Is there a case for differentiated longevity adjustment of the retirement age?

Professors of Economics Svend E. Hougaard Jensen and Gylfi Zoega call for public-private partnership as they discuss adjustments of the retirement age and pension funds according to life expectancy

The key theme of this article is the question of whether retirement age indexation based on average increases in longevity is fair: What if there is a large group of citizens whose health and work abilities do not follow the general increase in life expectancy? Wouldn’t it be wrong to disregard this when adjusting the retirement age?

It is well documented that there is considerable inequality in longevity. It has long been known that women, on average, live longer than men. We also know that highly skilled people, on average, have a longer life span than lower-skilled. Bluntly put; for those with a shorter education, there is typically a higher degree of attrition, which leads to a shorter lifetime.

Let us put some numbers on this: In Denmark, a 30-year-old unskilled man can expect to reach 76.1 years, while a 30-year-old man with a long higher education can expect to reach 83.7 years. For women, the numbers are 80.5 and 86.3 years. This is a difference of 7.6 years for men and 5.8 years for women.

The length of our education therefore dramatically influences, or at least predicts, how old we can expect to be; and there is no indication that this gap in lifespans will narrow in the foreseeable future. On the contrary. This means that if we all have the same old-age pension age, then highly skilled people get a longer retirement period than lower-skilled people.

Not surprisingly, this has given rise to the idea of ​​allowing an earlier withdrawal from the labour market for the lower-skilled and work-worn. How do you do it? Well, there are a number of different ways, but introducing differentiated retirement age is typically associated with a complex political process.

Public pensions

From an economic point of view, public pensions should be based on an actuarial principle, so that the total pension benefit received throughout retirement is not significantly affected by the timing of retirement.

Our preferred model is based on a public-private partnership (PPP). Again, taking Denmark as a case study, we can utilise the fact that over the past three decades, Denmark has developed a well-functioning system with occupational pensions – the so-called “pillar 2” of the pension system.

More specifically, the idea is that we calculate what the “average Dane” has in his/her total public pension claim, from the year they reach retirement age up to the expected year of their death. In other words, we take into account what, on average, each Dane draws on public expenditure on a public pension.

The amount resulting from this calculation is paid out as a lump sum to each Dane at the age of retirement. The amount is based on the average of current benefits from the basic, flat-rate benefit of the old-age pension and the supplementary, means-tested benefit. On the demographic side, the average takes into account both skilled and unskilled people and both men and women. So yes, everyone is included, and we simply take the average life expectancy of the entire population.

Here is a stylised numerical example: Suppose that the retirement age is 66 years and average life expectancy is 81 years. This gives a pension period of 15 years. In addition, suppose that the sum of the basic, flat-rate pension benefit and the supplementary, means-tested pension is, on average, €16,850 annually. Voilà – in a zero-rate environment you get a total amount of €256,000. It’s important not getting obsessed by the specific numbers; here we focus on the basic principles.

Can anyone, after receiving this sum, spend the money at his discretion? No! The amount must only be used for pension savings – and it must immediately be placed in a pension fund where it is converted into annuities. The annuity provides the benefit profile that best meets consumption needs. Most importantly, it provides a smooth pension benefit profile for the rest of your lifetime, no matter how old you become.

Pension funds

Speaking In favour of such a PPP model, Denmark has already built up pension funds, many representing a specific professional group in the labour market. The Doctors’ Pension Fund is for, yes, doctors. Other funds are for unskilled people. It goes on. And the boards of these pension funds are largely drawn by representatives of these professional groups.

So, where each recipient of €256,000 would go a pension fund, where they know their members and therefore have set an expected remaining lifetime that matches the profile of their members.

Simply put, we can say that with this model we ‘privatise’ the public system screenings. Instead, this task is left to the pension funds, which have accumulated a great deal of knowledge about Danes’ lifetimes, divided into the various professional groups in the labour market. Again, from the perspective of this article, it is important to stress that life expectancy for each pension fund differs from the national average so that those with a short life span get paid more per year until their (early) death.

A ‘customer pattern’ will quickly emerge: A pension fund, where members are typically low-skilled with a short life expectancy, will not accept members with a long education and long life-expectancy. Similarly, lower-skilled people will not apply for admission to an academic pension fund, where the members are expected to have long lives and a correspondingly low annuity for a given capital contribution.

So far, so good. But we have not yet solved the need for early retirement for worn-out workers. Here we propose that a worker aged 62, or at least some years before the official retirement age, should be able to raise his €256,000 and transfer the amount to a pension fund.

It goes without saying that the earlier this happens, the lower the monthly annuity. But the annuity offered to the worn-out early retiree will probably be higher than that offered to, say, the schoolteacher, who is expected to live longer. They already know that in the pension fund, so no screening is needed.

How are public finances affected by such a PPP model? In principle, the sustainability of public finances will not be affected. The point is that the present value of the state’s state pension expenditure will be unaffected by the reform – but the time profile will, of course, be quite different in the two scenarios. With our proposal, the state pension for a single year is paid out as a lump sum and therefore not spread over many years.

Svend E. Hougaard Jensen, PhD, is professor of economics at CBS, director of the Pension Research Centre (PeRCent) at CBS, member of the Systemic Risk Council and chair of Bruegel’s Scientific Council, Brussels. Gylfi Zoega, PhD, is Professor of Economics at the University of Iceland and Birkbeck College, London, and affiliated with the Pension Research Centre (PeRCent) at CBS.

Please note: This is a commercial profile