88221
MAY 2014 • Number 144
IS AGING BAD FOR THE ECONOMY? MAYBE
Harun Onder and Pierre Pestieau
The world’s aging population is expected to shape the future of economies across the globe. Without behavioral adapta-
tion by current and future generations, this demographic transformation is likely to slow down economic growth. How-
ever, aging will also induce behavioral adjustments in savings and labor force participation. Will these adjustments be
large enough to reverse the negative effects of demographic change? The answer depends on a number of conditions. This
note suggests that determining whether aging is driven by an increase in longevity or by a decrease in fertility is impor-
tant for understanding the size and direction of these demographic effects. Moreover, the type of unfunded social security
system that exists in the economy could also influence the net effect of aging.
Changing demographics in modern times are continuing to reshape both the scale and age composition of the world’s
break records. First, it was the remarkable speed of popula- population in coming decades, albeit by different degrees
tion growth. According to United Nations (UN) calculations, across countries.
the world population nearly doubled in the last 40 years, in- Table 1 shows that the “big jump” in the median age has
creasing from about 3.7 billion in 1970 to 6.9 billion in 2010. already occurred in high-income countries (HICs). In 2010,
Next, it will be about slowing down. Total population is ex- the median age in HICs was 9.5 years older than in 1970, and
pected to grow by only 40 percent within the next 40 years, is expected to increase an additional 5.9 years by 2050. In
reaching about 9.6 billion by 2050. comparison, middle- (MICs) and low-income countries
In addition to slowing population growth, the median (LICs) are expected to have such jumps within the next 40
age of Earth’s inhabitants will continue to get older, a phe- years. However, these changes will happen in different ways
nomenon known as demographic aging. Table 1 shows that due to variations in fertility and longevity trends.
the median age has increased by 7.1 years since 1970, and it First, compared to the last 40 years, the reduction in fer-
is expected to increase by another 7.8 years to reach 37 by tility rate will not be as dramatic in MICs, while it will con-
2050. tinue to decrease significantly in LICs. Second, the increase in
To put these two trends into perspective, it is impor- life expectancy at birth will slow down in both groups. How-
tant to remember that aging and population growth are ever, the increase in life expectancy at the age of 60, a measure
mainly driven by two factors. The first factor is longevity. of longevity, will slow down in MICs and accelerate in LICs
Mortality rates for each age group have been declining (see last column of table 1). Between 1970 and 2010, the in-
steadily for many decades. On average, people now tend to crease in life expectancy at the age of 60 was 3.4 years in MICs
live longer. The second factor is fertility. The average num- and 2.5 years in LICs. These will change to 2.6 and 3.4 years,
ber of births per woman has also declined sharply in the last respectively, by 2050.
several decades. These trends in increasing longevity and What effects will these changes have on different econo-
decreasing fertility rates are expected to continue, and will mies? There is no obvious answer to this question concerning
1 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK
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Table 1. Demographic Trends by Income Groups
Life expectancy
Median age Total fertility rate Life expectancy at birth at age 60
1970 2010 2050 1970 2010 2050 1970 2010 2050 1970 2010 2050
Low-income countries 18.0 20.0 27.5 6.7 4.6 2.8 45.1 57.5 69.7 14.3 16.8 20.2
Middle-income countries 19.5 28.1 37.7 5.7 2.5 2.1 54.4 67.2 73.9 15.2 18.6 21.2
High-income countries 29.6 39.1 45.0 2.6 1.7 1.8 69.2 77.8 83.7 17.7 22.8 26.2
World 22.1 29.2 37.0 5.0 2.6 2.2 55.5 66.5 73.9 16.2 19.8 21.9
Source: Onder, Hernandez, and Usmani (2014), based on UN population projections.
such a multi-dimensional process. A number of consequenc- Other Things Being Equal, Aging Is Bad for
es will clearly be unfavorable. For example, with aging comes the Economy
an increase in the old-age dependency ratio, or in other words,
A simplistic way of demonstrating the economic impact of ag-
an increase in the number of elderly individuals per young
ing is to use a counterfactual analysis. This is, in essence, an
person. This, in turn, leads to imbalances in unfunded (pay-
accounting exercise that studies the relative size of demo-
as-you-go [PAYG]) pension budgets. However, some of the
graphic shifts in the absence of behavioral adjustments. In the
consequences could be positive: for instance, a slowdown in
population growth could relieve some of the pressures on first step, historical growth rates in gross domestic product
limited environmental resources. (GDP) are decomposed into three components: labor produc-
There are some consequences for which there is no con- tivity growth, population growth, and growth in labor force
sensus on whether the outcomes would be beneficial or not. participation rate (box 1). Next, the last two components are
A particularly important one is the effect of aging on capital replaced with projections of future demographic changes,
accumulation and economic growth. The conventional wis- while the first component is held constant. A comparison of
dom is that aging would lead to slower growth, because the this new “counterfactual” GDP series with the original shows
old save less, which translates into higher interest rates, lower how a reduction in population and labor force participation
investments, and lower labor productivity. In contrast, others would have affected GDP growth in the absence of a change in
think aging may actually increase economic growth because productivity.
people will adapt by saving more and working longer (The Figure 1 shows the results of such an exercise for 167
Economist 2014). Bloom, Canning, and Sevilla (2001) discuss countries from all income categories. On average, had the
different approaches regarding the link between economic world already experienced the future demographic transition
growth and demographic change. Overall, this debate has not within the last 40 years, the average GDP growth rate would
yet been concluded. have fallen by about 1.2 percentage points annually. To put
Dedry, Onder and Pestieau (forthcoming) investigate this into perspective, a reduction of this size in the annual
this last effect by separating the incidences of increased lon- growth rate would translate into an almost 40 percent de-
gevity and reduced fertility on capital accumulation. Results crease in countries’ GDPs by the end of 40 years. The reduc-
show that the type of aging is important in determining the tion in the GDP growth rate reflects both the slowdown in
outcomes. This is mainly because changes in fertility and lon- population growth and the increase in old age dependency
gevity rates provide different incentives for individuals to save ratios. In comparison, the GDP per capita growth rates con-
more or work more. These differences could be more pro- trol for the change in the size of population (see also box 1).
nounced depending on the type of social security system in a As a result, growth rates would be reduced by only 0.4 per-
given economy. centage points annually.
This note starts with an investigation of the implications These results, however, are not the same across countries.
of the demographic transition without a discussion of the Whereas all HICs (except Estonia) would have experienced a
changes in incentives or associated behavioral adjustments, reduction in growth rates, many LICs and some MICs would
focusing on accounting effects only, and then introduces the have benefitted from the prospective dynamics of their demo-
behavioral effects as discussed in Dedry, Onder and Pestieau graphics. This contrast mainly arises from the “differences in
(forthcoming). differences.” Remember that the counterfactual exercise basi-
2 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK
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Box
Box1. Counterfactual Exercise
1. Counterfactual
Box 1. Counterfactual Exercise
Exercise
This counterfactual
Box 1. Counterfactual Exercise analysis provides a rule-of-thumb method for illustrating the implications of a forthcoming demographic
This counterfactual
This counterfactual analysis
analysis provides a rule-of-thumb method for illustrating the
the implications of
of a a forthcoming demographic
change on GDP growth. The provides first step a rule-of-thumb
involves reorganizing method the for GDP illustrating per working-age implications population to explicitly demographic
forthcoming identify the
change
This counterfactual
change on
Box
on GDP
GDP 1.analysis growth.
Counterfactual
growth. provides The
The first
first a Exercise step
rule-of-thumb
step involves
involves reorganizing
method for illustrating
reorganizing the
the GDP
GDP per
per the working-age
implications
working-age population
of a forthcoming
population to
to explicitly
explicitly demographic identify the
identify thechange
population
on GDP population
growth. Thesize and age structures.
population size
size firstand
and stepage
age involves
structures.
structures. reorganizing the GDP per working-age population to explicitly identify the population size and
This counterfactual analysis provides a rule-of-thumb method for illustrating the implications of a forthcoming demographic
age structures.
Let and be t, respectively.
change onthe GDP GDP growth. (measured The first in step purchasing involves reorganizing power parity the terms)GDP per and total population
working-age population in year to explicitly identify the Then, the
Let Let
Let
Yt and and
following
andPequation
population
t
be
be
be the
the the
GDP GDP
GDP
presents
size and
(measured
age
(measured
(measured
an identity
structures.
inin in that
purchasing
purchasing
purchasing must hold
power
power
power for all
parity
parity
parity values:
terms)
terms) and
terms) and total population
total
total populationin
population in inyear yearyeart t, ,t, respectively.
respectively.
respectively. Then,
Then,
Then, the
thethe fol-
following
following
lowing equation equation
equationan
presents presents
presents
identity an
anthat identity
identity must that
that hold must
must for hold hold
all values: for
for all values:all values:
Let and be the GDP (measured in purchasing power parity / and total population in year t, respectively. Then, the
terms)
/
following equation presents an identity that must hold for =
/
all = values:
= /
/
/
/
where shows the working-age population. By using a log transformation = and rearranging, the above identity becomes:
where Ltwhere
where
shows
the
shows
shows working-age the
the working-age
working-age population. population.
population. By using By
By a using
using log transformation a log
a log transformation /
transformation and rearranging, and
and rearranging, rearranging, the above the above
the above identity identity
identity becomes: becomes:
becomes:
where shows the working-age population. ln(
By /
using )
) a = ln(
log /
transformation ) +
) + ln(and ln( /
/ )
rearranging,
) the above identity becomes:
ln(
ln( / = ln( /
/
) = ln( / ) + ln( / )
Whereas the left-hand side denotes the income per ln( capita
/ ) =in ln( year / t), the + ln( first / term ) on the right-hand side shows the output per
Whereas
Whereas thethe the left-hand
left-hand side
side denotes
denotes the
the income
income per
per capita
capita in year t
t, , tthe first term on the right-hand side shows the output per
Whereas
working-age left-hand
person, side
and thedenotes second the term income shows per the sharein
capita in
of year year
working-age the
, the first first term
group term on inon thetotal right-hand
the right-hand
population. side The shows
side shows
first theandoutput
the per per
output
second
working-age
working-age
working-age person,Whereas person,
andthe left-hand
person, the and
and second the
the side seconddenotes
second
term term
term
shows the income shows
showsthe per
share the
the capita share
share
of in year
working-age of
of working-age
t, the first
working-age group term group
group on total
in thein in total
right-hand
total
population. population.
population. side shows The The
the output
The
first first
first
and per second
and
and
secondsecond
terms on
terms on the right-hand side of second this equation canthe beshare interpreted as average labor productivity and employment ratio,
terms
terms
the right-hand on
onworking-age
side the
the of right-hand
person,
right-hand
this equation side
and
side the
can of
of bethis
this equation
interpretedterm shows
equation can
can
as be
be
average interpreted
interpreted oflabor working-age as
as
productivity average
average group in andlabortotal
labor productivity
population.
productivity
employment The ratio, and
and employment
firstrespectively,
and second under
employment ratio,
ratio,
respectively, terms under on the a set of assumptions.
right-hand side of this equation These include can be interpreted the absence as average of unemployment, labor productivity full labor and employment force participation ratio, in a set
respectively,
respectively,
of assumptions. These under
underinclude a
a set
set the of
of absenceassumptions.
assumptions. of unemployment, These
These include include full the
the labor absence
absence force of
of participationunemployment,
unemployment, in full
full labor
working-age labor cohorts, force
force participation participation
and no laborin
in force
working-age respectively, cohorts, and
under no
ano labor
set force
of assumptions. participation These include among the the elderly
absence and
ofand children.
unemployment, full labor force participation in
working-age
working-age
participation among cohorts,
cohorts,
the elderly and
and andno labor
labor
children. force
force participation
participation among
among the
the elderly
elderly and children.
children.
working-age cohorts, and no labor force participation among the elderly and children.
Finally,
Finally, the the population
population can can be beremoved removed from from the the left-hand left-hand side
side to to focus focus on on GDP GDP growth. growth.
Finally,
Finally,Finally, the
the populationpopulation
the population can be
can be
canremoved
removed
be removed
from
from from
the
the the
left-hand
left-hand
left-hand side
side
sideto to
tofocus focus
focus onon
on GDP
GDP
GDP growth.
growth.
growth.
ln( ))= ln( / )) + ln( / )) + ln( ))
ln( ) = =ln( ln( / )+ + ln( / ) ln( + ln(
+ )
ln( ln(
) = ln(
/
)
/ +ln( ln(
/ /
)
+
ln( )
Iterating
Iterating this this identityidentity for for one one period
period and and subtracting
subtracting gives
gives usus the the growth growth rates rates in ineach each component: component:
Iterating this
Iterating this identity
Iterating identity for
this identityfor one one period
for period and
one period and subtracting
and subtracting gives
subtracting gives us
gives us the
us the growth
the growth rates
growth rates rates in in in each
each each component: component:
component:
+1 +1
��
+1
+1 ≡�����������
ln(
≡ +1 ln( )
�����������− ln( ) −
ln()= ) =
�ln � � ln
�+1 �− �− − ln ln ��
�� + + ��ln ln�� +1
+1 �� − − ln ln
�ln ����� [ln(
+ �������������
[ln(
+ ������������� [ln( +1
+1 ) − ln( )− ln( )]
)]
≡ ln(
�����������
+1 )
) −
+1 ln( )
) = � ln � +1 � ln � �� + � ln � +1 � − � ��
+
+ �������������
[ln( )
)− ln(
ln( )]
+1
+1 ≡ ln(
����������� +1
+1
− ln(
ℎ
= �������������
� ln
������������� �
�������������+1
+1 � − ln �
�� + �������������
� ln
�������������
������������� �
+1
+1 � − ln
� ��
������������� +1
+1
−
ℎ )]
ℎ
ℎ �������������
+1
+1
ℎ
ℎ �������������
+1
+1
ℎ
ℎ
ℎ
ℎ
ℎ ℎ
ℎ
ℎ
ℎ
ℎ
The
The first
first The
termtermfirst
in interm
square
square square
inbrackets brackets
brackets onon
the on
the the right-hand
right-hand
right-hand side
side
side shows
shows
shows thegrowth
the
the growth
growth inin
in per
per
per worker
worker
worker output, thus
output,
output, the the
thus
thus growth
the in labor
growth
growth inin labor
labor produc-
The
The first
first term
term in
in
productivity. square
square brackets
brackets
The second on
on
term shows the
the
theright-hand
right-hand side
side
growth in group shows
shows
working-age the
the
group growth
growth in
in
to populationper
per worker
worker
ratio, thus output,
output,
the change thus
thus the
in thethe growth
growth
dependency in
in labor
labor
tivity. The second term shows the growth in working-age to population ratio, thus the change
productivity. The second term shows the growth in working-age group to population ratio, thus the change in the dependency in the dependency ratio. Finally,
productivity. The
ratio. Finally,second term
the third term shows
shows the growth
population in working-age
in working-age group
growth. group toto population
population ratio,
ratio, thus
thus the change in
the change in the
the dependency
the thirdproductivity.
term shows The second
population term
growth.shows the
ratio. Finally, the third term shows population growth.growth dependency
ratio.
ratio. Finally,
Finally, the third
the third term shows
term shows population
population growth.
In the spirit
In of Bloom,
the spirit ofCanning
Bloom, and Fink
Canning and Fink growth.
(2011), the second
(2011), stage
the second of of
stage thetheexperiment
experiment uses theabove
uses the above decomposition
decomposition to to generate
In the
counterfactual spirit
GDP ofof
generate Bloom,
growth Canning
rates.
counterfactual Specifically,
GDP and
growth Fink the(2011),
rates.(2011),
average theannual
Specifically, second
the stage
employment
average of the
annual experiment
ratio
employment ratio uses
growth andthe
growth above
population
and decomposition
growth
population growthrates tobetween
In the spirit
In the spirit Bloom,
of Bloom, Canning
Canning and Fink
and Fink (2011), thethe second
second stage
stage of the
of the experiment
experiment uses
uses the above
the above decomposition
decomposition to
to
2010 and generate
2050 counterfactual
are
rates plugged
between 2010GDP
into
and growth
the
2050 are rates.
equationplugged Specifically,
along intowith thethe
the equation average
actual
alongvalues
withannual
the of employment
output
actual per
values ratio
ofworker
output growth
growth
per workerand
from population
the
growth from the growth
period 1970–2010.
generate
generate counterfactual
counterfactual GDP
GDP growth
growth rates.
rates. Specifically,
Specifically, the
the average
average annual
annual employment
employment ratio
ratio growth
growth and
and population
population growth
growth
between
ratesshow
The results period
what the and
2010
1970–2010. 2050
average are plugged
results
The annual show what
growthinto theaverage
the
rate ofequation
GDPannual along
would with
growth
be theof
rate
between actual
GDP
1970 values
and be
would 2010 hadper
output
ofbetween 1970
the worker
and 2010
countrygrowth
had
in from thealready
the
discussion
rates between
between
rates the 2010
2010 and
and 2050
2050 are
are plugged
plugged into
into the
the equation
equation along
along with
with the
the actual
actual values of output per worker growth from the
period
experienced country
1970–2010.in discussion
forthcoming The already
results show
demographic experienced
what the
change. the forthcoming
average annualdemographic
growth change.
rate of wouldof
GDPvalues output
be between worker
per 1970 and 2010 from
growth the
had the
period
period 1970–2010.
1970–2010. The
The results
results show
show what
what the
the average
average annual
annual growth
growth rate
rate of
of GDP
GDP would
would be
be between
between 1970
1970 and
and 2010
2010 had
had the
the
country
Source: Onder, in discussion
Hernandez,
Source: and Usmani
Onder, already
2014.experienced
Hernandez, and Usmani the forthcoming demographic change.
2014.
country in
country discussion already
in discussion already experienced
experienced the forthcoming demographic
the forthcoming demographic change.
change.
Source: Onder, Hernandez, and Usmani 2014.
Source: Onder, Hernandez,
Source: Onder, Hernandez, and Usmani 2014.
and Usmani 2014.
cally compares future demographic changes with the past. The first important behavioral adjustment can occur via
Those with favorable demographic dynamics in the coming savings. As people live longer lives after retirement, or as their
decades, or those who already completed the demographic retirement incomes change due to demographic transition,
transition to a new stable level, would have relatively smaller their incentives to save or dissave will also change. Changes in
differences between the actual and counterfactual growth savings will, in turn, affect the productivity of labor by chang-
rates. In comparison, those in the midst of the transition ing the capital available per worker.
would exhibit large impacts because the demographic chang- The second important behavioral adjustment could oc-
es in the future could be substantial compared to changes in cur in decisions regarding labor force participation. A longer
the past. life span could induce individuals to extend their active work
life if retirement is not mandatory. Thus, the size of the labor
But, Other Things Will Not Be Equal
force may not shrink as much as the demographic simulations
The counterfactual analysis is useful for demonstrating the predict.
relative magnitude of future demographic changes. However, By holding the age of retirement and labor productivity
in practice, aging affects the economy through other channels growth constant, the counterfactual exercise above shuts
as well. Individuals can change their behavior to cope with a down these behavioral channels. Therefore, aging and the
new economic reality. Overall, this adaptation can significant- slowdown in population growth always bring about negative
ly influence the impact of aging on economic growth. consequences in the accounting exercise. Therefore, the next
3 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK
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Figure 1. What Would Demographic Dynamics from 2010–50 Imply for Growth Rates in 1970–2010?
a. GDP b. GDP per capita
1
1
Implied change in growth rate
Implied change in growth rate
0
0
-1
-1
-2
-2
-3
-3
-4
-4
-5 0 5 10 -5 0 5 10
Actual Actual
HIC MIC LIC HIC MIC LIC
Mean deviation from zero: -1.181 Mean deviation from zero: -0.442
Mean absolute deviation from zero: 1.257 Mean absolute deviation from zero: 0.636
Source: Onder, Hernandez, and Usmani (2014), based on Penn World Tables 8.0; the United Nations World Population Prospects: The 2012 Revision, http://esa.un.org/wpp/;
and World Bank staff calculations.
obvious question is: can behavioral adjustments overcome the emerges in the way that they respond to demographic
negative accounting effects? changes. Under the DC system, contributions are fixed,
and any reduction in the number of contributors leads to a
Types of Aging and Social Security
reduction in benefits per beneficiary. In comparison, un-
Systems Matter
der the DB system, the benefits are fixed; hence, any loss
Dedry, Onder, and Pestieau (forthcoming) contribute to the due to a reduction in the number of contributors is com-
discussions on behavioral adaptations by showing that adjust- pensated by increasing the contribution rate. The DA sys-
ments may differ under different types of aging and social se- tem is similar to the DB system—the only difference is that
curity systems. Their analysis uses a two-period overlapping benefits are paid in lump sum under the DB, whereas un-
generations (OLG) model with endogenous retirement deci- der the DA they are paid in annuities. Therefore, the DB
sions. The model separates the factors that change the scale system is not affected by changes in the life span, whereas
and age composition of the population, for example, decreas- total benefits under the DA system increase if the individ-
es in fertility and increases in longevity. Savings are motivated ual lives longer.
by financing consumption in life after retirement. Therefore, To see how different pension systems and types of aging
changes in fertility and longevity have different impacts on may influence the impact of aging on capital accumulation, it
optimal savings. is useful to begin with a benchmark case.
Behavioral adjustments can affect capital per worker and Benchmark case with no pension system or work in old age
labor productivity through two channels. First, individuals The well-known standard Diamond model can be used as an
prefer to smooth consumption over their lifetime. Therefore, appropriate benchmark. In this model, individuals live two
when needed, they increase the savings to finance their con- periods in the absence of social security and work after retire-
sumption in old age. Higher savings will then increase the ment. Table 2 summarizes the results. Whether longevity in-
capital per worker, thus increasing labor productivity. Sec- creases or fertility decreases, aging increases the capital accu-
ond, individuals can increase the length of their active work mulation in the standard case.
life, especially when life spans increase. However, in contrast When aging is driven by a decrease in fertility, capital
to savings, higher labor force participation decreases produc- per worker increases because savings do not change, but the
tivity, mainly because there are more workers for a given level number of workers decreases compared to the case without
of capital stock. any change in fertility rate. When an increase in longevity is
The study also compares three unfunded pension sys- the reason for aging, the increase in capital per worker is
tems: defined contribution (DC), defined benefit (DB), driven by an increase in per person savings. This adjustment
and defined annuity (DA). In all cases, total contributions is a result of consumption-smoothing motives; for example,
are collected in the form of payroll taxes and fully distrib- individuals need more savings to support themselves if they
uted as benefits. Therefore, the pension system is finan- live longer. Thus, with higher savings comes more rapid cap-
cially balanced. The main difference of these systems ital accumulation.
4 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK
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Table 2. Aging’s Impact on Capital per Worker under Different Unfunded Pension Systems
Standard case Defined contribution Defined benefits Defined annuities
Mandatory early retirement
Decrease in fertility >0 >0 ≷0 ≷0
Increase in longevity >0 ≷0 ≷0 ≷0
Optimal retirement
Decrease in fertility >0 >0 ≷0 ≷0
Increase in longevity >0 ≷0 ≷0 ≷0
Source: Dedry, Onder, and Pestieau forthcoming.
An unfunded pension system with defined contributions In the context of increased longevity, the outcomes are
In this case, pension benefits adjust to satisfy the fiscal balance identical for both DC and DB systems. This is mainly because
when fertility rate changes. Changes in longevity, on the other the change in longevity has no effect on pension balances, be-
hand, do not create imbalances in the DC case. cause the pension lump sum payment is invariant to the
To see the impact of a reduction in fertility, remember length of the second period. Thus, there is no adjustment via
that there are two demographic factors that are relevant here. pension contributions or benefits channel.
First, the number of pension contributors decreases. This An unfunded pension system with defined annuities
translates into a decrease in pension benefits. In response to Under a DA pension system, changes in both longevity and
this reduction in old-age income, individuals save more. Sec- fertility affect the contribution ratios (box 2). Therefore, a de-
ond, the number of workers decreases. Therefore, with the crease in the fertility rate or an increase in longevity that is
number of workers shrinking and savings simultaneously in- more than the endogenous change in optimal retirement age
creasing, the fertility rate decrease has a positive impact on lead to higher contribution rates to rebalance the pension
capital accumulation. fund.
In contrast, the positive result from the benchmark case The impact of a decrease in the fertility rate on capital
weakens, and is possibly reversed, when there is an increase in accumulation with defined annuities is identical to the DB
longevity and a PAYG pension system with DCs and the pos- case. The net effect is ambiguous, and it is determined by two
sibility of work in old age are introduced. Remember, increas- opposing forces: a reduction in number of workers, which in-
ing longevity has multiple effects on decision makers. First, creases per worker capital, and a reduction in per person sav-
other things being equal, a longer life span induces higher sav- ings, which decreases it. In the end, country-specific charac-
ings via the consumption-smoothing channel. Second, as life teristics will determine which effect dominates.
spans increase, individuals would choose to work longer if re- The effects of an increase in longevity are complex in a
tirement age is not regulated. However, this second adjust- DA system. In contrast to other social security systems, an in-
ment could weaken or even reverse the need to save compared crease in life span increases second-period income. With man-
to the benchmark case. Therefore, the net effect of an increase datory retirement, this is solely because each individual re-
in longevity on capital per worker is ambiguous under a DC ceives the annuity for a longer period. When individuals can
pension system. choose the retirement age, however, a longer work life will
An unfunded pension system with defined benefits optimally contribute to second-period income via wage earn-
Unlike DC pension systems, when the fertility rate changes ings as well. The increase in old-age income, in turn, reduces
under a DB system, pension contributions adjust to satisfy the young generation’s incentives to save. However, savings
the pension system balance. Changes in longevity, however, may still increase if the annuities are small compared to first-
do not create imbalances, as in the previous case. period income, resulting from the need to finance a longer life
When the fertility rate decreases, contribution rates in- span. Thus, the net effect on savings is indeterminate, as is the
crease to reestablish the balances in the social security system. net effect on capital per worker.
This reduces first-period income. As a result, individual sav-
Simulations and More Technical Results
ings decrease to allocate adjustment costs across the periods as
implied by the consumption-smoothing motive. At the same There are two results that are interesting from more special-
time, the number of workers decreases with the reduction in ized perspectives. First, in the numerical simulations per-
fertility rate. Overall, the net effect on capital per worker is formed by Dedry, Onder, and Pestieau, the net effect of both
ambiguous because lower savings have a negative impact and decreasing fertility and increasing longevity on capital accu-
fewer workers have a positive impact on capital per worker. mulation and utility remained positive in all ambiguous cas-
5 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK
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Box 2. Modeling the Effects of Demographic Change on Capital Accumulation
Dedry, Onder, and Pestieau (forthcoming) use a standard two-period overlapping generation model with endogenous retirement to
investigate the impact of demographic changes on capital accumulation and growth.
An individual belonging to generation lives in two periods: and + 1. The first period of the individual’s life has a unitary length,
while the second one has a length ≤ 1, where reflects variable longevity. In the first period, the individual works and earns ,
which is devoted to the first period’s consumption, , saving , and pension contribution . In the second period, the individual
works an amount of time +1 ≤ ≤ 1 and earns +1 +1 . This earning, the proceeds of saving +1 , and the PAYG pension
finances second-period consumption, +1 . The model assumes that working in the second period +1 implies a monetary disutility
2
(+1 , ), with
> 0,
2
> 0 for the existence of a unique solution, and
< 0, which reflects the idea that an increase in longevity
fosters later retirement.
Note that, for simplicity, the earnings in the second period of life are not taxed. Intuitively, the end of the first period can be
interpreted as the statutory age of retirement. Dedry, Onder, and Pestieau (forthcoming) also abstract from modeling the funded
social security system by assuming it is identical to the standard savings. Thus, the pension contribution parameter measures the
relative size of the unfunded pensions. In other words, = 0 implies that the whole pension system is funded.
Denoting by (. ) the utility function for consumption or and the lifetime utility, the problem of an individual of generation is:
+1 +1 ++1 +−(+1 , )
max, = ( − − ) + � �,
where is time discount factor and the link between pension contributions () and benefits () is defined by the particular pension
system as follows:
: (1 + ) = ̅
: ̅(1 + ) =
: � ( − ) = (1 + ),
where is the population growth rate and denotes the annuities under the defined annuity system. Production side of the
economy is characterized by a Cobb-Douglas production function with constant returns to scale:
1−
= ( , ) = ,
and where is the stock of capital, is productivity parameter, and is the labor force. Capital accumulates according to the rule:
+1 = , where is the size of generation .
The analysis proceeds by solving for the equilibrium saving and retirement-age decisions for individuals under different social
security systems. Impacts of changing fertility and longevity are analyzed separately.
Source: Dedry, Onder, and Pestieau forthcoming.
es. However, these are all long-term effects which appear in behavioral adjustments, the results are mainly driven by ac-
the steady state. A dynamic simulation exercise revealed that, counting effects (for example, less workers and more depen-
in the short term, a transitory decrease in utility is likely when dents per worker in the economy), and are therefore necessar-
aging is driven by a reduction in fertility and a DC pension ily negative.
system is in place. Second, the analysis assumes underinvest- However, once behavioral adjustments are considered,
ment in all cases, for example, the equilibrium is on the good this picture may change substantially. First, workers could be-
side of the “golden rule,” thus, more savings are good. Interest- come more productive due to higher savings and, thus, in-
ingly, and again in all cases, mandatory retirement produced creased capital accumulation. Second, individuals may choose
more desirable outcomes than optimal retirement, despite to work longer, thus, the labor force could be larger than the
the distortions it imposed on the economy. These outcomes levels used by demographic projections with constant ages of
are mainly due to the fact that forced retirement induces retirement.
workers to save more than they would save if they were freely This note highlight the importance of considering pen-
choosing their own retirement age. sion system characteristics and types of aging when assess-
ing the extent to which behavioral adjustments may en-
Conclusion
hance or reverse the negative results suggested by the
This analysis shows that the net effect of demographic aging accounting effects. Results show that savings, thus capital
on economies may differ across countries. In the absence of accumulation, could increase when aging is mainly driven
6 POVERTY REDUCTION AND ECONOMIC MANAGEMENT (PREM) NETWORK
www.worldbank.org/economicpremise
by decreasing fertility rates and the pension system is char- About the Authors
acterized by defined contributions. This effect is weaker in
Harun Onder is an Economist in the Economic Policy and Debt
DB and DA systems. In comparison, when aging is driven by
Unit (PRMED) of the World Bank. Pierre Pestieau is Professor of
increasing longevity, the effects on savings are ambiguous in
Public Economics at the Université de Liège and a member of the
all types of unfunded pension systems. However, if regula-
Center for Operations Research and Econometrics at the Univer-
tions allow, labor force participation among the older popu-
sité Catholique de Louvain.
lation could increase. This is especially true in DC and DB
systems. References
Considering the important differences in aging styles
Bloom, D. E., D. Canning, and J. Sevilla. 2001. “Economic Growth
and social security systems across countries, and particularly and the Demographic Transition.” NBER Working Papers
between developing and advanced economies, studies that in- 8685, Cambridge, MA.
vestigate the economic impacts of aging would do well to take Bloom, D. E., D. Canning, and G. Fink. 2011. “Implications of
Population Aging for Economic Growth.” PGDA Working
these differences into consideration. Papers 64, Harvard University, Cambridge, MA.
Dedry, A., H. Onder, and P. Pestieau. forthcoming. “Aging, Social
Acknowledgments Security Design, and Capital Accumulation: CORE Discussion
Papers.” Université Catholique de Louvain, Center for Opera-
The authors are grateful to Jeffrey D. Lewis, Otaviano Canu- tions Research and Econometrics.
to, Leonardo Hernandez, Apurva Sanghi, William G. Battaile, Onder, H., F. L. Hernandez, and F. Usmani. 2014. “Aging Grace-
Stefanie Sieber, Julia Burr Oliver, and Martha Mary Schmitz fully? Macroeconomic and Fiscal Implications of Demographic
Trends in the Modern World.” Mimeo.
for valuable comments and suggestions.
The Economist. 2014. “Global Ageing: A Billion Shades of Grey.”
April 24.
The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty
Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect
those of the World Bank. The notes are available at: www.worldbank.org/economicpremise.
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