132964353.doc Pension arithmetic February 2011 (revised April 2012) Karl Seeley (SeeleyK@hartwick.edu; http://thedanceofthehippo.blogspot.

com/)

1 z 10

In a recent conversation with an economist colleague I asserted that the change to a private pension system without changes in the size of contributions to it couldnt have an aggregate effect on the performance of the system. The essence of pensions is that claims arising with firms and their employees must be redirected to retirees who lack incomes arising from current productive activity. Whether that takes place by means of taxes (that is, contributions to a state system) and payment of benefits by the state, or through contributions to private pension funds, which then pay out benefits to their retiree clients, the same thing has to happen: firms and their employees must relinquish a part of their purchasing power in favor of retirees. The key data are the ratio between workers and retirees, and the productivity of those workers; the choice between a state system and a private one doesnt change anything substantive. This observation seems obvious to me, but judging by the frequent occurrence of expressions about how in a private system everyone pays for his or her own pension and thus isnt dependent on broader economic conditions, not everyone sees it the same way. (More on one such claim below.) My colleagues answer was that, from a static perspective it was true, but that the move to a private system would raise economic growth. The idea is that the state is a bad manager, so as moneys previously under its control were freed up to go into private hands, the overall performance of the economy would improve. But that also seemed mistaken to me. The substantive issue here, after all, isnt the oversight of flows from workers to retirees, but the amount of real investment. In our verbal discussion we were somehow talking past each other and it wasnt clear whether we were talking about the same concepts. I would say that the widespread advocacy of privatized retirement systems is founded on at least one of these ideas: either by creating a private system we insulate individuals from unfavorable developments in the economy, or by removing pension funding from the incompetent hands of the state we accelerate economic growth. I will try here to show that both of these ideas are mistaken.

132964353.doc

2 z 10

I examine the possible impact of pure redirection of retirement contributions from a state system to a private one, that is, I leave unchanged the size of those contributions and likewise governmental expenditures outside the retirement system and the levels of consumption of all groups in society. In contrast to general opinion I claim that such a changethe pure redirectioncannot have any effect. I see two possible sources of this disagreement. We have to distinguish between gross flows into financial markets and net expenditures of private firms on real investments (e.g., new factories and machines, R&D, etc.). Its clear that the transfer of retirement contributions to a private system raises the gross flows, but my equations below assume that raising the gross flows in and of itself wont accelerate growth. So if the reader doesnt accept that assumption, theres no point in bothering with the equations. I support the assumption immediately below with a verbal argument, then with the equations I attempt to show that expenditures on real investment are unchanged. So first of all about flows into financial markets. I dont see any significance of greater flows into the stock market and flows out of it, so long as they dont lead to a higher level of real investment. For the majority of inflows dont go into the hands of private firms in order for them to undertake further real investment; rather, they go into the hands of previous private, non-firm holders of the stocks, who for various reasons want to liquidate a part of their stock-market positions. To the extent that a greater inflow to stock markets caused by pension reform goes partly to the expansion of sources available to firms for investment, arithmetically it must be balanced by a reduction of other sources, and so the aggregate size of those sources remains unchanged, which is the subject of the equations below. Another argument could be that even if a greater flow of savings into the stock market doesnt change the scale of investment, it nonetheless improves the allocation of those investment expenditures among various possible purposes. For the prices of shares on the stock market are a signal (at least in theory) of the markets evaluation of the prospects of various firms and thereby influence the ease of borrowingfirms whose share prices are rising can borrow greater amounts with a lower interest rate. But this signal must be derived not from the

132964353.doc absolute share price of a given firm, but rather from its performance relative to the share

3 z 10

prices of other firms. And so what matters is whether that signal will be better when new people brought into stock-market investing by pension reform participate in its formation. And thats something I can hardly imagine. The current participants in the stock market are likely to be those who have the greatest interest in such activity and thus have the greatest willingness to engage in the research needed to determine which firms have the best prospects. The addition of less informed participants is more likely to make the signal worse rather than better. Narrowing the choice of depositing ones pension savings into one or several previously designated index funds doesnt help matters, because index funds by design dont act on the basis of some sort of opinions about future success of different firms, they merely follow the opinions of others. This in effect weakens market signals about firms. If we are in agreement thus far, then the next question is whether changed flows into financial markets can raise the level of real investments, and so I turn to the equations that showat least I think they showthat they cant. I want to focus on reform in the manner of financing a pension system and not on the influence of other possible changes in the consumption by various parts of society or in government expenditures on non-pension matters, even though such changes may be necessary in the case of consumption and desirable in the case of government expenditures. I begin with the normal equation for Gross Domestic Product, for a closed economy (without international trade; I return to that point at the end of the note): Y=C+I+G where C, I, a G are as usual consumption, private investment, and government expenditure (which, as usual, doesnt include transfers, which means that it also doesnt include pension benefits in a state pension system), and Y is GDP. I make this equation more specific by dividing consumption among: B: consumption of retirees on the basis of retirement benefits, whether those come from a state system or a private one

132964353.doc CS: consumption on the basis of savings outside of possible savings in a private pension system, and Cw: consumption on the basis of wages. Y = Cw + CS + B + I + G.

4 z 10

(1)

All purchasing power for these expenditures arises from useful activity of the private sector. It originally belongs to owners and employees and is divided according to labor contracts: Y=+w (2)

where indicates the owners share (something like profit, though of course not identical with it) and w is the workers share (derived from "wages"). This means that all expenditure in equation 1 must lie at the end of various paths from the two amounts in equation 2. In the material below, I trace those paths, but already on this general level its clear that the amount of private investment cant be increased so long as: 1. the aggregate of the amounts Cw, CS, B, a G remains unchanged; 2. the size of GDP remains unchanged. The intuition behind this assertion can be illustrated by looking at a typical reflection of what seems to me a fundamental misunderstanding of the whole matter. Marek Hudema writes, In a [retirement] fund system, where everyone who participates pays for his own pension, future retirees arent threatened by a shortage of workers in the future. (Coalition has agreed on pension reform, Hospodsk noviny, February 18, 2011) But how would that actually work? You pay for your pension now during your working years, but you dont draw on it until the future. Because you dont eat money, the future validity of your pension still depends on the number and productivity of workers in the future, regardless of whether its a state system or a private one. Put in simplified terms, in the state system there could be a shortage of people paying retirement contributions, but entirely analogously in a private system that would more or less correspond to a shortage of demand for the shares of retirees who need to sell them to have money for consumption, which is, after all, the whole point of any pension system. Of course the details diverge from this simplified picture, but it nonetheless captures the essence of the matter.

132964353.doc For the details, lets start by dividing up a w and their paths to their final use.

5 z 10

Owners pay a profit tax at a rate of t. They pay dividends to shareholders, designated dS (the subscript S is to distinguish it from dB, which I will introduce later). And there are retained earnings r. So we have = t + dS + r. Wage earners have to pay income tax ty w and also pay their contributions to the retirement system w. From what remains, they save the portion sw, and whats left is used for consumption, Cw: w = ty w + w + sw(1 - - ty) w + Cw (of course we can rewrite this as in more familiar terms showing consumption as a share of disposable income: Cw = (1-sw)(1 - - ty) w). Now we have to trace the deposits into savings (including those that go to the stock market) and also those in the other direction, withdrawals from savings. The excess of deposits over withdrawals represents the amount available to firms for investment. For instance, a significant part of the money invested in the stock market doesnt go into the hands of firms for investment, but rather is paid to previous non-firm owners of the shares that were bought. In the following equations the subscript 0 indicates the original condition, that is, a state system for later comparison with a private system, for which I will use the subscript 1. Flows into the stock market come in part from savings out of wages and in part out of savings from dividends. Recipients of dividends pay the same income tax as wage earners, and from whats left they save the portion sd. So gross savings H [from the Czech hrub for gross] H0 = sd(1 - ty) dS + sw(1 - - ty) w.

132964353.doc

6 z 10

Withdrawals, flows out of savings, we designate Z, and because those are by definition money not available for investment, we can say that they are used for consumption. More precisely, they are a part of CS, consumption on the basis of earlier savings. The other component is that part of dividends that shareholders didnt save, so we have CS = (1-sd)(1-ty)dS + Z0 or Z0 = CS (1-sd)(1-ty)dS. So net savings of the private sector S are S0 = sd (1 - ty) dS + sw (1 - - ty) w Z0. But what interests us is the amount available to firms, and so we have to adjust net private saving by possible surplus or deficit in both parts of the government budget, that is, in the general budget and also in the pension system. Taxes other than retirement contributions are T0 = t + tydS + tyw so if we notate the balance in the general budget as GG, we can say that the general budget balance is GG0 = t + tydS + tyw G (in the case of a deficit, this amount is negative). The balance in the pension system is simply P0 = w B.

132964353.doc

7 z 10

The final source of means for investment are retained earnings, and in the original state they are R0 = r so the final sum of means available for investment is I0 = H0 Z0 + GG0 + P0 + R0 or I0 = sd (1 - ty) dS + sw(1 - - ty) w (CS (1-sd)(1-ty)dS) + (t + tydS + tyw G) + ( w B) + r or I0 = (1 - ty) dS + sw(1 - - ty) w CS + (t + tydS + tyw G) + ( w B) + r. (4) (3)

So theres the state system. For comparison with the private system lets assume that all parts of consumption (Cw, CS, B) remain unchanged, as do retirement contributions ( w). The amount B will no longer be paid by the state, but will be substituted by a combination of dividends and withdrawals from financial markets. Le me first note that dividends in the setting of the retirement system are a new element in the equations. A part of share ownership wouldnt be here under the state system and so we must make room for dividends to these shareholders. If we denote these dividends in the context of the retirement system dB, and if we assume that the owners share remains unchanged, then some combination of retained earnings and dividends to other shareholders must make way for these new dividends. If we denote these changes, as dS and r, where dS 0 and r 0, it follows that dB = -(dS + r). Further, so long as we dont change the aggregate amount of pension benefits B, the supplemental amount of withdrawals from the financial market must be (B dB) or (B + dS + r).

132964353.doc

8 z 10

And so in turn the changes in individual parts of equation 3. The state system is eliminated, so the state no longer receives retirement contributions, but it also no longer pays benefits, which means that the balance in the state pension system is zero: P1 = 0 and P1 P0 = ( w B). Gross flows into financial markets change by the pension contributions of current workers w, which flow now into private accounts, but also change by sd (1 - ty) dS, since recipients of dividends have less from which to save. So we have H1 H0 = w + sd (1 - ty) dS. Withdrawals from financial markets will have to change. First, when shareholders outside the retirement system lost -dS, they had less for consumption, by -(1 - sd) (1 - ty) dS, and that has to be replaced by increased withdrawals, in order to have unchanged consumption CS. Second, withdrawals have to provide that part of retirement benefits which are not covered by dividends in the context of the retirement system dB, that is, (B + dS + r). So we have Z1 Z0 = -(1 - sd) (1 - ty) dS + (B + dS + r). The state loses part of its tax revenue because of the diminished dividends, and thus GG1 GG0 = ty dS And finally, retained earnings are reduced by r, so R1 R0 = r.

132964353.doc

9 z 10

We now have all the components for the comparison of the level of investment under the state pension system and the private one, under the condition that there is no change in CS, Cw, B, and G. I1 I0 = (H1 H0) (Z1 Z0) + (GG1 GG0) + (P1 P0) + (R1 R0) = [ w + sd (1 - ty) dS] [-(1 - sd) (1 - ty) dS + (B + dS + r)] + ty dS ( w B) + r. Rearranging terms we have I1 I0 = w w + sd (1 - ty) dS + (1 - sd) (1 - ty) dS + ty dS dS r + r B + B = (1 - ty) dS + ty dS dS = 0. The fact that retirement contributions flow to private accounts rather than into a state system cannot, in and of itself, increase the quantity of real investment. I said I would return to the question of an open economy, and its high time for that. I dont have it worked out in similar detail as with the closed economy, but I see the outlines and I think that a similar principle is at work in this case as well. Its true that participants in a private system have the option of buying shares of firms in other economies where there are more favorable demographic trends or faster economic growth. In this way Czechs, paying into their pension funds, could insure themselves against unfavorable domestic trends. It also seems that the entire economy in aggregate could escape from the strict limitations embodied in the foregoing equations. The redirection of w from the state system not into the domestic stock market but into livelier foreign stock exchanges seemingly

132964353.doc

10 z 10

holds out the possibility that with pension contributions of the same size as today we can allow ourselves larger pension benefits in the future, or that we can support unchanged future benefits with smaller contributions today. But this is deceptive. For the purchase of foreign shares, the Czech economy as a whole has roughly its foreign trade surplus, exports minus imports. Some actors are already making use of that surplus and buying some foreign shares. If participants in a privatized pension system want to buy foreign shares, that necessarily means that people who were already buying those shares will have to buy less than they would have, had we stayed with a state-run pension system. And these reduced purchases will later show up as reduced consumption on the basis of savings (held abroad). Put slightly differently, in some future yearlets say 2035the amount the Czech Republic will have available for consumption will be its own GDP, minus government expenditures G, minus investment I, plus the net gain from the ownership of foreign shares F (payments to Czechs owning foreign shares minus payments from the Czech Republic to foreign owners of Czech shares): C2035 = Y2035 I2035 G2035 + F2035. A greater share of F2035 for some individuals means a smaller share for others. And a greater aggregate size of F in the future means larger purchases of foreign shares in the present, which also requires other changes in the present: lower consumption, lower investments, lower government expenditures, or higher GDP. But in making any of those changes we would not maintain the condition that we are examining only redirection of financial flows.