Ageing Populations Mean Lower Savings - But Fall Will Be Reduced If State Pensions Are Phased Out

04 Jan 1999

The demographic structures of European countries will change significantly over the next few decades and this will have major economic effects, according to calculations by Professor David Miles, writing in the January 1999 issue of the Economic Journal. Assuming, as seems likely, the ratio of people of working age to pensioners halves by 2050, aggregate savings will fall well below recent levels - from around 16% of national income in 1995 to 5% by 2045 - and average per capita GDP will be substantially lower than it would be under an unchanged demographic structure. But if unfunded state pensions were to be replaced by funded schemes, Miles estimates that the decline in the savings rate will be much reduced - stabilising at around 10% by 2050.


Falling saving rates should certainly not be seen as a ''problem'', Miles points out, any more than a decline in an individual's saving rate or a fall in their labour income late in life are necessarily a problem. Nevertheless, governments may feel they should respond to low savings with tax breaks on wealth accumulation or, perhaps more likely and certainly more helpful in terms of reducing public sector deficits and taxes, by sharply reducing the value of the state pension.


Miles considers an experiment with the value of the average European replacement rate - the ratio between the state pension and the average gross earnings of workers. In his experiment, the replacement rate is reduced by 0.01 a year from its assumed starting value in 2010 of 0.4 - when the state pension is 40% of earnings. The starting date for cutting the relative value of pensions is set some time in the future to allow individuals to begin adjusting now to the prospect of lower benefits in the future. And an annual reduction of .01 from 2010 implies that the state pension will be completely abolished by 2050.


Miles'' simulations reveal that varying the value of the replacement rate in this way has a dramatic impact: with the complete phasing out of state pensions, the decline in the aggregate saving rate is much reduced. When the replacement rate remains constant at 40%, the saving rate falls from 16% in 1995 to 5% by 2045. But with phasing out of the state pension, the saving rate stabilises at around 10% by 2050.


Higher savings imply a higher wealth to income ratio and a higher capital to labour ratio: consequently, there would be lower rates of return on savings. And so with gradual abolition of the pension, the real interest rate would fall from just over 5% in 1995 to 4.2% by the middle of the next century.


Miles draws three broad conclusions from his simulations:

  • First, that there may well be substantial swings in private saving rates over the next 50 years, but savings in the longer term are likely to fall well below recent levels as the proportion of the population aged over 65 rises to levels never seen before.
  • Second, the impact of the reduced saving rate on rates of return on capital may be relatively muted because a lower saving rate (which, other things being equal, would lower the path of the capital to labour ratio) is likely to be offset by a smaller workforce (which works in the opposite direction). In simulations for the European economy as a whole, the saving rate will be less than half its recent level by 2030, while the real interest rate will fall by 40 basis points (from around 5%), a proportionate decline of under 10%.
  • Third, because the rate of return on assets will exceed the growth in aggregate wages, once a switch away from unfunded pensions was completed, welfare for all future generations would be higher. But the scale of losses to many cohorts of the population during the transition would be substantial. This has important implications for how to engineer a switch from unfunded to funded pensions.

''Modelling the Impact of Demographic Change Upon the Economy'' by David Miles is published in the January 1999 issue of the Economic Journal. Miles is Professor of Economics at Imperial College, University of London.

David Miles

0171-594-9112 | d.miles@ic.ac.uk