GPP 501 Microeconomic Analysis for Public Policy Fall 2017 Given - PowerPoint PPT Presentation

GPP 501 Microeconomic Analysis for Public Policy Fall 2017 Given by Kevin Milligan Vancouver School of Economics University of British Columbia Lecture November 22 nd Asymmetric Information: Pensions GPP501: Lecture Nov.22 nd 1 of 27

Agenda 1. Pension Facts 2. Governments and pensions 3. Can/Should we privatize? GPP501: Lecture Nov.22 nd 2 of 27

Pension facts: Public pensions / GDP GPP501: Lecture Nov.22 nd 3 of 27

Pension facts: Income composition Figure 15: Income Composition All Individuals 100% 90% 80% 70% 60% Proportion 50% 40% 30% 20% 10% 0% 50-54 55-59 60-64 65-69 70-74 75-79 80+ Age CPP/QPP OAS/GIS Private Employment Pension Investment Earnings Other Source: Baker and Milligan (2009) GPP501: Lecture Nov.22 nd 4 of 27

Pension facts: Population share 65+ GPP501: Lecture Nov.22 nd 5 of 27

Pension Facts: Old Age Security spending as share of GDP GPP501: Lecture Nov.22 nd 6 of 27

Pension Facts: Life Expectancy from age 65: 1921 to 2011 GPP501: Lecture Nov.22 nd 7 of 27

Pension Facts: Elderly poverty after GIS expansions .2 .15 .1 .05 0 20 40 60 80 Age Income poverty in 1977 Income poverty in 1982 GPP501: Lecture Nov.22 nd 8 of 27

Pension Facts: CPP Investment Board From CPPIB 2016 Annual Report: GPP501: Lecture Nov.22 nd 9 of 27

Actuarial Projections for CPP as of Dec. 31, 2015 PAYG Cont'n Total Total Net Cash Investm't Annual Year rate rate Cont'ns Expenses Flow Income Assets yield 1995 7.91% 5.40% 10911 15986 -5075 4412 39683 11.30% 2000 7.69% 7.80% 19977 19683 294 4446 47523 9.90% 2005 8.37% 9.90% 29539 24976 4563 11083 94361 13.20% 2010 8.83% 9.90% 35885 32023 3862 11804 142502 8.90% 2015 8.79% 9.90% 46026 40883 5143 38667 285358 15.60% 2020 9.79% 9.90% 51971 50457 1514 17069 359306 5.07% 2021 9.95% 9.90% 56182 56493 -311 20412 389087 5.45% 2030 11.00% 9.90% 79523 88311 -8788 34886 600717 6.03% 2050 11.17% 9.90% 170538 192433 -21895 84405 1457678 6.02% 2070 11.78% 9.90% 348970 415068 -66098 185553 3197264 6.02% 2090 12.07% 9.90% 720380 878046 -157666 391621 6739676 6.02% Source: Office of the Chief Actuary, Office of the Superintendent of Financial Institutions, 27 th Actuarial Report on the Canada Pension Plan. GPP501: Lecture Nov.22 nd 10 of 27

Agenda 1. Pension Facts 2. Governments and pensions 3. Can/Should we privatize? GPP501: Lecture Nov.22 nd 11 of 27

Why Should governments be involved in pensions? Two arguments: i) Market failures ii) Paternalism/behavioural motivations GPP501: Lecture Nov.22 nd 12 of 27

Governments and pensions (i): market failures Will insurance markets work well for pensions? Consider these three risks:  Riskiness of future earnings: What if I get continually bad labour market draws and therefore end up with lower savings at retirement than I had expected when I made my plan?  Riskiness of future returns: What if the stock market tanks the day before I retire?  Riskiness of longevity: What if I live to 110 – will my pension be there? Q: Does moral hazard or adverse selection affect any of these? GPP501: Lecture Nov.22 nd 13 of 27

Governments and pensions (ii): paternalism People might make ‘bad’ savings decisions.  Myopia – don’t think about the future.  Time inconsistencies. We have a low discount rate in the long run, but a big discount rate in the short run. So, we always mean to save, but never get around to it. So we might make bad decisions. Why is it a large concern?  Consequences of getting it wrong are severe.  Irreversible; can’t play it again if you get it wrong – no experimentation.  No learning by doing. GPP501: Lecture Nov.22 nd 14 of 27

Governments and pensions (ii): paternalism Examples of behavioural biases in savings / consumption decisions:  Myopia: if people exhibit present-biased preferences, they may place too little weight on benefits received in the future and too much weight on costs borne in the present. This may lead people to procrastinate and under save or retire too early.  Salience focus: Things which are salient receive undue attention. Retirement consumption is likely not salient for many young people.  Endowment effects / status quo bias: People put too much weight on the status quo. If they are not presently saving, this can generate a long-run savings deficit.  Framing: choices depend on the way they are presented.  Excessive optimism: People may put too high a probability on the possibility of high investment returns or high future earnings. GPP501: Lecture Nov.22 nd 15 of 27

Governments and pensions (ii): paternalism What are arguments against paternalism?  Assumption of rational, well-informed, sovereign consumers.  Worry that even if individuals make ‘wrong’ choices, it is their right to do so (libertarian argument.)  Worry that governments may make even worse choices. (Public choice critique.) GPP501: Lecture Nov.22 nd 16 of 27

Governments and pensions (ii): paternalism What is the paternalistic government solution?  Government runs a pension plan. ‘Softer’ version:  Mandatory contributions.  Regulated pension funds. What is consequence of someone arriving at old ages with too little income?  The ‘ savers ’ might have to pay for the non-savers.  So, the ‘ savers ’ might be better off by forcing the non-savers to pay.  This is called the “ Samaritan ’ s Dilemma ” GPP501: Lecture Nov.22 nd 17 of 27

Agenda 1. Pension Facts 2. Governments and pensions 3. Can/Should we privatize? GPP501: Lecture Nov.22 nd 18 of 27

‘Private’ pensions : what do we mean? Seven aspects that help determine degree of ‘privatization’ (Fullerton and Geruso 2006) 1. Funding: PAYGO or pre-funded? 2. Contributions: Mandatory or voluntary? 3. Investment decisions: Centralized or personalized? 4. Administration: centralized or decentralized? 5. Annuitization: mandatory or lump-sum allowed? 6. Benefits: Redistributive or neutral? 7. Benefits: defined benefit or defined contribution? GPP501: Lecture Nov.22 nd 19 of 27

1. Funding: PAYGO or pre-funded? PAYGO troubling for slow-growing economies.  Can equity premium be exploited on large scale? Pre-funding may add to the capital stock of the economy. For less-developed countries, pension funds can contribute to development of financial markets.  A buyer for assets. Canada : partially funded… GPP501: Lecture Nov.22 nd 20 of 27

2. Contributions: Mandatory or voluntary? If voluntary, lose some risk sharing. Mandatory savings can help by  Forcing savings on the short-sighted, saving the government money in the long-term.  Can relieve insurance problems by forcing everyone into the same risk pool. Downside: interferes with personal decision making. New Approach: The ‘Default Option’  Set as the ‘default’ a saving s option — but people can opt out if they choose.  This helps those without foresight but allows for more personal decision making. Canada: mandatory GPP501: Lecture Nov.22 nd 21 of 27

3. Investment Decisions: Centralized or personalized? Centralized investment decisions: Advantages  Lower cost of administration.  Professionals may make better investment choices. Disadvantages  Political risk: government may make political rather than economic investments.  Doesn’t allow for different risk preferences – everyone gets the same portfolio. Again, a ‘Default Option’ can be useful here.  Set as a default some reasonable portfolio mix.  Let people change the option if they choose. Canada: Centralized GPP501: Lecture Nov.22 nd 22 of 27

4. Administration: centralized or decentralized? Several aspects to consider here:  Do contributions go through central authority or straight to investment?  Who keeps records of contributions?  Who keeps records of benefits?  Who makes the benefit payments? Canada: centralized. GPP501: Lecture Nov.22 nd 23 of 27

5. Annuitization: mandatory or lumpsum allowed? This is at the core of the ‘market failure’ case for public pensions.  Market for annuities is plagued by adverse selection.  Only the ‘good risks’ want to buy annuities. You could have private funds, but with mandatory annuitization: Canada: mandatory; no discretionary lump sum. GPP501: Lecture Nov.22 nd 24 of 27

6. Benefits: redistribution or neutral? Do the benefits redistribute to lower earners? Or does everyone get the same ‘replacement rate’?  Replacement rate is benefit/earnings. Hard to do redistributive benefit formula in a more privatized system. GPP501: Lecture Nov.22 nd 25 of 27

7. Benefits: defined contribution (DC) or defined benefit (DB)? Defined contribution: your contribution is fixed, but your benefit depends on investment returns. Defined benefit : your benefit depends on a formula that is fixed; doesn’t depend on investment returns. Most public systems have DB formulas.  Sweden and Italy have ‘notional’ defined contribution programs.  A rate of return is applied to contributions to determine benefits. Canada: DB. GPP501: Lecture Nov.22 nd 26 of 27

Up next:  Assignment due on Friday.  Review questions for Tuesday.  Exam on Wednesday GPP501: Lecture Nov.22 nd 27 of 27