Will you still need me?
Will you still feed me?
When I'm sixty-four?”

~Lennon-McCartney

All retirement strategies that don't rely on the savings of the individual retiree are in trouble and nobody has found a fiscally responsible system that has stood the test of time. This fact is related with something called the ‘dependency ratio’ and the ‘demographic transition’. Both terms refer to aspects that have an economic nature and undoubtedly will have an impact in business.

The dependency ratio is the relation between the number of people who are considered of working age and the number of people who are not. This dependency ratio is projected to increase dramatically in almost all advanced economies and many developing countries, and this is called the demographic transition.

In the following section we will clarify certain aspects related to the dependency ratio, in particular the difference between the global and the partial dependency ratios.

The Dependency Ratios

Actually there are three dependency ratios: the youth, the aged, and the total. The first is the number of young age persons to those in working age, the next is the number of old age persons to those in working age, and the third one is the sum of the two.

Of course, if the number of people in working age is greater than that of the dependants, it is an ideal situation because the funds gathered by current workers would be enough to pay for the expenses generated by the younger and the elder. Such a situation would be represented by a small dependency ratio. For instance, a ratio of 0.3 means that the dependants are only 30% of the persons in working age.

On the contrary, if the dependency ratio is high, it means that the dependant population is larger compared to the working age population. In fact, when the ratio is greater than one, it implies that the dependents exceed the working population of that particular moment.

Dependency ratios are not fixed in time, and they may change considerably in a few years. Moreover, the dependency ratio is projected to increase dramatically in almost all advanced economies and many developing countries during the coming 50 years.

The Demographic Transition

This global tendency or “demographic transition” where any country transits from a high fertility and mortality rate to low mortality, first, and to low fertility, next. Countries are at widely different stages of that transition, during which the dependency ratio typically falls to extremely low levels and then increases.

The problem with that tendency is that the taxes model will imply an increase in the tax level to ensure the payment of scheduled social security benefits. In fact, according to a report written by the President’s Commission in 2001, the tax should increase from the present 12.4% to 17.8% by 2038, and 19.4% by 2075.

In the “company pension” model, the situation would be rather similar because it is reasonable to expect, statistically, a similar demographic structure to dependency ratios: those that compare their retired dependants to their current employees. In other words, in a nation with a great dependency ratio, companies that pay pensions will also have to pay to many former employees.

This situation has led to many to consider alternatives like the Chicago model as ways to deal with the issue. However, the Chicago model has been widely criticized because of the bad experiences obtained in Chile and other places where it has been applied.

Now we will review the three retirement models, starting with the most affected by the dependency ratio, the company pension, and ending with the – in theory – less affected, the Chicago model.

The Company Pension

There was a time when people spent all of their productive lives working for one single firm. Under such conditions, unions wanted long term security for their members and they managed to get it from the employers. Therefore, most firms began to offer their employees health care benefits and a company pension.

The problem arose when work was no more guaranteed and workers also began to look for better positions in other companies. The result was that workers moved from one company to another and the pensions started to rely only on the last employer, regardless of the fact that maybe those particular workers stayed only a couple of years there before their retirement. This situation was obviously unfair to the employers and they started to ask for a minimum amount of permanence.

Particularly a union head from Ohio, Richard Gosser, came up in 1949 proposing that every company in the area should pay ten cents an hour, per worker, into a centralized fund to fulfil that goal. One year later, Walter Reuther and the other union heads claimed that the safest and most efficient way to provide insurance against ill health or old age was to spread the costs and risks of benefits over the biggest and most diverse group possible.

The Taxes Model

During the early 1950’s, the labour movement, headed by people like Gosser and Reuther, pointed out that in the free-market system it made little sense for the burdens of insurance to be borne by one company. One way of dealing with this fact was by developing a national or local social security system based upon taxes.

Under the taxes model, typically, when you get your payslip you will find there a line displaying the amount diverted to social items. Typically, states use the income obtained from those social taxes to pay for the retirement pensions and health insurance. In other words, social items are examples of a tax paid over a payslip.

Of course the union heads would claim for that tax to be paid by the employers and not by the employees. However, as happens with any other tax, social items are not entirely paid for by either of them, since the state appears here as a third party. Furthermore, economists have shown that taxes are always paid by consumers and suppliers in a combined fashion – that is related with the concept of elasticity – and this is no exception.

The Chicago Model

We will call “The Chicago Model” a third way in which a free market can handle the issue of retirement pensions. Chicago theorists, and particularly Milton Friedman, are the proponents of a novel retirement system based on Reuther’s idea that the safest and most efficient way to provide insurance against old age was to spread the costs and risks of benefits over the biggest and most diverse group possible. Although Reuther may have been thinking of a “Social Security System”, Friedman and his followers thought of a set of private firms in charge of handling the pension credits of their particular “clients”, the employees.

This is a major shift in the whole idea of the retirement system, since it ceases to be a mechanism by which pensions of current retirements depend on current workers. It turns out to be a system in which every individual capitalizes his/her own pension in time. In other words: contributions are invested, just like saving in a bank, instead of being used to pay current benefits. Private specialized firms are created to handle or manage those funds.

Most of the nations that privatise pensions have also devised a similar system to provide health insurance. In Chile, for instance, workers are forced by law to divert some funds of their payslip to a particular health insurance company that pays for – at least in part – their medical expenses when needed.

Long Term Effects of the Pension Plans

The most affected by this phenomenon will be the firms that pay retirement pensions to their former workers. These companies should be aware of their own ‘dependency ratio’, the amount of retired workers divided by the current workers. If this ratio is too high, and there is a certain probability for this to happen, it might be dangerous for the firm’s viability. The company will have to carry the weigh of their retired workers, even if the current number of workers is much smaller.

This situation will also affect the companies that operate in states that implement the taxes model. The only difference is that here there will be no need to be aware of an ‘internal dependency ratio’. All the information required will be brought by the state’s global ratio, because the retirement’s burden will be spread among the companies.

Companies that operate in Chile and in other countries that have adopted the Chicago model will be the less affected; but this doesn’t mean they will be free of the demographic transition consequences. Pension funds handlers will have to pay for longer pensions and they may start to produce political pressure to increase their incomes. If this becomes law, companies will have to pay at last, just as in the other two models.

So companies might need to think future – of demographic transitions and dependency ratios - before they adopt any particular pension plan long term.

Copyright © 2007 by Luis E. Bastias.
Copyright © 2007 by The Working Manager, Ltd.
All Rights Reserved.