Retirement income and the choices of youth

When you get to a certain age, anyone under 35 seems young.

People born after 1984 have different preferences and a different life experience than people born earlier. Their phones are better, their clothes use less cloth, their cars are more fuel efficient, and they probably left home at a later age. They may eat less meat, be more concerned about global warming, and have a longer life expectancy.

Firms design products for these cohorts that are very different to the products they designed for young people a generation or two ago.

Strangely, however, the government obliges these cohorts to use a similar retirement income policy as their parents. Sure, they occasionally argue over small details such as whether the age of entitlement (on young cohorts) will be raised from 65 to 67, but they never ask: is the current system fit for purpose for a new generation?

What’s wrong with current retirement policy?

There are two good reasons why old people don’t ask this question.

First, the answer is that it is not fit for purpose and will impose large costs on current and future young people.

It was designed with minimal input from current cohorts and is unlikely to meet their needs or desires, particularly as it imposes very large opportunity costs on current and future generations of young people – billions of dollars of costs .

Secondly, it is not easy to change.

The current system directly intertwines people of all ages and if young cohorts were freed from the system there would be large costs on old cohorts. Politicians and bureaucrats of all stripes have been of the opinion that it is better to continue in silence than to unravel that Gordian knot. 

The core problem was examined half a century ago by a trio of Nobel-prize winning economists: Paul Samuelson, Edmond Phelps, and Peter Diamond.

They noted there are two basic ways that you can design a retirement income policy, a pay-as-you-go system and a save-as-you-go system.

In a pay-as-you-go system, young cohorts make transfers directly to old cohorts, and nothing is saved.

This was the traditional arrangement within families from time immemorial: when people got too old to work, they lived with their adult children and their adult children supported them – just as they may have supported their parents when they were younger adults, and just as they supported their children when their children were young. Starting in the 1930s many countries designed public retirement income schemes around this principle. Ironically, these systems were introduced at the same time as they were starting to go out of fashion within the family. 

In a save-as-you-go system cohorts fund their own retirement.

In the private sector, this means people provide for their own retirements by saving, investing and accumulating assets. This is possible in the public sector as well: instead of transferring taxes directly from tax-payers to New Zealand Superannuation recipients, the taxes would be accumulated in a fund and the savings plus compounded earnings, interest, and dividends would be used to pay the pensions of the contributors much later in life. This is the basic idea behind the New Zealand Superannuation Fund.  

Does it matter which system you use?

Peter Diamond showed that the cost of the system depends on whether or not the return to investment exceeds the growth rate of the economy, a condition economists call “dynamic efficiency”.

The implicit return to a pay-as-you-go system is the rate of economic growth (population growth plus productivity growth) [I have explained this elsewhere: see Coleman 2014]. The return to a save-as-you-go system is the average return to investments.

If the economic growth rate is higher than return to investment, a pay-as-you-go-system is the best system. If the return to investment is higher than the economic growth rate, a save-as-you-system is less costly. The difference can be considerable. New Zealand currently raises about $14 billion in taxes to pay pensions. If we had a save-as-you go system, the same pensions could be paid for half that sum. 

The big problem is that once you have a pay-as-you-go system, you can’t exit it without imposing costs.

If young people stopped paying taxes to provide the pensions of old people, these costs would fall on old people – an unacceptable solution. If young people were asked to pay the pensions for old people and save for their own pensions, the costs would fall on themselves.

Rather than confront this difficult arithmetic, politicians have been prepared to avert their gaze and proceed with the current system. Sadly this means turning a blind eye to the large opportunity costs that fall on current and future young generations – something an honest economist can’t abide. 

Well this sucks … what could we do?

Fortunately, there are middle solutions.

One is to significantly increase funding contributions to the New Zealand Superannuation Fund: that is, to increase taxes now so that the future increases in the taxes necessary to pay future government-provided pensions is reduced. Survey evidence suggests that two-thirds of New Zealanders of all ages support this option [Au, Coleman, Sullivan 2019, working paper here].

But in some ways, this avoids one of the central questions. This question is how to design a pension scheme that young people want?

Public policy often proceeds on the principle that there should be a single rule for everyone. This makes sense for some rules – yes, all people should drive on the left (unless all people drive on the right). But it doesn’t make sense for all rules.

There is no inherent reason why people born after 1985 should have the same pension scheme as people born before 1985. There is no inherent reason why people born after 1985 should have the same structure of taxes as people born before 1985. True, it may be difficult to make the transition from one system to another, but difficult and impossible are different things. 

There are good reasons why people born before 1985 might want a different superannuation system, or even an entirely different tax-transfer system than the system currently in place.

Economists have not explored these questions in depth – how might an economy work if it had two tax systems concurrently, one for people born after 1985, and one for people born before 1985? We don’t know. But there are three good reasons to find out.:

  • First it is profoundly democratic – young people could have a system designed by themselves, for themselves, meeting their aims and objectives.
  • Secondly, it may enable a transition out of the current system, a system that economists recognize probably imposes very large costs on young generations and future generations.
  • Thirdly, it may enable them to design a system which is much more environmentally friendly – a topic for future posts. 

Young people arise. You have nothing to lose but their claims.