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Chapter 1: Introduction:
According to many renowned economists and policymakers across the globe, there is an increasingly prominent yet urgent problem facing the future sustainability of the public and private pension systems.
Firstly, I will review existing literature surrounding the current designs of the various pension systems while digging deep into the application of behavioural finance to enhance these pension system designs to which many are still very traditional in the sense that they need updating.
Secondly, I will analyse various environmental indicators to assess the changing demographics that are putting pressure on Ireland’s current pension structure. This data-driven approach will provide us with an illustration of current trends with a focus on fertility rates, life expectancy rates, old-age dependency rates, various labour market participation rates, public debt and governmental expenditure as percentages of Gross Domestic Product.
Thirdly, I will initially begin to outline the Irish pension system while giving a detailed analyse of how the Government and the private sector currently meets the demands of the population of retired workers. Furthermore, I will introduce the main issues and challenges facing the Irish pension system while addressing the critical areas of current reform that is road-mapped by the Irish Government from 2018 to 2023.
Lastly, I will begin to analyse these challenges and issues facing the Irish pension system while applying diverse behavioural financial thought to provide possible solutions to these concerns. Thereafter, I will propose areas of further analyse that can enhance pension reform policies.
The main aim of this working paper is to initially review existing literature surrounding the pensions systems while assessing data that illustrates the impact of an ever-changing environment to the future sustainability of the Irish public and private pension systems. How can behavioural financial thought positively impact the growing need for more individuals to start saving or save more to enable them to have an adequate, self-sustainable retirement annual income.
Throughout this research paper, I will examine the demographic changes of Irish society to which analyses an ageing population to which retirement that may not be as financially comfortable as most would wish for. According to the CSO & Eurostat, over the next thirty years the population in Ireland that is aged over 65 years old will double which will see the over 65s consist of one in every five people. This will put considerable pressure on the Irish State pension as there will be more people retiring while there will be less people contributing to supporting the older generations.
Reform by the Irish Government
What stands out is the planned introduction of an auto-enrolment savings scheme. Not for the first time, the Government has stated its desire for employees without private pensions to be automatically enrolled in a workplace retirement scheme from 2022 onwards. Interestingly, Ireland is one of the only OECD countries without a mandatory earnings-related scheme to complement the State pension.
There are current questions of the sustainability of the Irish State pension as it is currently estimated to be approximately 12,651.60 a year where according to a research carried out by Coyne in December 2017, 35% of people expect that the Irish State pension will be their main source of income in retirement. As there is a surge of growth in the over 65s population, the current amount provided from the State pension could face a large reduction. Increasing the retirement age to 66 in 2021 and then further to 67 in 2028 addresses the problem in the short run however with uncertainties facing the State pension, people need to start an adequate savings plan to compliment the State pension they may receive in the future.
Chapter 2: Literature Review
This chapter will examine previous studies that have developed the existing literature regarding the design of 21st century pension systems, behavioural economics and individual decision-making the combination of both while outlining some of the merits and the flaws associated with these studies. This should provide a foundation in understanding the impact of applying behavioural financial theory/thought to address the future sustainability problem of our current pension system in Ireland.
2.1 21st Century Pension System Designs
According to the OECD’s Pensions at a Glance (2011) report, there are currently three main pillars associated with the different types of retirement income provisions. These three pillars consist of (i) Mandatory – Adequacy, (ii) Mandatory – Savings & (iii) Voluntary – Savings. In the first pillar, an individual can receive a basic, resource-tested and/or a minimum pubic mandatory, adequate pension to which differs from country to country. In Ireland, the public system currently provides a basic state pension to all individuals above the retirement age of sixty-six years of age. In the second pillar, an individual are set up on a defined benefit scheme, points scheme or notional accounts scheme through the public sector on behalf of the state or an individual operating in the private sector can expect to be set up on a defined benefit or defined contribution scheme. However currently, there are no mandatory saving schemes provided in the Irish public or private sectors. This puts a lot of pressure on the third tier which is the voluntary saving schemes such as defined benefit or defined contribution which is solely provided by the private sector.
2.2 Overview of behavioural finance
Behavioural Finance is a field that seeks to combine behavioural and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions. One assumption that traditional theories make is that people are rational and always seek to maximize their own well-being by increasing their wealth with emotions and other factors not influencing people when it comes to making economic choices. However, several studies have shown that human emotions (sentiment) affect market outcomes as humans often act irrationally. The application of behavioural finance to the current pensions & retirement can provide key insights to enhance these structures.
2.3 Application of behavioural finance insights to pensions & retirement savings
According to IGEES report (2013), there are two main reasons as to why people save less than required for their retirement. These two reasons are: 1. The trade-off between current & future consumption & 2. Financial literacy: The ability to comprehend the complexity of various financial products. As a result, consumers defer this financial decision until a later date. In Ireland’s case, many people have to opt-in to a voluntary private retirement savings scheme which takes individual time & effort to which many young people choose not to engage in as a result. This research implies that a change from an opt-in to an auto-enrolment, opt-out scheme may well have major consequences for the future sustainability of the Irish Pension system. In the United States & the United Kingdom, the auto-enrolment systems have been implemented to which have seen success in participating rates doubling while the number of people opting out of this default have been minimal. In Ireland, there is currently an examination into the concept of having an autoenrollment to which behavioural finance thought could inform this policy design for it to be effective. Problems such as anchoring could arise if default levels of contribution are set too high or too low. If default contributions are initially set too low, people are most likely not going to opt to save more and if default contributions are set too high then people are most likely to opt-out of the scheme altogether.
Behavioural Economics, Central Expenditure Evaluation Unit, DPER
2.4 Challenges facing the Irish pensions and retirement savings industry
As stated by the President of the European Commission “Demographic trends are a powerful force for change”.
Demographic changes can have detrimental economic and social consequences. To examine the current trends which are challenging the current pension schemes, we must concentrate on various environmental & performance indicators.
The environmental indicators span across demographic, labour market and fiscal policy indicators. This concentration will allow us to examine the extent of this problem that’s slowly developing. With respect to the demographic indicators, I will examine current fertility rates, life expectancies, old-age dependency rates and the co-residence rate of the elderly. Thereafter, I will focus on the labour market indicators using indicators such as labour force participation rates of working age population, labour force participation rates among those older than 65 and share of labour force in agriculture. Finally, I will analyse public debt as share of GDP, Government spending as share of GDP and public deficit as share of GDP.
To analyse the current performance of our pension system in Ireland, I will examine performance indicators such as coverage, adequacy, sustainability and affordability, economic efficiency, administrative efficiency and security.
Occupational pensions are now are a cause for concern as there is a decline in firms opting for the Defined Benefit (DB) schemes for their employees which effectively translates the risk previously taken by the firm to the employee as Defined Contribution (DC) schemes are now common amongst pension schemes offered by employers. This is problematic especially for Ireland as there is no second-tier, mandatory-savings schemes that individuals are not automatically enrolled.
As a result of having a Social Insurance Fund, which is currently managed and controlled by the National Treasury Management Agency, Ireland will face problems with financing the PAYG (Pay as you go) system as, by 2050, the ratio of the working-age population to every retiree will have halved from approximately four to only two people working for a retiree.
Chapter 3: Data Collection & Manipulation
To examine the current trends which are challenging the current pension schemes, we must concentrate on various environmental and performance indicators.
The environmental indicators span across demographic, labour market and fiscal policy indicators. This concentration will allow us to examine the extent of this problem that’s slowly developing. With respect to the demographic indicators, I will examine current fertility rates, life expectancies and old-age dependency rates. Thereafter, I will focus on the labour market indicators using indicators such as the labour force participation rates of working age population and the labour force participation rates among those older than 65. Finally, I will analyse public debt as share of GDP and Government expenditure as share of GDP.
Based on the fertility rate data compiled by the World Bank, there is a sharp decline in fertility rates across the world which can mainly be attributed to the rise in women included in the work force which has positively contributed to the overall growth in Gross Domestic Product while clearly negatively impacting fertility rates across the world. In the year 1980, there were approximately 3.2 births per woman in Ireland however if we fast-forward to the 1990, fertility rates fell to circa 2.1 births per woman in Ireland. It is important to note that Ireland had an above average fertility rate in 1980 in comparison to the OECD members. We are now experiencing fertility rates that are at a 57-year low where in 2017, there are approximately 1.8 births per woman in Ireland. New Zealand
According to data provided by the World Bank and the Central Statistics Office (CSO), Ireland amongst many other developed and developing economies are facing rapid growth in the total number of years that an average man or woman can expect to live until. This is largely a very positive development however this poses new challenges to existing pension structures & designs worldwide. Currently, the average man and woman in Ireland can expect to live until a very respectable 78.4 years and 82.8 years respectively. This is in direct contrast to the historical life expectancy at birth in the year 1960 where on average men and women in Ireland could expect to live until approximately 70 years old. This poses as a direct threat to the future sustainability and feasibility of our current pensions system where on average individuals are experiencing a longer, healthier lifespan which presents the need to be adequately and appropriately financed by a combination of public and private pensions. The problem is that many individuals are ignoring the current warning signs that they need to start contributing to their pension as soon as they come of working age. Individuals who are currently enrolled in a defined benefit scheme can expect to be guaranteed a life-long pension upon retirement however individuals who are on a defined contribution scheme need to be more proactive with contributing towards their saving schemes as this will eventually contribute to their retirement fund to which will determine their annual income upon retirement.
Historical data of old-age dependency ratios in countries such as Ireland, Switzerland, Luxembourg and New Zealand have shown a significant increase globally which is shown in Table 3.3 based on data provided by the World Bank. Specifically, Ireland’s old-age dependency ratio significantly during the years 2010 and 2015 where the ratio increased by approximately 4% from c.16% to c.20% over the span of five years. This dramatic increase in the old-age dependency ratio could be as a result of a reduction in the working-age population and/or an increased amount of people ageing above the working-age population criterion while also the reduction in mortality rates signifies that people are living longer. Ever since this “kink” in the trend, there has been steady growth in this ratio which shows an ageing population which is growing while less and less youth workers are matching this growth to steady this growth in the old-age dependency ratio. To add perspective, in Ireland there are currently roughly four workers for every individual above the age of sixty-five however by 2055, the number of workers per retiree is set to exponentially decline by nearly half based on projections made by the Chartered Accountants of Ireland. This puts incredible pressure on the State pension scheme of which many people are currently relying on to finance their future retirement as they have little or no retirement savings due to having no occupational or private pension scheme.
Labour market data compiled by the Organisation for Economic Co-operation and Development (OECD) shows increasing participation rates in the Irish Labour force which is expressed as a percentage of the working age population. Over the last four years, the participation rate has increased from 71.71% to 73.05% where there is a year-on-year growth of +0.47%. This growth can also be assumed to originate from the decline of the working age population which is mainly due to low fertility rates or it could be due to over sixty-fives continuing employment (Table 3.5) as a result of their increased life expectancy or their insufficient retirement savings. These are some of the assumptions taken when analysing the trend in the data provided by the OECD.
As our left-skewed, ageing population grows older, this poses questions around the State’s ability to uphold its ability to meet the current State pension offered to retiree in the future. The current State pension is c.12,000 euro per annum however as more & more people retire in future years the law of demand & supply will kick in with respect to the Irish Governments’ scarce resources as the demand for the State pension will increase exponentially which signifies that the average State pension will decrease. This decrease is mainly as a result of the State’s scarce resource which are ultimately financed through the Social Insurance Fund where the current Labour Force in Ireland contribute towards the current retirement needs of the retirees in Ireland. To summarise, more people will require assistance from the state through the State pension however less people will be working to raise enough finance for the Government to use to match the needs of the retired population.
Chapter 4: Main research and Hypothesis Development
In 2019, Ireland is currently one of the only OECD countries to not have a second-tier, earnings-related mandatory savings scheme while only providing a first-tier, mandatory basic state pension according to the OECD. As a result, this is a cause for concern.
In Ireland, the PAYG (pay as you go) social insurance fund (SIF) was set up as a system to insure nearly all workers against various “contingencies such as old age, illness, maternity and unemployment” according to the OECD Pension system reform report on Ireland in 2014. This PAYG SIF finances these benefits to the Irish citizens by using contributions made by employers, employees and the self-employed. The main expenditure on behalf of this fund is the financing of pensions which consists of approx. two thirds (60% – 2012, 64% – 2013) of overall expenditure. This expenditure is used to finance the ever-increasing pension needs in Ireland with a 4% increase between 2012 and 2013. The non-contributory, State pension is funded through general governmental taxation where this need is paid accordingly which is solely dependent on demand.
During 2001, the National Pension Reserve Fund (NPRF) was set up by the Irish Government to effectively meet enough of the costs associated with the Country’s social welfare and public service pension schemes from the year 2025. This fund, which is controlled by the National Pension Reserve Fund and managed by the National Treasury Management Agency (NTMA), was primarily set up to protect the financing of the pension system from the ageing population.
To address the current trends contributing to the Irish retirement-savings dilemma, there is a widespread shift of responsibility from employer to employee in both public and private sectors. Individuals entering the work force since the year 2003 have been entered in more defined contribution schemes then defined benefit schemes with overall membership in either schemes facing a constant decline since 2009 for defined contribution schemes which are viewed as “voluntary employee contribution” while defined benefit membership has been consistently declining since 2011 based on Table 4.4.
As the adequacy of the future state pension is under intense scrutiny, there is further individual responsibility especially in Ireland to have private, personal defined benefit or defined contribution schemes in place especially if you are not enrolled in an occupational pension plan via an employer.
According to CSO in 2018, 53% of all workers in Ireland between the ages of 20 and 65 have neither an occupational nor a personal pension. This statistic present us with the issue of coverage in the sense that not enough people are saving or saving enough for their retirement. Based on statistics provided by Irish Life in 2018, the average age for joining a defined contribution plan is thirty-seven years old which is way too late. To further this insight, in total, 90% of people are not on track with their pension savings. These statistics convey a clear picture that the traditional Irish attitude towards pension planning is heavily reliant on the State and employers whether in the Public or Private sector. Clearly, there is a significant challenge facing the Irish Government to maintain the adequacy of the State pension while it’s in the best interest of the Labour Force and the Government to increase the coverage.
4.2 Issues and challenges associated with the current system in Ireland
A. Defined Benefit & Defined Contribution Dilemma
There is currently a shift from Defined Benefit (DB) schemes to Defined Contribution (DC) schemes in the private sector where employers are currently off-loading the financial responsibility to save for the employees’ retirement from employer to employee through this shift in Defined Benefit schemes to Defined Contribution schemes. This shift in responsibility is causing grave concern in relation to a behavioural financial perspective as individuals often make irrational decisions. Irrational decision making such as consuming all their income presently rather than saving five percent of their annual salary towards future consumption when the time to retire dawns. Rational individuals would ensure to enrol in either pension schemes so that they can maximise their welfare both presently and in the future. However, this is not the case. The attitude towards future consumption is not urgent in the eyes of many workers as Irish Life stated the average age for joining a defined contribution scheme is thirty-seven years of age.
B. Financial literacy and the future of retirement savings
The nature of the pensions industry is that consumers often have to make a trade-off between present and future consumption of their income to which many young working-aged individuals choose to consume all their income in the present with little or no savings to when they come of age to start saving for their retirement. This poses the question are the generation financially literate? Well the simple answer to this question is that if they are, they would understand the importance of saving for retirement while having a comprehension of three important, very useful concepts when it comes to saving: 1. Compound Interest, 2. Diversification and 3. Inflation.
Currently, less than one third (33%) of Americans understand these three concepts according to Forbes while there often is a strongly positive correlation between those who have very low financial literacy and those who are least likely to save for retirement.
To address the current issue with regards to retirement-savings, there is currently an annual shortfall of approximately of 6,800 euro based on a targeted annual retirement income of 16,900 (excluding the State pension due to uncertainty as to the future adequacy) which is calculated on the assumption that the average individual joins a defined contribution pension plan which an average annual salary of 51,000 euro while contributions average just above 11%. Some of the main reasons individuals offset their pension plan contributions is as a result of the affordability, inertia while also the complexity and comprehension of pension plans.
C. How adequate is our system? Is there enough coverage?
There are two main challenges that is currently putting pressure on the Irish pension system.
Firstly, an increasingly amount of people need to save more for retirement to uphold some sort of adequate retirement lifestyle in terms of being financially comfortable. This problem causes a “domino” effect as the longer workers leave saving for retirement, the more they will have to contribute in the future. For example, an individual/employee aged 25 years old who is enrolled in an occupational defined contribution scheme contributes 5% of their 35,000 euro salary annually which is matched by their employer each year will have approximately 462,000 euro of a retirement pot which is an annual salary of c.17,000 euro in addition to the State pension. However, in direct contrast, if an individual started his pension plan aged 40 years old, their expected annual salary would be c.9,100 (excluding the state pension) euro based on an expected retirement fund of c.246,000 which is nearly half. This illustration shows the importance of early enrolment in these pension schemes while it takes the reliance off the State pension.
Secondly, there is an alarming amount of people who have neither an occupational nor personal pension plan as according to the Central Statistic’s Office in Ireland, 53% of all workers aged from twenty to sixty are not currently enrolled in neither an occupational nor a private personal pension scheme. As a result of research carried out by Coyne in December 2017, 74% of people said they are currently not planning for retirement or they don’t know what their expected retirement fund or annual retirement salary will be. There is an urgent direct coverage need, on behalf of the Irish people, for more people to join pension plans whether personal or through their occupation. There are many reasons as to why people don’t feel the need to save for retirement such as the affordability of pension schemes, inertia where people never get around to it, the accessibility of the money saved and the perception of investing as it is often viewed as complex to the average worker which could mainly be due to the standard of financial literacy in Ireland. Also, a current incentive that most people are unaware of is the fact that there is very generous tax relief (c.40%) on savings for retirement.
These two core issues need to be tackled in order to address the problems of pension coverage and income in the future.
D. Life Expectancy Rates – Low fertility rates and low mortality rates
We are currently living in a world of increased female participation in the Labour Force while the average lifespan is growing year-on-year as a result of improved productivity due to worldwide technological growth as our health and wealth have been positively impacted due to reaping the benefits of Globalisation 1.0, 2.0 and 3.0. However, with every opportunity there comes a challenge. We are now living in a world with low fertility rates which is being met with low mortality rates signifying how our life expectancy is increasing where many individuals living above and beyond historical highs in terms of age. As this is a fantastic development in terms of demographics, this presents a challenge to the economists and politicians of the world with respect to how this demographically driven pendulum swing impacts the sustainability of our currently outdated pension system which is evident in Ireland specifically.
4.3 The Government Roadmap for pension reform 2018-2023
The Government are currently implementing a reform strategy for the pension structure in Ireland with the introduction of the Government Roadmap of Pension Reform 2018-2023. The areas of reform are the introduction of automatic enrolment, the public service pension restructuring, the state pension reform through a Total Contributions Approach (TCA) while supporting the sustainability of the Defined Benefit schemes.
The main area of reform is the introduction of automatic enrolment which is replicating the United Kingdom’s successful implementation of this strategy in tackling the coverage of their pensions system. This strategy is where individuals are automatically enrolled in an occupational pension plan when they are above the age of 23 while earning a minimum of 20,000 euro a year. Those who are on lower salaries can opt-in to the scheme.
Chapter 5: Analysis of possible solutions for recommendation
5.1 The Ultimate Nudge: Solving Inertia through Automatic enrolment
Richard Thaler, the winner of a Nobel peace prize in 2017 for his profound theory on “From Cashews to Nudges: The evolution of behavioural economics”, introduced the theory of nudging while emphasizing its importance & effectiveness to curb irrational human decision-making. A nudge is defined by Thaler and Sunstein in 2008 as “any aspect of the choice architecture that alters people’s behaviour in a predictable way without forbidding any options or significantly changing their economic incentives”.
Automatic enrolment is a method of nudging as it still maintains the preservation of choice in the sense that people maintain the freedom to do as they please in the sense of opt in or opt out as Thaler can be quoted “Libertarian paternalism is not an oxymoron” with reference to choice architecture.
Automatic enrolment is currently included as one of the main areas of reform in the Government’s Roadmap to Pension Reform report. Although automatic enrolment is largely a very positive development, there are a few problems. There are two main problems which are people may fail to join while those that do join may not be saving enough. To those who may opt out of automatic enrolment when it is introduced in 2022, employers should take responsibility in actively informing their employees that are not in a pension plan in an attempt to increase overall coverage of their employees as it is in the best interests of these individuals. To those who are automatically enrolled but aren’t saving sufficiently, they should be notified about the major concerns surrounding their pension plan to educate them on their potential retirement income short comings. Also, employers could enhance their employee’s decision making, with regards to their contributions to their pension plan, by informing them how the pension plans of their peers are performing. These simple yet effective potential solutions could have a drastic effect on the problem of inertia solving future adequacy and coverage pension problems.
In the New Zealand, automatic enrolment was introduced in 2007 which was branded the “KiwiSaver”. This nudge had a very positive effect as according to Irish Life, as per June 2017, over 2.5 million people opted into the automatic enrolment which is just over 50% of the overall population.
In Australia, since the arrival of the Superannuation Saver, coverage has been very high as in June 2017, Irish Life stated that the rate of coverage of the population was over 60% with approximately 15 million enrolled in a super fund account.
5.2 Modernise and simplify the outlook and choice of pensions plans for individuals
Employers and the State should try to appeal the idea of saving for their retirement by simplifying the information needed to engage the individual while making the information more accessible in terms of being easy to engage, understand and take necessary action. This simplicity alongside automatic enrolment could effectively combat this inertia that individuals have and could improve and/or financially educate those who are financially illiterate.
While this simplification helps solves the problem of inertia, another one of the problematic assumptions in economic theory is that consumers are better off with varied amounts of options or choices however, as research shows according to the OECD’s report on the implications of behavioural economics for mandatory individual account pension systems, limiting the amount of investment options is another technique used to prevent individuals from confusion and complexity as a result of information overloading.
5.3 The role of active decision making and the default option
Another key issue is, if there is a simplified menu of options, the design of the default option is very important as although individuals have limited choice, they still make inactive decisions based on the choice provided so they choose the default option. A possible recommendation with regards to the designing of this default option is that it would automatically adjust the asset allocation of the individuals retirement fund scheme in line with the age-based risk profile in a means-tested way to ensure the problem of adequacy and affordability of both the retirement fund and the contributions are restored respectively.
Chapter 6: Conclusion
To conclude, although the Irish pension system is facing a varied amount of challenges with regards to aforementioned problems as discussed throughout this working paper, behavioural financial thought can positively impact the future sustainability of the Irish pension system through the usage of theories such as the theory of nudging which was introduced by Richard Thaler in order for automatic enrolment to have a long-lasting effect to boost the coverage and adequacy of current retirement savings for the people of Ireland. Throughout the research and analysis of this problem in Ireland, I believe more effort is needed on behalf of employers and the State to ensure employees and the self-employed are consistently updated on the status of their future retirement fund based on current annual contributions while also educating and simplifying the complexity and/or comprehension of the three main concepts of wealth management which are inflation, compound interest and diversification of investments. It is vital that financial literacy is instilled in our work force of today and tomorrow as highlighted throughout this working paper. Behavioural finance is still in its infancy stage however as we learn more about human irrationalities, the more we can improve and enhance our capabilities to meet the growing wants and needs of society today with reference to the idea of saving for future consumption.
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