the timing of retirement which is given exogenously, etc. Capital mar-kets function perfectly, and hence consumption can in fact be postponed-and if necessary - anticipated without any constraints or transaction costs.

Individuals attempt to consume all of their lifetime eamings, and they only leave a bequest if they happen to die earlier than expected. There is not even a reason for the possibility of involuntary bequests to arise, since a perfect market for annuities will allow the individual to insure herself against the risk of longevity. By converting accumulated wealth into an actuarially fair annuity, totallifetime utility can be maximized.

This basic theoretical model has been the point of departure for the extensive debate - espedally among American economists - about the effect of sodal security pensions on the aggregate savings rate. According to the model, people will react to the introduction or expansion of public pension benefits simply by saving less, or if necessary dissaving, in their economically active years in order to achieve the preferred consumption profile already revealed before the introduction or expansion of public pensions. Similarly, a reduction in public pension provision will be met by increased private saving in order to re-establish the preferred consumption profile. Since public pensions are generally not prefunded Cbased on pay-as-you-go finandng), while all private retirement provision is assumed to take the form of individual saving efforts, the model predicts that the intro-duction and expansion of public pensions will tend to seriously depress the aggregate savings rate in the economy (Feldstein, 1974).

The issue whether public pensions have a negative effect on the aggregate savings rate is clearly related to the question that concems us here, namely a possible effect on the scope and distribution of private sources of retirement income.¹³¹ The simple life-cycle model predicts that attempts to redistribute income over the life-cycle are liable to fail. Behav-ioral responses, in the form of lower private saving or dissaving, will offset the effect of granting public pension benefits. Nothing happens to

131 The two issues are not completely equivalent, though. For instance, not all private re-tirement provision is funded, so the potential crowding-out of such components will have no effect on aggregate savings.

the distribution of income/ consumption among retirees, unless the public pension system leads to some redistribution of lifetime incomes. But, even then, not much is likely to happen to the retirement distribution in particular, since the gain (loss) that some might have will, if anticipated in due time, be treated as any addition (reduction) to the individual's time wealth, and it will presurnably be re-allocated over the entire life-cyde. In other words, the model predicts very dramatic behavioral responses to changes in public pension provision, but changes of a kind that leave the income distribution among the retired largely unaffected.

The distribution of income and consumption among retirees is, thus, a function of the distribution of lifetime incomes and individual variation in preferences about its allocation over the life-cyde, and there is not much a public pension system can do about it.

The basic model can be relaxed in a number of ways in order to achieve a higher degree of realism: allowing for a bequest motive behind private wealth accumulation and for uncertainty about the future earnings capacity, endogenizing the retirement decision and introducing imperfect capital markets, etc. Some of the more complicated and flexible models do lead to rather different predictions about the effect of public pensions on the aggregate, private savings rate.¹³²

There is general agreement in the literature that the markets for life insurance and retirement annuities are subject to serious imperfections.

Because of classic market failures such as "adverse selection", "moral haz-ard" and informational constraints on the part of the individual purchaser, the markets for these finandal servkes wil1 tend to be imperfect, incom-plete, and they will not necessarily operate in away that is actuarially fair (Diamond, 1977; Atkinson, 1987; Feldstein, 1987). A public pension system can, thus, help to satisfy a need for insurance against longevity in retire-ment that will not be satisfactorily and effidently covered by an unregu-lated market. The result might be both a higher level of income provision in retirement than would have appeared in the absence of public pensions, and less inequality in retirement incornes because of the ex-post redistribu-tion that takes place even within an actuarially fair insurance scheme.

The life-cycle hypothesis cannot easily account for the repeated Hnd-ing that those among the e1derly who have built up significant amounts of

132 Barro (1974) is a "c1assical" contribution, showing that the presence of a bequest motive could lead to the prediction that private savings would be more or less unaf-fected by the expansion of public pensions. For a good and up-to-date summary of this debate see Magnussen (1994).

private wealth do not appear to dissave in retirement - at least not any-where to the extent expected by the hypothesis (Venti and Wise, 1987;

Hurd, 1990; Alessie et a1., 1995). In particular, housing equity tends to be left untouched. In many countries, special insurance products have become available (inverse mortgages), allowing elderly people to realize their housing wealth while they maintain the right to live in the house for the rest of their lives. However, according to the available evidence, this option has not (yet) become widely used. This latter phenomenon could be explained with reference to astrong bequest motive (Barro, 1974), but as far as housing wealth is concerned, it might also indicate that many home owners do not consider their house as simply (a less liquid) equiv-alent to any financial asset.

However, not all extensions to or modifications of the life-cycle hypothesis represent unquestionable improvements in terms of realism.

In models where the timing of retirement is assumed to be endogenous, the individual will continue to work until lifetime wealth is sufficient to sustain a preferred level of lifetime consumption. The increasing generos-ity of public pensions could then explain the observed tendency from the last decades for effective retirement ages to decline. In practice, however, the timing of retirement seerns to be much more readily explicable in terms of the specific incentives created by public and occupational pen-sion systems to retire at a certain age, individual and contextual factors affecting the supply and demand for labor (health status, unemployment, etc.) and expectations by employers/employees as to the "normal" retire-ment age (Zabalsa et al; 1980; Kotlikoff and Wise, 1987; ]ohnson and Falkingham, 1992:96ff).

Myopic behavior

The radical antithesis to the life-cycle hypothesis is a model with myopic individuals. According to this model, individuals do not plan their income/

consumption in an inter-temporal perspective at all. They simply decide on labor supply and savings behavior according to short-term considerations.

It is possible, at least from a formal point ofview, to interpret such a behav-ioral disposition in rationalistic terms by allowing for people to have an extreme preferenee for the present over the future, Le., to have an indefi-nitely high discount rate on future income/consumption (Elster, 1989:42ff).

The myopic model is not necessarily incompatible with the fact that some people do accumulate wealth in various forms that can in turn be a source of income and consumption in retirement. The point is that such

wealth accumulation is assumed to be based on other types of motivation than considerations for a re-allocation of consumption over the life-cyc1e.

People might buy thernselves a house, pay mortgages and eventually become owners of a housing asset that is a potential source of retirement income without being driven (primarily) by the motive of retirement pro-vision. Once theyenter retirement they might or might not decide to exploit such sources of wealth. As I have already noted, the observation that people do not tend to reduce their housing wealth over retirement is astrong indication that the acquisition of housing wealth is linked prima-rily with a different set of motives.

Thus, a model of myopic behavior does not necessarily exclude that private income sources are available in retirement or that their distribu-tion might be systematically related to pre-retirement income levels. The general notion of a decreasing marginal utility of income and consump-tion might be relevant here, as it could help explain why other motiva-tional forces - like the desire for prestige and power flowing from the accumulation of wealth - tend to come more easily into play among members of high-income brackets. Still, the model is clearly more rele-vant for explaining why some people do not built up retirement wealth than for explaining why other people in fact do so, given that retirement provision is not part of the motive. Econornic man rnight well be myopic, but then it is difficult to understand why she would not decide to con-sume all her current income. However, peculiarities of the housing market and lirnits on the possibility to borrow against future income strearns rnight provide a partial explanation.

The myopic model leads to the prediction that there will be little behavioral responses to variation in the public pension system - except perhaps in terms of the economic behavior displayed by people once they have reached retirement.¹³³ Changes in the generosity of public pen-sion benefits will directly affect the level of income enjoyed by retirees as well as the distribution of retirement income. Means-tested and/or flat-rate benefits can, thus, be expected to do an effective job in alleviating poverty and truncating the income distribution from below. However, the prospects for an equalizing impact of sodal insurance benefits are more discouraging since they cannot be expected to have a significant crowd-ing-out effect on private income sources.

133 For instance, means-tested benefits and taxation could still affect the labor supply of people above the normal retirement age.

Mixed and relativistic models

These two extreme models are better thought of as heuristic devices than serious attempts to capture the complex motivational structure behind observable behavior in the area of individual (or for that matter, collec-tive) retirement provision.

There is ample evidence that the propensity to save for old age -through occupational pension schemes, individual annuities, or the accu-mulation of other forms of private wealth - tends to increase sharply with the level of income enjoyed prior to retirement (Mayer, 1972; Diamond and Hausman, 1984).

[Olur most important finding is the extent to which the savings to permanent income ratio rises with permanent income. Not only does the savings (wealth) rise with permanent income, but it does so in a sharply non-linear fashion. (Dia-mond and Hausman, 1984).

The "preferences" for postponing income and consumption to retirement seem to be highly income elastic, if judged by the way they are revealed in people's behavior - especially in cross-sectional data. Evidence from many countries shows that a substantial portion of the population, prima-rily those people with comparatively low levels of pre-retirement income, do not built up any substantial financial wealth or claims on private retire-ment income (Diamond, 1977; Burkhauser and Wilkinson, 1983; Hurd, 1990; Falkingham and Johnson, 1992; Alessie et al., 1995).

This pattern, which appears to repeat itself under very different institu-tional conditions, is difficult to accommodate with a model of rainstitu-tional behavior where all individuals consciously plan their time profile of con-sumption, and hence it is difficult to reconcile with the life-cyc1e hypoth-esis. Within the framework of the life-cycle hypothesis, there is no reason to expect that people with low levels of lifetime income should be less concerned to reallocate income and consumption to achieve a rather con-stant consumption profile into and throughout retirement. 134

A possible way to make sense of this pattern is to allow for different time orientations to be represented in the population, with, for instance, one segment behaving with foresight according to the life-cycle hypothe-sis, and another segment that is largely myopic in behavior (Diamond,

134 The facts of a lower life expectancy and higher mortality rates among the lower social strata do provide rational grounds for people belonging to such strata to employ a higher discount rate on future eamings and consumption, and thus to be less liable to redistribute income and consumption towards the later part of the life-course.

1977; FeIdstein, 1987). A model where high-income groups plan over time according to the life-cyde hypothesis, and where people belonging to lower-income strata exhibit more myopic behavior, offers a neat expla-nation for the observation that the distribution of private retirement income tends to be extremely concentrated among the more weU-off seg-ments and characterized by a much higher level of inequality than the pre-retirement distribution. It is weU suited to support a basically pater-nalistic argument for obligatory sodal insurance (Diamond, 1977). Under the conditions of the model, an actuariaUy fair social insurance scheme will force the lower- and middle-income strata to "save" at higher rates than they would otherwise have done, and the gap to higher-income brackets with a stronger initial propensity to save (either individuaUy or collectively) will even be reduced, as the latter can be expected to respond to the forced saving by relaxing their private efforts.

However, the assumption about a tendency towards myopia among the less privileged strata of the population begs a further explanation.

One type of explanation would simply refer to cultural differences between sodal dasses, in the spirit of "culturalist" sociologists like Bourdieu, according to which one of the characteristics of working dass (as opposed to middle dass) culture is a tendency to be less oriented towards the future. 135 Altematively, one could invoke more concrete social-psychological mechanisms like resignation, the subconscious downward adjustment of aspirations in the face of adverse conditions (Elster, 1989:40).136 People who recognize that they will have severe dif-ficulties in building up substantial private means to support themselves in retirement might be indined to accept, and take for granted, the idea that retirement will be associated with economic hardship. FinaUy, one could

One type of explanation would simply refer to cultural differences between sodal dasses, in the spirit of "culturalist" sociologists like Bourdieu, according to which one of the characteristics of working dass (as opposed to middle dass) culture is a tendency to be less oriented towards the future. 135 Altematively, one could invoke more concrete social-psychological mechanisms like resignation, the subconscious downward adjustment of aspirations in the face of adverse conditions (Elster, 1989:40).136 People who recognize that they will have severe dif-ficulties in building up substantial private means to support themselves in retirement might be indined to accept, and take for granted, the idea that retirement will be associated with economic hardship. FinaUy, one could