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I just finished reading one of the scariest documents I have read in a long time. If you are planning to watch a double bill of “Psycho” and “Nightmare on Elm Street,” you could prepare by reading this first. However, if you have a very nervous disposition, stop here.
The document is called The Financial Impact of Longevity Risk. It is chapter four of the IMF’s latest Global Financial Stability Report, which was published in April.
Some of us have been aware of longevity risk for some time and know it has been underestimated. What is so shocking is just how large the exposure to this risk is—not just in advanced economies, but in developing economies, too. Equally shocking is the very matter-of-fact language used in the chapter. The first paragraph reads: “As populations age in the decades ahead, the elderly will consume a growing share of resources. It is recognized that this will strain public and private balance sheets, and governments and private pension providers have been preparing for the financial consequences of aging. However, these preparations are based on baseline population forecasts that in the past have consistently underestimated how long people live.” Really? Governments and private pension providers have seriously been preparing for the financial consequences of aging? You could have fooled me.
First, let’s look at how much we have underestimated increases in life expectancy. In 1981, the United Kingdom (UK) Office for National Statistics estimated that male life expectancy at birth would rise to 74 by 2031. It hit that age in 1994. In 2002, the 2031 estimate was 81, but we are now expected to pass that in 2019. This systematic underestimation of official life expectancy increases occurs around the world. It is not an accident. It is deliberate. Politicians put pressure on official agencies to do this, so that the full cost of longevity increases does not fall on them or the current generation of voters. The reason is clear: If more accurate and hence higher projection of life expectancy were produced today, then social security contributions would have to rise now rather than later—and this would be politically very unpopular. The bottom line: On average, people have been living three years longer than official agencies have predicted.
Now let’s look at the IMF’s estimates of the costs of both anticipated increases in life expectancy and of underestimating life expectancy by three years (what it calls a longevity shock). In advanced economies, the annual cost of supporting a replacement rate of 60% in retirement in 2010 is 5.3% of 2050 GDP. To maintain this standard of living in retirement in 2050, the additional cost to account for expected aging will be 5.8% of GDP, while a three-year longevity shock adds another 1.5%—a total of 11.1% of GDP. In other words, the annual cost is expected to be more than 100% higher in 2050 in advanced economies. But it will be more than 150% higher in emerging economies than it was in 2010.
These are frightening increases. I do not think they are sustainable, nor do I believe the next younger generation of taxpayers will tolerate them.
What can be done? The IMF chapter offers three sets of measures for dealing with this problem: “(i) acknowledging government exposure to longevity risk and implementing measures to ensure that it does not threaten medium-and long-term fiscal sustainability; (ii) risk sharing between governments, private pension providers, and individuals… (iii) transferring longevity risk in capital markets to those that can better bear it. An important part of reform will be to link retirement ages to advances in longevity.”
These are all very sensible measures and ones that I and others have been recommending for some time, but the significance and urgency of the required governmental response is seriously understated.
Further, let’s look at what happens when governments try to follow this strategy. In the UK, attempts to reduce the future cost of public-sector pensions through higher retirement ages and increased employee contributions led to strikes. These reforms are very modest compared with the true cost of providing public-sector pensions, yet employees refuse to acknowledge this, claiming instead that they are being asked to pay for the financial crisis. In France, Francois Hollande’s new government was elected, in part, due to the promise to reverse the increase in state pension age from 60 to 62, which was introduced by the previous government. I now have no doubt that there will be intergenerational conflict on this planet in a few decades’ time.
In just 31 pages, the IMF gives a very thorough analysis of the problems facing governments in almost every part of the world—and it offers some sensible solutions. The problem is that it is expressed in such an understated way that the message is unlikely to be heard. I’m off to watch “Psycho” and “Nightmare on Elm Street,” but somebody somewhere needs to start shouting until everyone hears: “It’s the demographics, stupid!”
Dr. David Blake is Professor of Pension Economics at Cass Business School, Director of the Pensions Institute, and Chairman of Square Mile Consultants, a training and research consultancy.