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Population ageing in Europe: risks for growth and fiscal position

Economic Report

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  • With lower fertility and higher life expectancy population ageing in Europe is real and will have an impact on economic growth and the public cost of pensions and healthcare. Economic growth will be affected through a contraction of the working age population and the reallocation of a higher share of resources towards care for the elderly
  • This effect can be mitigated with pension reforms that counter the contracting of the working age population and by increasing the immigration of high-skilled migrants
  • There are three mitigating factors that enhance sustainability of the public cost of pensions: transformation of the public pension to a notional defined contribution (NDC) scheme, accumulation of public pension reserves and substitution of public for private pension schemes
  • Health care cost will also rise as increasing longevity leads to increasing demand for health care, while technological progress and innovation are important drivers of healthcare expenditure
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Population ageing in Europe

Europe as a whole faces population ageing. As fertility has halved since the 1950s, the share of younger cohorts in the total population has declined. At the same time, life expectancy at birth has increased vastly and is expected to increase further (UN, 2013). The changing age structure will affect economic growth and the public cost of pensions and healthcare in European countries.

Growth risks: declining working age population and higher dependency ratio

Population ageing negatively affects growth through two channels. First, without accommodating policy, the working age population is projected to contract (UN, 2013). This limits potential growth. For Europe as a whole, we see a clear downward trend over the next decades (figure 1).[1]

Figure 1: Development working age population (aged 20 – 65) 2015-2040 by region
Figure 1: Development working age population (aged 20 – 65) 2015-2040 by regionSource: UN, Rabobank

 Only in the Nordics and Turkey will the working age population increase slightly, driven primarily by persistent population growth. In the Baltics the total population itself will contract as a result of low fertility and emigration, causing the sharpest decline in the working age population of all the regions analysed. Secondly, the structure of demand will change as a result of ageing. The demand for care will rise as the elderly become less self-sufficient with advancing age. This means a greater share of resources will be needed to service their needs, taking resources away from the other (tradable) sectors. This may put upward pressure on wages in the tradable sector and could therefore hurt competitiveness, which in turn hurts growth. Empirical findings suggest that a 1% increase in the proportion of people aged over 65 in the total population decreases per capita growth by between 1% and 2%, assuming a constant retirement age (Lindh and Malmberg, 1999).

There are a number of policies that can be pursued to mitigate the effects of population ageing on economic growth. Firstly, a country can try to increase the participation rates of the current working age population or increase the participation of older people by raising the retirement age. Secondly, a country can increase immigration of younger cohorts to increase the working age population.

Increasing labour market participation of older workers

There are broadly speaking three instruments available to raise the retirement age: raising the statutory retirement age, reducing the ability to take early retirement and providing (fiscal) incentives to continue working. Table 1 shows to what extent countries have reformed their national pension systems. Particularly the countries with the lowest effective retirement ages have pursued reforms.[2] 

Table 1: Effective retirement age (2012) and reforms 2012-2014
Table 1: Effective retirement age (2012) and reforms 2012-2014Source: OECD, Rabobank

Bringing in new workers

Bringing in migrants compensates for older workers who exit the labour market. However, immigration may reduce per capita growth if migrants have low productivity. European countries therefore benefit primarily from highly-skilled immigrants as these people complement the existing physical capital and human capital that characterises the economic structure of a developed (capital-intensive) economy.

To that end, the EU adopted the Blue Card directive in 2009. The directive facilitates the admission and mobility of highly qualified migrants by harmonising entry and residence conditions throughout the EU and by providing for a legal status and a set of rights. While the UK, Ireland and Denmark have opted out of the Blue Card directive, for other countries the European Commission concluded that: “[there remain] flaws in the transposition, the low level of coherence, [and] the limited set of rights and barriers to intra-EU mobility”. Consequently, only 10,000 Blue cards have been issued in the first two years after the implementation deadline. Juncker has vowed that one of his priorities will be to review the Blue Card Directive and to broaden it substantially, which could contribute to mitigating the effects of population ageing in the future.

Impact of ageing on public finance

Population ageing may also negatively affect fiscal sustainability, via higher age-related spending on pension benefits and healthcare, which are analysed respectively in the sections below. Although ageing is likely to have a wider impact on society, we restrict our analysis to the effects on public finances. Accordingly, we do not include private pension and healthcare schemes, and focus only on public schemes.

Pension expenses projections

The EC (2015) forecasts that public expenditure on old-age and early retirement pensions in the European Union will increase by 0.5 of a percentage point of GDP between 2013-2030. However, the increase varies significantly from one country to another (figure 2). The projections incorporate pension legislation implemented or announced up till April 2015, reforms thereafter are not included.

The extent to which pensions are impacted is driven by the change in the relationship between what goes into (contributions) and what comes out of (benefits) the pension pot. Pension expenditure is forecast to increase in more than half of the European countries (figure 3) due to the rising proportion of older people in the total population (EC, 2015; IMF, 2014). The red shaded area in figure 3 denotes countries where net public pension expenditure is projected to outstrip the increase in contribution revenues. Differences in pension expenditure developments between countries are due to variations in developments in the number of retirees, longevity, entitlement and pension benefits. An increase in any of these variables will result in higher pension expenditure.

Figure 2: Gross ageing expenses to rise substantially
Figure 2: Gross ageing expenses to rise substantiallySource: EC (2015)
Figure 3: Trends in public pension contributions and expenses
Figure 3: Trends in public pension contributions and expensesSource: EC (2015)

Pension system characteristics that enhance fiscal sustainability

Most public pension schemes in Europe are unfunded and financed on a pay-as-you-go (PAYG) basis, whereby current contribution revenues are used for the payments of current pension benefits (annex table IV). With a contracting labour force and an increasing number of elderly people, the funding of PAYG public pension programmes will involve greater challenges. There are three ways to enhance fiscal sustainability: transformation to a notional defined contribution (NDC) scheme, accumulation of public pension reserves and substitution by private pension schemes.

Some countries (Italy, Sweden, Norway, Latvia and Poland) have implemented notional defined contribution (NDC) programmes on a PAYG basis. Since these pension schemes link pension benefits to increasing longevity, they achieve a considerable degree of fiscal stability. Longevity risk is effectively shifted to the pensioners. In Italy and Poland, for example, the EC (2015) projects that pension expenses will decrease over the next 20 years (figure 3), partly due to an expected decline of respectively 2 and 5 percentage points of the gross replacement rate for public pensions. It should be noted that an NDC scheme is not necessarily risk-free for the public finances, as sharp reductions in benefits may lead to popular resistance and therefore to political unwillingness to reduce benefits (i.e. the pension contract may be time-inconsistent).

The existence of a public pension reserve fund mitigates fiscal sustainability risks, as such funds finance future public pension benefits and therefore alleviate the impact of population ageing on the public purse. A fully capitalised public pension fund (in fact the opposite of a PAYG system) therefore greatly reduces the risks an ageing society could pose for public finances. These funds are however almost non-existent in Europe (figure 4, insofar as data is available).

Figure 4: Net replacement rates and public pension reserve funds, 2011 values
Figure 4: Net replacement rates and public pension reserve funds, 2011 valuesSource: OECD (2013)

The existence of private pension schemes also enhances fiscal sustainability, as it lightens the benefit burden for the public sector. Moreover a public sector retreat becomes more feasible if a larger proportion of entitlements comes from private pension schemes. Private sector entitlements may mitigate cuts in public pension benefits and therefore limitpolitical resistance to such measures. As for countries with an public NDC scheme, private schemes are present in Norway, Sweden and Poland, but not in Italy (figure 4). This increases the risk of resistance to reducing public pension benefits in Italy. High household savings or high housing wealth might however act as a buffer against public sector retreat. 

Healthcare spending

Public expenditure on health care due to ageing is on the rise in most European countries (figure 2). Older people have a higher incidence of complex health problems and require continuous professional care beyond a certain age. A higher proportion of elderly people leads to higher health care spending (Rabobank, 2012; Ministerie van Volksgezondheid, 2012). This may pose a risk to the sustainability of public finances in three ways. Firstly, increasing longevity without an improvement in health status leads to increasing demand for health care and thus increases the level of public spending needed. 

Figure 5: Old age population will increase, working age population will decrease
Figure 5: Old age population will increase, working age population will decreaseSource: UN

Secondly, public health care in many European countries is largely financed by social security contributions from the working population. Since ageing increases the old-age dependency ratio, there will be fewer people contributing to and more people in need of health care (figure 5). Thirdly, technological progress and innovation appear to be important drivers of healthcare expenditure, as more and often more expensive treatments become available. 

Footnotes

[1] The regions are defined as follows: Nordics (Denmark, Finland, Iceland, Norway, Sweden), Western Europe (Austria, Belgium, France, Germany, Ireland, Luxembourg, Netherlands, UK, Switzerland), Southern Europe (Cyprus, Greece, Italy, Malta, Portugal, Slovenia, Spain), Baltics (Estonia, Latvia, Lithuania), CEE (Czech Republic, Hungary, Poland, Slovakia), SEE (Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Kosovo, FYR Macedonia, Moldova, Montenegro, Romania, Serbia), and Turkey.

[2] See table III in the appendix for EC estimations of labour market participation of older workers, based on 2012 data.

Literature

Rabobank Themabericht (2012), Stinkende wonden door zachte heelmeesters. Rabobank Themabericht, september 2012

European Commission(2015), The 2015 Ageing Report: Economic and budgetary projections for the 28 EU Member States (2013-2060)

International Monetary Fund (2014), Fiscal Monitor – Back to Work: How Fiscal Policy can Help

Lindh, T., and B. Malmberg (1999), Age structure effects and growth in the OECD, 1950–1990. Journal of population Economics, 12(3), 431-449.

Ministerie van Volksgezondheid (2012), De zorg: hoeveel extra is het ons waard?

OECD ( 2014), Pensions Outlook 2014, OECD Publishing

OECD (2013), Pensions at a Glance 2013: OECD and G20 indicators, OECD Publishing

UN Department of Economic and Social Affairs, Population Division (2013), World Population Ageing 2013. ST/ESA/SER.A/348. 

Appendix

Table I: Percentage increase working age population
Table I: Percentage increase working age populationSource: UN, Rabobank
Table II: Dependency ratio % total population
Table II: Dependency ratio % total populationSource: UN, Rabobank
Table III: Participation rate older workers
Table III: Participation rate older workersSource: EC, Rabobank
Table IV: Structure of pension schemes
Table IV: Structure of pension schemesSource: OECD (2013)

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This study is a publication of Economic Research (KEO) of Rabobank.

The views presented in this publication are based on data from sources we consider to be reliable. Among others, these include Macrobond. The economic growth forecasts are generated from the NiGEM global econometric structure models.

This data has been carefully incorporated into our analyses. Rabobank accepts, however, no liability whatsoever should the data or prognoses presented in this publication contain any errors. The information concerned is of a general nature and is subject to change.

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Abbreviations for sources: AMECO: Annual Macro-Economic Database, BIS: Bank for International Settlements, DOTS: Directions of Trade Statistics, EC: European Commission, ECB: European Central Bank, OECD: Organisation for Economic Co-operation and Development, EIU: Economist Intelligence Unit, IMF: International Monetary Fund, WEO: World Economic Outlook, UN: United Nations

Abbreviations used for countries: AL: Albania, AT: Austria, BE: Belgium, BG: Bulgaria, BA: Bosnia and Herzegovina, CH: Switzerland, CY: Cyprus, CZ: Czech Republic, DE: Germany, DK: Denmark, EE: Estonia, ES: Spain, FI: Finland, GB: Great Britain (UK), GR/EL: Greece IE: HR: Croatia, Ireland, IS: Iceland, HU: Hungary, IT: Italy, LU: LV: Latvia, Luxembourg, LT: Lithuania, MD: Moldova, ME: Montenegro, MK: Macedonia, FYR, MT: Malta, NL: The Netherlands, NO: Norway, PL: Poland, PT: Portugal, RO: Romania, RS: Serbia, SI: Slovenia, SK: Slovakia, TR/TK: Turkey, XK: Kosovo, SE: Sweden, EA17: Euro Area-17, EU27: European Union.

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Editors-in-chief: 
Allard Bruinshoofd, head of International Research, Economic Research

Graphics: Selma Heijnekamp and Reinier Meijer

Production coordinator: Maartje Wijffelaars an Christel Frentz

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