Confronting the challenge of an ageing population

As the population continues to age, John Wilson explains why preparation must become a global imperative.

It’s hard to imagine a shock to the global economy that will rival the global financial crisis (GFC). But there is another one looming: the global ageing population.

While the consequences of our ageing demographic will be widespread, the future impact on our healthcare and pensions systems are perhaps most acute.

And they have been significantly worsened by the sharp run-up in the deficits of the major developed economies during the GFC.

Sharply elevated deficit and debt levels will eventually crimp these economies once current surplus capacity is absorbed.

The International Monetary Fund estimates the lift in debt levels could lead to an increase in interest rates of 2 percentage points over the next several years and a reduction of growth by a half to 1 percentage point per year.

As these economic constraints play out and more of us retire than enter the workforce, improvements to living standards will slow unless productivity increases.

There will also be fewer income earners to pay for government obligations; and the way governments respond will determine longer-term fiscal robustness.

Affordability of health care and age-related pensions are the two government obligations dominating concerns.

As countries become richer, more is spent on health care, with expenditure growing faster than the underlying economies.

The proportion of gross domestic product absorbed by health care in OECD countries has risen from a median of 3.8 per cent in 1960 to 9 per cent recently.

But we cannot blame our ageing population entirely. In fact, there are stronger forces causing the rise in health costs. The reality is the main impact from ageing is yet to be felt.

For example, Australia’s total health care spending is expected to rise from $50 billion currently to $250 billion by 2050.

Of the $200 billion increase, $75 billion will be due to an ageing and growing population. The balance results from demands for higher standards of care and more expensive procedures associated with technological innovation.

Retirement funding is the other major expenditure concern arising from our ageing population that comes from public pensions, private pensions or other private resources (or some combination of these).

When discussing pension systems, there are clear objectives and principles that all well-designed pension schemes share.

These include:

• coverage through both mandatory and voluntary schemes;
• the adequacy of the retirement benefits;
• sustainability of pensions to taxpayers and contributors; and
• the security of the benefits in different risks and uncertainties.

The pension systems must also ensure collecting contributions, paying benefits and managing investments is administratively and economically efficient.

In line with these principles, the World Bank in 1994 advocated a three-pillar model:

• a safety-net provided by the state to ensure a minimum level of income to keep retirees out of poverty;
• a compulsory scheme that is funded and aims to give retirees a level of income replacement; and
• personal savings, which may or may not get a tax advantage.

Australia already had this model in place and continues to fine-tune it along the lines of the six objectives outlined above.

As a result, Australia has one of the most robust retirement income systems in the world. But are other countries as well prepared?

The Center for Strategic and International Studies (a public policy institute based in Washington) recently completed an analysis measuring international levels of preparedness.

The level of preparedness is measured by the GAP Index, which focuses on old-age dependency. The index covers 20 countries — developed and selected emerging countries — and is made up of two components: a ‘fiscal sustainability index’ and an ‘income adequacy index’.

On the fiscal side, the index projects public old-age benefit spending — both pensions and health care — and also takes into account what fiscal leeway countries have to fund their growing old age dependency burdens. It also considers the degree to which the elderly depend on public benefits as a measure of political resistance to enact reforms.

On the adequacy side, the index tracks trends in living standards of the elderly relative to the non-elderly in each country, along with the robustness of safety net and family support networks.

The main finding for a large number of countries is a worrisome trade-off between fiscal sustainability and income adequacy.

Some countries rank well on sustainability because they provide little (Mexico, China, and Russia).

Conversely, a number of countries rank poorly on sustainability because they provide too much (the Netherlands, Brazil, Germany, and the UK).

To assist the ageing problem, many countries are pursuing policies designed to alter the underlying demographics, such as increasing immigration and improving fertility by making it easier for mothers to work.

Other strategies to meet the ageing challenge involve increasing the adequacy of income for the old without putting additional burdens on the young.

Examples in the findings include extending working lives and compulsory funded pensions instead of relying on tax incentives to encourage retirement savings.

Global ageing will affect many aspects of societies, both economic and civic. One of the most obvious challenges to emerge is how well prepared we are to provide a comfortable living for retirees while not burdening those of working age.

Australia appears to be remarkably well placed to meet this challenge, with only some areas requiring minor adjustments. Even so, there are areas where Australia needs to improve, such as raising safety net support levels and reducing the growth rate of health care costs.

John Wilson is the chief executive of PIMCO Australia.