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The Actuary The magazine of the Institute & Faculty of Actuaries

A time machine?

magine what it would be like if time travel was possible. We could load goods into the time machine and transport them to our old age. We could even hire someone to visit our future self and provide old age care, or even provide it ourselves! In such a world there would be no ‘pensions gap’.

Demographic effects on saving
The most popular substitute for the time machine is saving. But is it a good substitute? Long-run economic policy should consider the effects from demographic factors, as well as economic effects on demographic variables. For example, according to the theory of ‘life cycle saving behaviour’, people save while they are young and spend while they are old. The larger the proportion of young people, the more the economy saves, and vice versa. The saving rate of Japan was high during the 1980s and has declined sharply since because of rapid demographic changes.
Another demographic effect on saving is what is often described as ‘the implicit public debt’, which consists of the benefits people expect to receive from the state. To understand how it works, assume that the government issues a debt. For the economy as a whole the debt represents zero net wealth, as it is merely a transfer. But for the individuals who hold government securities it is real wealth which, if the government hadn’t issued the debt, would have been invested productively in shares, for example. In other words, the effect of public debt is to divert savings away from productive investment. The effect of state-provided benefits is exactly the same: people rely on these benefits and save less. The more people rely on old-age provisions, the higher the implicit public debt and the lower the level of saving, investment, and growth of the economy.
It is for these reasons that the Turner report recommends measures that focus on saving. The problem, however, is that bonds and shares cannot be eaten; they merely represent a claim on the future output of the economy. If productivity and growth fall, so will the interest rates and shares prices, and today’s ‘securities’ will not be ‘secure’ at all. It is possible that, as the population ages, economic growth will fall, even if a high saving rate is sustained. The reason is that, while savings are used to build physical capital, the productivity of the latter, and hence the return to the securities held against it, depends on whether there will be enough labourers to use it productively.
Children of quality
How large will the labour force be then? As Gary Becker first argued in 1960 (to win the Nobel Prize), child-bearing decisions depend on economic variables like income, wealth, and consumption preferences. The latter also refer to the balance between the ‘quantity’ and ‘quality’ of children, ‘quality’ meaning education and well-being. The higher the quality that parents want for their children, the less quantity they can afford and vice versa. There are many reasons to believe that ‘consumers’ shift away from quantity towards quality. Consequently, the trend is for lower fertility and an older population. Furthermore, a higher dependency ratio with larger transfers from the young to the old will reduce the income of the young. As a result, they will reduce their consumption of all ‘goods’, including children.
Therefore, the future labour force is expected to be small, reducing the return to savings. One way to avoid this scenario is if the smaller labour force is also a more productive one, through investment in human capital (that is, education). And the good news is that the smaller a generation is, the less it costs to educate it, assuming that the government does not shift resources from education to old age support, for example, by introducing tuition fees in universities. Extending the retirement age would also help, and research has found that an individual’s productivity peaks in the mid-50s, so there are many productive years beyond 65.

The government’s time machine
The focus should be on both saving and the rate of return. Demographic changes affect both. While the Turner report focuses on saving, there are various ways to increase the rate of return. To start with, the savings should be managed by the private sector, with certain guarantees, as the private sector is usually more efficient than the public. Government can contribute plenty, by doing what the government is there for: by defining the legal framework, not increasing its borrowing, enhancing the efficiency of the future labour force through training and education, and increasing the retirement age. Government should also ensure that everyone saves enough for their own retirement and that it doesn’t rely on means-tested provisions, which in effect take advantage of the savings of others and which undermine both saving and reproduction.
Either this, or invent a time machine to transport goods and services to the future.