The best way to encourage people to save for retirement is with an SSIA-type account, writes John McHale.
Many of us are putting aside less for our retirements than we know we should. Retirement income adequacy is likely to receive intense scrutiny in the coming months as the Pensions Board delivers its National Pensions Review.
Raising the stakes, the Minister for Social and Family Affairs, Séamus Brennan, has already signalled the Government's willingness to look at mandatory retirement saving options. All sides - employers, the financial sector, unions and advocates for the poor - are readying for a fight.
There is a good deal of international evidence that people have trouble sacrificing instant gratification to save for retirement. The typical (median) household tends to reach retirement with little in the way of financial assets, and studies show that retirement is often associated with significant drops in income and consumption.
International surveys also show that large majorities themselves believe they are saving too little. Significant numbers also say they plan to increase their saving in the near future. Unfortunately, surveys show that few follow through on their good intentions.
While there is no reason to suppose that Irish consumers are more profligate than consumers elsewhere, there is one reason that the problem of sustaining living standards in retirement poses a greater challenge for Irish households: Ireland is the only country in the OECD (besides New Zealand) that has neither an earnings-related state pension nor mandatory private coverage.
Instead, it has a relatively austere system of flat-rate State pensions, set at a level equal to roughly one-third of the average wage. While private coverage is increasing, it is still the case that almost half the workforce lacks private pension coverage.
Even many with private coverage are not saving enough to sustain their living standard through their older years; a problem that could become more severe as defined-contribution plans grow in importance relative to traditional defined-benefit occupational pensions.
Facing this challenge, it is easy to see why the Minister is willing to contemplate a fight for compulsory coverage. But mandating significant contributions by employees (and probably employers) to retirement accounts is a significant curtailment of the freedom to choose how to spend your after-tax money.
Before taking this drastic step, it is worth considering ideas that have come out of recent behavioural economics research, and which have already been shown to work in small-scale trials.
The central idea is that, rather than mandating contributions to retirement accounts, the Government makes contributing to an account the default option. Individuals are free, however, to change the default if they wish, including the option to contribute nothing.
Behavioural research has shown that many of us are procrastinators, following the "path of least resistance" in our saving decisions. When the default is "no contribution" we don't save (even though we know we should); when the default is some positive contribution we tend to leave it in place (and are happy we are saving).
There are numerous ways in which such a system could be set up. To get a sense of what the system might look like, I sketch one design that utilises the current withholding system and asset management by the National Treasury Management Agency.
An account is established for everyone with a personal public service number. For those subject to withholding, initially 3 per cent of pre-tax earnings is sent to their account. The amount rises by a percentage point per year to reach 6 per cent after three years. Those not subject to withholding are free to contribute to their accounts on the same terms.
The default investment is a low (or even zero) cost investment linked to the National Pension Reserve Fund. Initially, the Government provides an SSIA-style match (subject to a cap) to get the system established, although the match could be phased out over time to lower the fiscal cost.
Individuals are free to shift their investments to approved investment products. They are also free to change their contribution rate, including, with a little administrative hassle, the option of contributing nothing. Pre-retirement withdrawals are subject to significant penalties to help people cordon off their savings for retirement.
This type of policy help has been labelled "libertarian paternalism". The paternalism part recognises that many of us do a very poor job saving for retirement, and that the consequences of our behavioural failings in terms of reduced well-being can be great. The libertarian part follows from the existence of the opt-out: those who do not want or need the policy help are free to opt out at very little cost.
This policy holds out the possibility of substantial increases in retirement saving without resorting to compulsion. Of course, the benefits would only be enjoyed by future retirees. Consideration should also be given to current retirees and those nearing retirement.
Unfortunately, a major impediment to increasing the generosity of the State pension is that the costs of funding it are set to rise dramatically as the population ages. By one estimate the share of GNP spent on State pensions and free schemes will rise from 3.1 per cent today to 9.3 per cent by 2050.
Prudent governments are thus constrained by the future cost and sustainability of any increases in the state pension as a share of average earnings, even though more generous pensions appear to be affordable today.
The National Pension Reserve Fund (NPRF) provides a useful device for a forward-looking government to get around this constraint. By increasing current contributions to the fund (currently at 1 per cent of GNP), the Government could limit the future tax increases that would be necessary to fund higher pensions, making it more likely that those benefits would be sustained and avoiding an overly heavy burden on future generations of workers.
The policies that I have suggested are certainly not painless, not least for the Government, which would face an increased administrative and fiscal burden. Their political feasibility should be enhanced by the fact they offer substantial benefits to both employees and pensioners, and avoid placing significant additional burdens on employers.
John McHale is Associate Professor of Economics at Queen's University, Ontario, Canada