Just when it seemed the debate on pensions would never end.. This summer, the secretary of state Klijnsma unfolded her plans regarding the future of the Dutch pension scheme to the Second Chamber. With a clear sketch of the adjustments to the current pension scheme and the contours of the new scheme. More transparency, more simplicity, more variety, more freedom of choice, a better coverage (think of the self-employed) and, last but not least, abolishing the financing principle of frontloaded pension contributions. Particularly, the government aims to phase out this financing principle from 2020 onwards. How this will be done has not been decided yet.
What is so peculiar about this frontloading principle?
What is so peculiar about this frontloading principle? Actually, that is the distinction between judicial and economic fairness. The law dictates judicial fairness by requiring that the same pension contribution rate and the same build-up rate apply to every worker, irrespective his or her age. Economically, this implies a difference between old and young workers, however. A euro that is contributed by a young worker becomes more valuable over time due to the interest attached to it, a euro contributed by an old worker doesn’t. Hence, to build up the same pension right the young worker should contribute (far) less than the old worker. The fact that pension schemes are required to apply the same contribution rate to workers of all ages, implies that the young worker contributes too much to the pension scheme (i.e., more than corresponds to the build-up of pension rights) and the old worker too little. That is economically unfair.
That the government wants to abolish the financing principle of frontloaded pension contributions thus seems pretty obvious. But the frontloading principle has more drawbacks. It hinders a proper functioning of the labour market as it makes it more difficult for workers to switch from jobs with a defined benefit pension to jobs without such a pension. In addition, the frontloading principle is incompatible with increasing choice possibilities for workers as pursued by the government.
Another argument that calls for abolishing the frontloading principle is that this will increase the return on pension savings. The return on pension saving could be increased with some 8 percentage points, according to a CPB study. The precise number depends on the interest rate and the rate of economic growth.This argument has less weight than may appear at first sight, however. For elimination of the frontloading principle implies a redistribution, from current workers to future generations. When the government decides to introduce additional policies in order to compensate current working generations for his redistribution, then the gain in the return on pension saving will vanish as well. In her plans Klijnsma indeed has stated to strive for compensating current working generations and the question what is the most appropriate way to do so is the subject of many current studies.
One can expect that old workers will then reduce their labour supply
One element has received less attention however: the labour market. An actuarially fair pension scheme – the scheme that, according to the government, will replace the current scheme, is less attractive for workers older than, say, 45. How depends on some institutional details (for those interested in these details, the issue is whether the new scheme is a degressive build-up scheme or a progressive contributions scheme). But whatever the details, older workers will receive less (pension) value for their (contributions) money. One can expect that old workers will then reduce their labour supply, either by working less hours per week or by accelerating their retirement.
People will start to act more like calculating citizens
One objection against this argument is the lack of knowledge about pensions. If older workers have little knowledge about their pensions, their labour supply behaviour will change little in case of a pension reform. And pensions is a theme about which many have little knowledge. However, this changes with age. Older workers who are close to retirement know more about their pension than young people who just have entered the labour market. On top of that, the government aims to increase the transparency of pensions. This is another reason why informational deficiencies may play only a minor role. If pension contributions and the corresponding build-up of pension rights are clearly communicated, people will start to act more like calculating citizens.
Many people have become aware that living longer requires a longer working life
Wrapping up, abolishing the frontloading principle reduces the labour market participation of the elderly. And this is actually rather strange. For we live in an era in which life expectancy keeps increasing, in which the government has earlier decided to stepwise raise the retirement age and in which many people have become aware that living longer requires a longer working life.
Now, one could argue that the opposite is true for young workers, so not much will change on the macro level. According to this argument, abolition of the frontloading principle would imply that young workers will receive more value for their money and that their labour market participation would increase for the same reason as that of old workers will decrease. This argument is only partly true, however. As said, young workers are relatively uninformed. Furthermore, empirical studies indicate that the labour supply behaviour of old workers is much more price elastic than that of young workers. According to a study by Eric French and John Jones, the labour supply elasticity of a 60-year old worker is seven times as large as the elasticity of a 40-year old worker.
Because of its labour market effects, abolition of the frontloading principle is bad news for the government budget. Less labour market participation means less tax revenues. This would not be very relevant if it was a temporary issue. Unfortunately, it is not. The effects on labour market and government budget relate to the pension scheme itself and are therefore permanent. Economists are used to say that There is nothing like a free lunch. The abolition of the frontloading principle has many advantages, but drawbacks as well.