Pension Headache and the Missing Part of the Puzzle

Albert Rutten
Albert Rutten is currently a first year research master student at Tilburg University. He is particularly interested in the fields of banking supervision, labor economics, and macroeconomics.

The first Rutte cabinet (Rutte I) decided to increase the retirement age in 2011. At that time, the Dutch parliament agreed upon an increase of the retirement age to 66 in 2020. After the fall of this cabinet, the second Rutte cabinet (Rutte II) proposed a more rigorous solution in the retirement age question. The retirement age should increase to 66 in 2018 and in steps to 67 in 2021. From 2022 onwards it will be linked to the life expectancy. That is why as of this year the retirement age to receive the (full) AOW-benefit increased to 66[1].

Proponents of this increase claim that the retirement system cannot sustain without an increase of the retirement age. The AOW expenditures will become an unsustainable burden for the labor force, due to longevity and fertility changes. The first term is covering life expectancy, which has been increased over the years and will further increase in the future. Whereas in the past, people died (on average) 5-10 years after retirement, right now the retirement period increased up to 20 years. The second term deals with the dependency ratio (i.e. number of retirees to number of working people). With more and more people retiring and a lower fertility leading to a smaller current and future labor force compared to the retirees, the dependency ratio will keep increasing.

Therefore, the solution looks simple. An increase of the retirement age will make sure more people are still part of the labor force, less people receive benefits and the duration of the benefits drops.  Although this sounds reasonable at first glance, proponents refuse to face the real problem: The Dutch labor market.

An increase in the retirement age will only increase the sustainability of the pension system if everyone is able to work until the age of 67. If not, people will just get (stuck) in another welfare program. As a result, the Dutch government does not receive any additional tax revenue and the benefit expenditures will remain (more or less) the same. Untitled-3

And when observing the graph above, one is able to see that the labor force participation rate went up in the last decade. However, with approximately one out of two lower educated people in the age category 60-65 it is quite obvious that large progress still has to be made.

The new minister of Social Affairs Wouter Koolmees (D66) sees lots of chances to tackle this issue. However, as often with his party, all his solutions point in the wrong direction (click here). At least, this hinges on the assumption that you care about the purchasing power of the 55+ generations. If not, this new minister is the right person for the job.

The actions he proposes are demotion (i.e. descending on the career ladder), part-time pensions, and lastly re-educating workers (in Dutch: omscholing). Demotion is already a mission impossible given the increasing age of the median voter. Moreover, the labor unions are a fierce opponent of this. Hence, this is not going to happen. Part-time pensions will probably be just as ‘successful’ as part-time unemployment benefits, resulting in a mass lay off of full-time workers, who had to accept part-time work. The only thing that remains is re-educating workers after they have lost their job. However, the results of these programs are at best ambiguous.

So let us therefore propose an alternative plan. Re-educating is a great plan to introduce, however it shouldn’t be used after someone lost his or her job. No, it should be used during their working time at an employer. But employers don’t like investing money in older employees. The payback-period is simply too short. Thus, there is no incentive for employers to pay for re-educating older workers. It is much easier for them to hire an employee of say age 30 and re-educate this new employee instead of the older one, who will retire in a couple of years. It is at this point that the government has to step in. They need to subsidize employers that are willing to re-educate their older working force. For employers the costs go down and it will become more interesting to invest in older workers.

Of course one could come up with the argument, who is going to pay for it? This argument is easily tackled. For the employer it is more beneficial to fire the older worker and hire a younger one to re-educate. Since it is not a matter of course that older employees find a new job quickly, we can easily assume that a large fraction of the older unemployed people will not find a job anymore. In this scenario, the moment the older worker is fired it will cost the government (and indirect the tax-payer) money via three ways. First, an unemployment benefit and later on a social assistance benefit has to be paid. Second, a lower income for the unemployed people leads to a drop in personal consumption. This means that the Treasury will miss out on Value Added Tax  and personal income tax. Third, becoming unemployed goes hand in hand with no further build-up of second pillar pension benefits. Although it is possible to fill this gap by saving for third pillar pension benefits, this will be unlikely to happen after a negative (persistent) income shock after becoming unemployed. Consequently, the pension payments after retirement decline. Hence, the Treasury will as well miss out on second pillar tax revenue after retirement.[2] To answer the question brought forward at the beginning of this paragraph. It will probably not cost us any money, and it might turn out to be beneficial for the Treasury.

Where increasing the retirement age seems the easy solution to the whole pension problem, things are a bit more complicated. Lots of plans are proposed, but most of them ignore a large fraction of the Dutch labor force, namely the lower educated workers close to their retirement age. Therefore, a different solution has been brought forward: a government subsidy for employers investing in the human capital of older workers. Since this solution doesn’t ignore an important fraction of the labor force and avoids the burden of lower tax income, it turns out to be a great way to solve part of the pension headache. Compared to many other plans, it takes the missing ‘puzzle piece’ into account. We acknowledge that the proposed solution doesn’t solve the complete pension problem of the first and second pillar and their corresponding details. Nevertheless, it is a solution that can be part of the larger plan to tackle the current and future pension issues.

[1] In the Netherlands we have an EET form of taxation of pension plans. The first ‘E’ stands for exemption of paying taxes at the moment the pension contributions are made. The second ‘E’ is the exemption of paying taxes on capital gains or investment income of the pension fund. The ‘T’ stands for paying taxes when receiving the pension benefits.

[2] (i.e. withdrawing AOW earlier will result in a discount of 6.5% per year. It should be noted that this is still a proposition, which is not enacted in law yet. Nevertheless, research to a flexible AOW has been conducted and a new proposal on this issue is likely to come).

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