Mervyn King on Uncertainty

by Daniel on December 15, 2004

I don’t ask much of you lot, but I’m asking you to read this (yes yes, pdf, they’re not exactly uncommon you know) speech by Mervyn King, Governor of the Bank of England. As well as being one of the UK’s best technical economists, King really is uncommonly thoughtful and insightful when it comes to issues outside his direct area of specialisation (I notice that he thanks Tony Yates in the acknowledgements, who is also a top bloke). This British Academy lecture takes on the concept of risk in the abstract, and illustrates it with a number of examples related to the retirement savings industry. It’s really very good. If you take nothing else away from it, there is one point which is extremely well made; that part of the reason why we have a role for public provision of pensions is that it allows us to spread the burden of longevity risk between present and future generations.



P O'Neill 12.15.04 at 2:27 pm

The newspaper accounts when he originally gave the speech focused on his idea of Longevity Bonds, or some other related type of insurance based on the life expectancy of cohorts. The potential demand for this instrument is clear — but less clear is who would be either willing or able to supply them. He’s implying that it’s the government but doesn’t quite say so, and kicks the issue into touch via footnote 25. But it’s certainly relevant in the rush towards privatisation and the downgrading of the generational insurance aspect of pensions to have an answer.


Tracy 12.15.04 at 5:05 pm

The cause for concern with current public pension systems is that they shift too much of the risk to future generations, in that future generations are likely to be too small to pay for the pensions promised to the baby boomers. (Obviously some of these future generations already exist and are working).

E.g. the NZ superannuation scheme ‘guarantees’ NZ super paid at age 65 at a fixed ratio to the average wage. Consequently, if longevity goes up, under this scheme retirees’ income doesn’t fall, except indirectly if taxes are raised or government spending cut, instead then-workers’ income falls or other government services are cut. Especially since the NZ tax system is roughly progressive, so most retirees will lose less as a proportion of their income if taxes are raised than workers.

Most privatisation schemes appear to be designed to shift some of the burden back to current workers, by requiring current workers both to pay for current retirees and set aside money for their own retirement. Ditto Dr Cullen’s super fund. This does raise the question of who is expected to buy all these assets when around the world the baby boomers start retiring. It also means none of the risk is borne by currently retired.

In other words, it’s going to be painful one way the other.


Dubious 12.15.04 at 6:39 pm

As pointed out in the paper, there are two types of uncertainty over lifespan.

First, there is uncertainty over one’s individual longevity. Defined Benefit pensions (such as SocSec) and annuities are extremely useful products for that kind of risk. Extremely naive economic theory (The Lifecycle Theory of Consumption) suggests that retirees should annuitize 100% of their lifetime wealth. There are many theoretical reasons why this would not hold true. There is a fair amount of empirical evidence that retirees in the US, particularly poor retirees, hold TOO MUCH of their income in annuitized form. Many poor households hold essentially 100% of their wealth in SocSec or other defined benefit pensions. They would prefer lower monthly payments in exchange for a stock of liquid wealth.

As mentioned by Tracy, given that increases in population-wide life expectancy (or shortfalls in birthrates) rarely seem to have resulted in benefit cuts (with the exception of raising the normal retirement age to 67), it would seem the current system puts all the risk on the working age population. This seems somewhat lopsided.


Jason McCullough 12.15.04 at 10:39 pm

For some reason annuity companies & life-insurance companies trading off opposite-direction risks on life expectancy through financial instruments reminds me of the old Warner Brothers cartoons.


Alex 12.15.04 at 11:34 pm

Transferring some of the risk to future generations can be justified on the basis that they are likely to have significantly higher real incomes than current generations.


Tracy 12.16.04 at 8:14 am

Alex – unfortunately under NZ super since superannuation payments are tied to the average wage (to be specific, the married couple’s rate is set at 65% of the average wage), it is nearly impossible under current rules for economic growth to diminish the problem. As incomes go up, retiree’s incomes go up. As the ratio of retirees to workers goes up, this implies that the relative proportion of incomes going to workers goes down. And then you can add in healthcare costs, which are likely to go up substantially too.

(Nearly impossible because there could be some massive transformation in the economy which means that the bulk of income increases show up in self-employed and investment income, while wage income relatively declines. This seems unlikely.)

I don’t know how many other countries around the world face the same problem.

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