Unraveling pension-system confusion

I’m constantly surprised at how fundamental concepts in economics are so easily confused as soon as they are applied to real life policy.

Take the issue of fully-funded versus pay-go pension systems. In a pay-go system, pensions are paid to qualifying individuals each year by the government out of general revenues. In the fully-funded system individuals are forced to save in their working years to fund their retirement in later years.

Australia and many other countries have transitioned towards fully funded systems in the past couple of decades. This change can partly be attributed to a fear that pay-go systems are unsustainable, and partly because economic theory suggests that fully funded systems can increase the growth path of the economy through their effect on increasing savings, and therefore increased investment.

But the fear of unsustainable pay-go pensions, and the growth effects of fully funded systems, are both unfounded.

This is a very confusing area for many people, which is why it was so important to clarify the difference between saving and investment in my earlier post. When an individual or group within society spends less of their income, this does not automatically imply increased investment in new capital goods in proportion to that saving.

When I my fully-funded pension account buys BHP shares, it buys them from existing owners, who may very well be retirees selling down their assets to fund their retirement.

Using this basic example we can see that a fully funded pension system involves the young buying assets from the old, which is a transfer to the old in exchange for an asset.

But this is exactly what a pay-go system is as well. It is a transfer from the young to the old via the tax system rather than via other financial vehicles. Or we could think of it as an exchange of the asset of a guaranteed retirement income instead of a BHP share.

Regarding the investment effects, some have argued that when pension accounts buy shares they force prices up, thereby generating more investment. But to believe this you then need to explain some mechanism by which the share price was a binding constrain on new investment.

Does the BHP share price determine investment decisions in new mining ventures? Or is it the expected price path of the minerals, the ability to secure contracts for future output, and the costs of the facility?

Sure, there may be some small cases where equity value is binding, but that doesn’t mean than an investment opportunity will not instead be undertaken by a separate entity that doesn’t have that constraint.

Others have suggested that the share of savings that does go to direct investment funding, such as the example here, is sufficient to make the point. To me this is the rare exception that proves the general rule, and moreover makes the point that under normal circumstances debt, in the form of bank lending, is the almost universal investment funding tool.

To wrap up this point, here is the breakdown of assets in Australian superannuation (retirement savings) accounts from APRA. Only a very small share of these assets could be interpreted as being new investment. Most shares would be purchases of existing assets, with a rare exception of capital raising for new ventures. Cash and property are obviously not related to new investment, leaving fixed interest assets that may also involved a component of new investment.

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The other important point here is that there is nothing that makes pay-go systems unsustainable that wouldn’t also make a fully-funded system unsustainable, though I think neither system is. Each is merely a transfer from one group to another in society, with the same level of output to be shared at each point in time.

Let’s be clear about this. In the pay-go system wealth is transferred between tax payers and the retirees each year. The retirees share of the economic pie is whatever is determined by demographics and government policy on retirement pensions.

In the fully-funded system we have the bizarre situation of working age people buying assets from retired people who had accumulated them in the past, so that they can then sell them when they retire. There is a lot of asset churn in this system to generate what is a transfer from working age to the retired at all points in time. In essence, it is a pay-go system with the added cost of private funds management.

I have made this point in more detail in the past.

My point here is that this is yet another example of economists inappropriately equating savings, which are transfers, with investment, which is the production of new capital equipment.

Comments

  1. A good thought; one which I hadn’t devoted much time to! And as you suggest, whichever way society goes, there are going to be more and more older people selling their accumulated assets, in whatever guise, to the new lot of younger citizens. Given that there are going to be ever more elderly ‘with stuff/superannuation accounts’ arriving on the sell-down door step, how can the future be anything but deflationary? It can’t as more and more ‘stuff’ chases less and less money – no matter how much is created!

    • migtronixMEMBER

      You got it wrong J they’ll be renting their accumulated assets. They’ll take it to the grave if they ever end up in one..

      • casewithscience

        @mig

        I don’t know you too well, but I think if the shoe was on the other foot, wouldn’t you do the same?

      • McPaddyMEMBER

        Agree CWS. Makes no sense to blame individuals for maximizing their personal profit. The problem is in our ruling classes who fail to discharge their responsibility of stewardship of our society as a going concern. Isn’t that supposed to be the whole point of government?

  2. There is a lot of confusion about economics…and it’s in this article. This is why people get confused about economics. The author tries to claim that savings and investment are two different things but savings is simply the precursor to investment.

    If, as the author states, that savings is simply a transfer then where did the transferer obtain the asset? They may have had it transferred to them but eventually you get to the point where someone had to make a direct investment to create the initial asset. And how do you create an asset? Through savings which comes from underconsumption today to purchase capital goods which will hopefully produce more consumption in the future.

    In the authors argument in which investment is different to savings how does his idea of investment materialise if it’s not through savings. It would be a great world if these investments in capital goods just appeared out of thin air. Unfortunately though you need to underconsume or save to increase overall investment.

    As for pension pay as you go, it’s a Ponzi scheme that is doomed to fail. It’s great if you get in early but as more promises are made by politicians to buy votes, later participants are saddled with the burden of paying pensions to people who barely contributed. This is why they have to raise the retirement age and cut the level of indexation as it is an unsustainable system.

      • Yes…it’s the opposite side of the savings equation. How do people to into debt? By borrowing off the people who saved. That’s the case for real savings any way. I understand that through fractional reserve banking that banks create credit but is not real savings. Credit creation is just inflation that reduces the value of real savings. Real saving comes from effort…it cannot be printed. Zimbabwe and plenty of other countries have tried inflation…didn’t work out well for any of them.

      • Yes…it’s the opposite side of the savings equation. How do people to into debt? By borrowing off the people who saved. That’s the case for real savings any way. I understand that through fractional reserve banking that banks create credit but is not real savings. Credit creation is just inflation that reduces the value of real savings. Real saving comes from effort…it cannot be printed. Zimbabwe and plenty of other countries have tried inflation…didn’t work out well for any of them.

      • How do people to into debt? By borrowing off the people who saved. That’s the case for real savings any way.

        Mate it hasn’t been that way for a long time. Are you familiar with the way the banking system works these days?

      • casewithscience

        @Monk

        Ummm, I think banks (Central banks) don’t “save money” before giving it away under debt arrangements. They just print it.

        PS: Banks can lend a lot more than they actually have. They just issue credit notes amongst themselves.

    • Rumplestatskin

      “The author tries to claim that savings and investment are two different things but savings is simply the precursor to investment.”

      No. Savings are income not spent on consumption items. That can include investment, but also the purchase of existing assets.

      “If savings is simply a transfer then where did the transferer obtain the asset?”

      From out institutional arrangements. When land was privatised, a whole bunch of lucky people got what was freely available land for nothing.

      Patents aren’t investment, and you can certainly get a monopoly right to a stream of income from that institutional arrangement.

      There are natural monopolies, privatisation of public assets and much more.

      In case you haven’t noticed, capital goods, as in the machines and equipment, are not assets. The institutional rights are assets. Capital goods can always be duplicated for the construction cost. The reason they maintain value is because they are tied to institutional monopolies – of land, intellectual property an so forth.

      “How do you create an asset?”

      Through laws that create protection for certain income streams.

      • Stephen Morris

        Do I hear an echo of the late Ronald Coase?

        “. . . what are traded on the market are not, as is often supposed by economists, physical entities but the rights to perform certain actions, and the rights which individuals possess are established by the legal system. ”

        (1991 Alfred Nobel Memorial Prize Lecture.)

      • Rumplestatskin

        Yep, Coase knew what he was talking about. And from what I have seen of him, and read, he was repeatedly frustrated to have to keep explaining these basic principles to his economics colleagues.

      • That’s good to know. I don’t need to actually go to any physical effort to create an asset. I just create a law and voila my perfectly constructed house will appear. I understand that to enjoy your property you need property rights to enforce those claims that but that in itself does not create an asset. Its the cart before the horse.

        Even patents and intellectual property require effort to come up with an idea, invention etc which is an investment in human capital at the least. Land needs to be cared for, fenced off and secured etc which requires effort. Then in order to protect these assets for your own use you require laws like property rights.

      • Rumplestatskin

        Monks,

        I think you’ll find that while building a house is most certainly an investment, if you go and build one in the absence of property rights you won’t have an asset, since anyone will be able to occupy the home whenever they like. You won’t be able to charge rent or capture any future incomes, nor trade it.

        You will however, have made an investment, and we will all be wealthier for having an extra house around.

        So no, to create an asset, as in a monopoly right to a future stream of income, there is no investment required.

        Patents are not investments. They are also institutionalised monopoly rights. I can have all the ideas and patents in the world and be stranded on an island and be as poor as if I never had those ideas or patents. It is the actual investment in the types of equipment covered by patents that are investment.

        Look at China. Basically no intellectual property law in comparison with the west. Yet massive amounts of investment, much of which would be subject patent laws in other countries.

        How about your land example? I own a block next door to yours that is identical. You invest in a perimeter fence.

        Was your investment in the fence an asset? No. Was it capital? Yes.

        You can now lease your land for a price that includes a fence (say it lasts ten years to use round numbers). I can lease my land for ten years to someone for the same rate less the cost of the fence.

        We both end up with the same net income from our asset. The fence (investment) has given you no extra claim to future incomes.

        The big question then is how does investment come about if not through the choice of savings?

        An answer to this question requires a dynamic assessment of future asset values and income streams. Basically the rule is (and I will write more about this in the future), that investment occurs when the expected rate of growth in the value of the asset with the investment exceeds the expected rate of growth in the value of the asset without investment.

        This is a dynamic problem that results in feedbacks and macro cycles of asset prices and rates of investment.

  3. both systems appear to be similar but there is one large difference that makes huge difference to retirees: investment based systems are created to provide funding source for financial speculators at the expense of retirees, large portions of retirement savings get “stolen” during stock market crashes, housing bursts, periods of inflation, revolutions, …. No single generation anywhere in the world successfully retired (more than 50% of people had enough money until the end of the life) thanks to investment based system. Pay as you go, on the other hand is working well for more than a century, survived world wars, revolutions, hyperinflation, stock market crashes, bubble bursts, … despite the fact that the country with the longest history of such pension system had been completely destroyed twice, had the highest inflation in history, revolutions, population decline, … that country is still the one with the strongest economy out there.

    so all those stories how pay as you go pension systems are not sustainable and drag economy down are just ideological propaganda

    • Yes, ultimately the resources available to support retirees must be extracted from the economy when they are required and therefore the capacity of the economy at the time of retirement is what matters.

      Defined benefit schemes do not work because they attempt to fix the benefit without regard to actual economic capacity at the time of retirement. And people tend to be very generous making promises to be paid by their grand kids.

      Defined contribution schemes have the problem that they imply that you are building a large stock of acorns for the winter months of life but you are not.

      Pay as you go with the knowledge that what pension you get will depend on the countries wealth at the time of retirement is as Rumple notes probably the best approach for most.

      Of course people can still create and accumulate wealth assets if they choose but there does not need to be a complex expensive super system for that.

      • Ah. Finally an intelligent comment on the matter.

        Most of the resources that retirees require cannot be stored-up for them. These resources must be extracted from other [young] people at the time and hence represent a burden on them.

        As a group the old should be ensuring that society is as prosperous as possible, and that the young are rich and happy and feeling good towards the old. They should be gold-plating the country’s infrastructure to give the young a free ride whilst the young support the old in retirement.

  4. migtronixMEMBER

    Sorry but this is all crap because you’re using a ex-nihilo debt currency, there is no “true” savings OR investment because the “money” will have to evaporate one day when the debt is paid down. Why are you ignoring destructive, self immolating nature of debt currency?

    • casewithscience

      I never get too wound up about currency – it is just the necessary shadow of actual exchange of value. Forex trading is gaming the system in the typical way that humans tend to do. It has little to do with actual value.

      • migtronixMEMBER

        Sure FX trading is pure arbitrage, which all well and good as long someone needs exchange what they have to get what they don’t have. But when the exchange medium is “owned” by a central issuer the ratios change completely

  5. Aggregate saving = aggregate investment because national income accounting says so.

    Desired saving = investment demand because asset prices and incomes supposedly ensure the equilibrium.

    However an individuals decision to save does not automatically lead to an offsetting decision to invest. It just depresses demand. Whether it encourages offsetting investment depends on price stickiness/CB policy – That’s the standard view.

    If all households increased their individual saving by buying BHP shares the yield on BHP shares would fall. Changing the risk/return of holding BHP vs safe bonds. Ultimately the only way this could stimulate investment (apart from Tobins q) is if it led to the yield on safe assets falling.

  6. Ronin8317MEMBER

    There is one important difference between a pay-go system and a fully-funded system : the former depends on your faith in government, while the later depends on your faith in the ‘market’.

    Fundamentally, wealth is ‘future obligation’. “Monopoly on use of asset” is merely one form of it. Obligations can be broken : the government may confiscate your asset, war may occur, a meteor may fall on earth, however some events are more likely than others. People see ‘pay-go’ as a ponzi scheme when they cannot believe their government can run a surplus, EVER, leading to the current generation will receive more benefit compared to the future generation. While the same applies to a private fully-funded system, at least there is hope!!

    • Stephen Morris

      “. . . .the former depends on your faith in government, while the later depends on your faith in the ‘market’.”

      Then the Australian system is the worst of both worlds! It requires faith in BOTH government and market.

      It requires faith in the market that the assets will have sufficient value when you come to retire.

      AND it requires faith in government that you will be allowed to sell those assets and take the money.

      The increase in preservation age (and the suggestion that lump sums be banned entirely) shows how easy it is for government to restrict access to “your own” assets.

      The proposals floating around for enforcing superannuation funds (and – who knows? – annuity providers) to “invest” a certain proportion of their funds in private infrastructure projects shows how easy it is for government to divert “your savings” into other uses.

      Worst of both worlds. The only ones who benefit are the fund managers/investment bankers who administer this needlessly complex scheme.

      Bear in mind that fees on superannuation funds average almost 1.25% p.a., a total of over $18 billion p.a. paid to the ticket clippers running this scam!!

      • Ronin8317MEMBER

        I agree it’s a raw deal. The 1.25% is the ‘protection money’ paying the banks and finance companies save it from government confiscation. Unfortunately, self interest indicates the banks will do the opposite and roll over, as it’s not their money to begin with. Nevertheless, by labelling superannuation as ‘your money’, it makes it harder politically to confiscate it.

      • migtronixMEMBER

        Actually Ronin it is “their money” as someone had to borrow it from a bank to begin with. Which is why they can do whatever they want short of inciting revolution..

  7. Stephen Morris

    As for the defined-contribution superannuation system increasing savings, just look at the chart. From the introduction of compulsory superannuation, households savings (including superannuation contributions) went into steady decline and became negative until the GFC eventually scared the wits out of people and got them to save again.

    The propaganda surrounding the superannuation system encouraged people to believe that they were magically protected against the future. So they stopped saving in the traditional ways (i.e. forgoing spending and paying off their mortgage) and maintained their spending. This is vividly illustrated in the second chart of savings excluding superannuation contributions.

    • migtronixMEMBER

      Plus savings rates kept collapsing for like 20 years, that’s not a great motivator…

      EDIT: The line “save for tomorrow so the bank can spend today” isn’t very appealing

  8. Whats ignored is the taxation differences between the schemes and effects on consumption.
    If you tax someone more to pay a pension, that person has less to invest. If you tax less and allow them to invest you have no guarrantee that the investment will be wise or pay off but atleast the opportunity is there.

    • Rumplestatskin

      “If you tax someone more to pay a pension, that person has less to invest”

      But the pensioner has more.

  9. Some property is new investment too.

    EG Super fund expands shopping centre in its portfolio, or contracts to buy an office block at the development stage, or invests in an infrastructure fund which is funding a new piece of infrastructuer eg a toll road.

    While nearly all your examples can contain some element of new real investment rather than mere purchase of existing assets, I agree that this is a relatively small portion each year.

    I must re-read your original piece to get my head around it more.

  10. arctic explorer

    This is a decent line of thought that follows the money trail from savings. This line of thought can usefully be extended to the concept of property investors purchasing housing.

    Often this is oversimplified as: “property investment provides no value to the economy because investors only buy existing property”.

    However, as you point out, it is actually a transfer of funds from investors to Australians with housing assets – who do something with it.

    These newly cashed-up Australians don’t all immediately die or leave the country permanently. Rather, they spend it on other housing, white goods, renovations, cars, clothes, holidays, gifting to children, taxes, businesses (ie. investment), etc.

    Money goes round and is used productively in many sectors of the economy.

    • Rumplestatskin

      Yes, exactly. The money goes round whether we give money to pensioners, or they get their money by selling assets they previously accumulated.

  11. Alex Heyworth

    “When I my fully-funded pension account buys BHP shares, it buys them from existing owners, who may very well be retirees selling down their assets to fund their retirement.

    Using this basic example we can see that a fully funded pension system involves the young buying assets from the old, which is a transfer to the old in exchange for an asset.”

    False. Your pension account might be buying the BHP shares from overseas owners. More likely to be, in fact, given around 80% of it is foreign-owned.

    PS, not that this is all that important in the scheme of things. The important thing to remember is that all consumption, whether by retirees or anyone else, needs to be paid for either by domestic production (whether for local consumption or export) or by borrowing to pay for imports. This fundamental rule means that there is not a huge difference between PAYG or funded superannuation arrangements if the current account is unaffected. Funded superannuation would only have an advantage if it meant buying a lot of overseas assets and the country running a surplus. So far, all it seems to have resulted in here is more household debt.

    • Rumplestatskin

      Sure, buying from foreign entities is also possible. I put the table in to given an idea of what superannuation accounts actually own.

  12. Hi Rummples,
    I’m really enjoying your treatment of this topic but I think you definitely need to incorporate New Asset creation into the model. I realize that new asset creation might not be as important in Australia as it is in other countries (which I think is a major problem that Australia needs to address) however this is always the phenomenon that constrains price. Think of it this way: What would Rio and BHP be worth (NPV of discounted cash flow) if Vale didnt exist, wouldn’t all 3 be worth much more without FMG? how much for all 4 without Chinese ore?

    Sure excess cashflow of the young becomes “savings” by purchasing revenue generating assets from the elderly but the price is ultimately set by the uniqueness/demand for the asset. For all assets that effect our true wealth (ability to generate external cashflow…exports) there is really no such thing as a monopoly because multiple independent countries exist that have access to similar assets (capital, mineral or human).

    OK so the bottom line is that all existing assets are ultimately valued by the ability of others to recreate these assets what M&A types call the Buy-OR-Build calculation.

    IMHO a in properly functioning capitalist system the cash flow from savings chases growth and yield by creating new assets whenever prices (NPV) in a particular sector exceeds the new-build-cost for a similar asset.