Longevity gains and the internal rate of return of PAYG pension plans – Evidence for 17 OECD countries

Abstract

We study the impact of the continuous increase of longevity on the internal rate of return from PAYG pension schemes. We use an empirical analysis based on the evidence from 17 developed OECD countries to find that the trend to longer life expectancy leads to an additional return on top of the growth rate of the economy. Depending on the settings of the plan, particularly the retirement age, this extra return varies between 0.10% point and more than 1%-point over time and across countries for cohorts born in the period 1935–1990. The retirement age in most countries during the postwar period lagged the increase in longevity, implying redistribution form younger cohorts to older cohorts. A fair allocation of longevity growth would imply a proportional distribution over the working and retirement periods so that the ratio of working period length and pension period length remains stable over time. We show that an implementation of this fair rule as of the year 1960 would have led to an average reduction in the internal rates of return of 0.4%-point for all countries. The fall in return per country depends on the country-specific divergence of the actual retirement age and the fair rule retirement age. Furthermore, the implementation of the fair rule would have led to more stable contribution rates and to more stable ratios between the retired part and the working part of the population.