Chapter 9. Accounting for the financial consequences of demographic changes1

Jorrit Zwijnenburg
(OECD)
Paul Goebel
(Treasury Board of Canada Secretariat)

Many OECD countries are facing pronounced demographic changes, primarily in the form of ageing populations. It is therefore important to not only understand these effects, but to also monitor and analyse their impact on macroeconomic developments. This chapter explains the effects that demographic changes may have on the economy. It starts by explaining how households’ income, consumption and saving vary across age groups and how demographic changes can affect the saving ratio and the net worth of the household sector as a whole. It then analyses the link between demographic changes and governments’ finances and how the sustainability of government finances can be assessed in the light of changing populations. Finally, this chapter discusses the various ways in which pension systems are organised across countries, how they are recorded in the system of national accounts, and how the resulting data can (not) be used to assess their financial sustainability.

  

1. The effect of demographic changes on household saving and wealth

As saving varies across age groups, demographic changes may affect the saving ratio and the net wealth of the household sector in an economy. This relates to the life-cycle hypothesis by Modigliani and Brumberg (1954), as well as to the permanent income hypothesis formulated by Friedman (1957). The life-cycle hypothesis explains that individuals do not plan their consumption and saving on the basis of their current income, but that they smooth consumption over their life-time on the basis of their lifetime earnings and their initial net worth. Modigliani and Brumberg developed their hypothesis in response to the common understanding in those days that consumption and saving were a function of income and that consumption and saving would increase with income. This was fed by empirical results that the share of consumption in income is lower for higher income households and therefore, saving is positively correlated with income. However, in their hypothesis Modigliani and Brumberg explain that this is not due to a direct link between income and consumption, but merely due to the position of households in their lifecycle. The utility function of an individual consumer is a function of his current and future consumption, and the typical household will try to maximise his utility on the basis of his earnings over his lifetime. Whereas income shows fluctuation over a lifetime, consumption remains relatively stable, as a consequence of which saving fluctuates over time.

Figure 9.1 presents how the life-cycle hypothesis works in theory. Most people borrow during their younger years, when they are studying, in anticipation of future earnings. During their working life, people save to pay off the debt incurred in their youth and to amass funds for retirement. During their retirement, people usually do not earn income from employment and tend to dissave. This pattern of borrowing at a young age and saving up during the active career leads to wealth being accumulated towards retirement age. Saving will be small (or negative) at the start of the career, but will increase towards the retirement age. Consequently, net worth will increase during working life and decrease after retirement.

Figure 9.1. Life cycle hypothesis in theory
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The permanent income hypothesis, which is closely tied to the life-cycle hypothesis, provides an explanation for levels of consumption for various households. This hypothesis, which was developed by Milton Friedman, states that individuals’ consumption will depend on their current income, as well as on their expected future income flows. It is the permanent income that determines how much households will consume. The permanent income can be defined as the average of the expected income flows over a lifetime. The hypothesis implies that temporary income shocks will not lead to an increase in consumption, whereas permanent changes in income will. Temporary shocks will only affect saving. Friedman also explains that, as the amount spent on consumption is on average the same fraction of permanent income, the saving rate will not necessarily depend on the level of current income. It will, on the other hand, depend on variables such as the interest rate, degree of uncertainty about future earnings, the length of the retirement period, initial wealth and family size. The main difference between the two models is that the life-cycle hypothesis assumes a finite life-span, whereas the permanent income hypothesis focuses on an infinite life-span. In this respect, the latter also takes into account bequests, which do not play a role in the standard life-cycle hypothesis.

Both theories are supported by empirical evidence. For example, Figure 9.2 presents saving ratios for Australia by age group on the basis of methodology developed by the Expert Group on Disparities within National Accounts (EG DNA) (Zwijnenburg et al., 2017). This Expert Group developed methodology to compile distributional results in line with national accounts totals on the basis of micro-data. As results are aligned with national accounts totals, they can be linked to other macroeconomic aggregates, such as gross domestic product (GDP), household disposable income and household wealth. The results for Australia show that the youngest age group (between 15 and 24) and the oldest age group (65+) have lower or even negative saving ratios, whereas the middle age groups show positive ratios, with ratios varying across age groups.

Figure 9.2. Saving ratio per age group for Australia
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Source: Australian Bureau of Statistics (2015), 5204.0.55.011 – Australian National Accounts: Distribution of Household Income, Consumption and Wealth, 2003-04 to 2014-15 (database), www.abs.gov.au/AUSSTATS/[email protected]/DetailsPage/5204.0.55.0112003-04%20to%202014-15?OpenDocument.

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Both hypotheses also provide a rationale for the variations in net worth, or net wealth, across age groups. Young people will have low or negative net worth as they start their lives, borrowing funds to pay for their consumption. Once they start their working lives, they save up money, which adds to their net wealth. After retirement they will use these assets to pay for their consumption. These hypotheses are also confirmed by empirical results. Figure 9.3 shows the wealth per household according to age group for Australia (for the year 2013/14). It shows that wealth increases up until retirement and that net worth is highest for the pre-retirement age group.

Figure 9.3. Wealth according to age group in Australia, 2013/14
AUD, millions
picture

Source: Australian Bureau of Statistics (2015), 5204.0.55.011 – Australian National Accounts: Distribution of Household Income, Consumption and Wealth, 2003-04 to 2014-15 (database), www.abs.gov.au/AUSSTATS/[email protected]/DetailsPage/5204.0.55.0112003-04%20to%202014-15?OpenDocument.

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As saving relates to the life-cycle of individuals, the saving ratio and accumulated wealth will differ across age groups. This is why demographic changes will also affect the saving ratio for the household sector as a whole, as well as household wealth. In this respect, Modigliani and Brumberg also developed an aggregated consumption function for a community as a whole and related this to national saving and the accumulation of national wealth, for which Goldsmith (1955) found that it was equal to 4-5 times private income and relatively stable over time. This wealth relates to the sum of saving that has been accrued within an economy as part of individuals’ life-cycle patterns. On the basis of their life-cycle hypothesis, Modigliani and Brumberg explain that the aggregate saving rate is independent from per capita income, but depends on the level of productivity growth (an increase in productivity growth increases the aggregate saving rate as the income of those who save increases relative to those who dissave), the demographic structure of a society, and life expectancy in relation to the retirement age (see also Jappelli, 2005). This, in turn, will also determine the aggregate wealth-to-income ratio in a country.

In a so-called stationary economy, saving and dissaving will cancel out at the national level, and national wealth will remain at a constant level. Wealth will move across the various age groups over time. People in retirement have large amounts of wealth, part of which is used to supplement lower levels of income and to maintain a certain level of consumption. These funds are usually obtained by the younger working generation, which is saving to pay off debt incurred during youth and to build up wealth for their retirement. However, in the case of changing demographic structures (i.e. a non-stationary economy), the total national wealth will change. For example, in the case of population growth, the number of people saving up for retirement will increase in comparison to the elderly, giving rise to saving exceeding dissaving and therefore an increase in wealth. Other reasons for changes in the saving ratio include changes in productivity growth and changes in life expectancy (relative to the retirement age).

As illustrated above, saving and wealth accumulation are affected by demographic changes. In the case of population growth, the aggregate saving ratio and national wealth will both increase. However, in the case of an ageing society which many countries will probably have to deal with in the next few decades (see Box 9.1) dissaving by the elderly may start to exceed the saving of the younger generations, leading to a decrease of the wealth of the household sector as a whole. The latter may affect financial markets as retired people will try to dispose of assets in times of subdued demand for financial investments. Empirical results confirm these findings. Higgins (1998) shows, using data from 100 countries, that national saving is negatively correlated with youth and old-age dependency. Figure 9.4 presents results for Japan, showing the dependency ratio and the saving ratio for the period 1980-2015. Whereas the dependency ratio shows an increase over time, the saving ratio declines over the years. As this may affect macroeconomic developments in various ways, it is thus important to closely monitor these impacts.

Figure 9.4. Dependency ratio and saving ratio in Japan
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1. Gross national saving, % of GDP.

Source: International Monetary Fund (2016), World Economic Outlook Database: April 2016, www.imf.org/external/pubs/ft/weo/2016/01/weodata/download.aspx and OECD (2017a), “Labour Force Statistics: Population projections”, OECD Employment and Labour Market Statistics (database), http://dx.doi.org/10.1787/data-00538-en.

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Box 9.1. Demographic changes

In many countries, the demographic composition of the population is expected to change dramatically over the next few decades. This is due to increasing life expectancy and decreasing fertility rates (UN, 2015). Figure 9.5 shows demographic results for 1950, 2015 and forecasts for 2050 for the total of OECD countries. The figure shows a clear increase in the share of older age groups, not only the total of people in retirement (65+), but also the people in the age group of 85 and older. This is not only caused by increasing life expectancy, but is also related to the impact of the Baby Boom generation currently going into retirement. On the other hand, the figure also shows decreasing shares for younger and middle-aged groups when comparing with the current phrasing pointing to ‘decreasing shares’, I think it should be ‘when comparing 2050 with 2015’, not only related to the growing share of older people, but also caused by lower fertility rates.

Figure 9.5. Demographic changes for OECD countries, 1950-2050
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Source: OECD (2017a), “Labour Force Statistics: Population projections”, OECD Employment and Labour Market Statistics (database), http://dx.doi.org/10.1787/data-00538-en.

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The demographic changes will lead to changes in the old age dependency ratios, i.e. the ratio of the elderly population (65+) as a percentage of the working population (20-64). In 2015, this ratio was 13.8, but this will increase to 47.1 in 2050. This implies that the future working population will have to provide financial and other care to an increasing number of elderly.

2. Demographic changes and government finances

Ageing societies may also affect government finances, as a significant part of government expenditures is related to age, such as public pensions, health care costs, social housing, and early retirement plans. In a study that was released in 2001, Dang et al. found that for OECD countries between 40 to 60 percent of total public spending consists of expenditure that is sensitive to the age structure of the population. If there is increased life expectancy, the number of retired people will increase and they will claim pension benefits for a longer period of time, thereby increasing pension costs. Furthermore, health care costs, including the costs of retirement homes, are also likely to increase as older people on average, tend to incur greater health care.2 In addition, costs will also increase for benefits related to early retirement, unemployment and disability, as older people will have to work longer to fund their longer retirements and it may be difficult to help them find appropriate employment. On the other hand, it is expected that costs related to young age, such as education costs and child care, are likely to decrease in an ageing society.

Dang et al. (2001) made projections on changes in age-related spending for the period 2000 to 2050, distinguishing four categories, i.e. old age pensions, early retirement programmes, health care and long-term care, and child/family benefits and educations. Table 9.1 presents the results for 21 OECD countries. The first column of each category shows the expenditure level in 2000 as percentage of GDP. The second columns show the percentage point change for the period between 2000 and 2050. It shows that age-related spending is likely to increase in almost all OECD countries, with Poland as the only exception. Regarding the magnitude of the changes, Norway records the largest change, with a 13.4 percentage point increase. Other countries with large increases are the Netherlands, Canada, Finland, Korea and New Zealand. The underlying components show that old-age pensions as well as health care and long-term care are the main drivers for the increase in old age expenditure.

Table 9.1. Changes in age-related spending, 2000-50

Total age-related spending

Old-age pension

Early-retirement programmes

Health care and long-term care

Child/family benefits and education

Level 00

Change 00-50

Level 00

Change 00-50

Level 00

Change 00-50

Level 00

Change 00-50

Level 00

Change 00-50

Australia

16.7

5.6

3.0

1.6

0.9

0.2

6.8

6.2

6.1

-2.3

Austria

10.4

2.3

9.5

2.2

-

-

-

-

-

-

Belgium

22.1

5.2

8.8

3.3

1.1

0.1

6.2

3.0

6.0

-1.3

Canada

17.9

8.7

5.1

5.8

-

-

6.3

4.2

6.4

-1.3

Czech Republic

23.1

6.9

7.8

6.8

1.8

-0.7

7.5

2.0

6.0

-1.2

Denmark

29.3

5.7

6.1

2.7

4.0

0.2

6.6

2.7

6.3

0.0

Finland

19.4

8.5

8.1

4.8

3.1

-0.1

8.1

3.8

-

-

France

-

-

12.1

3.9

-

-

-

-

-

-

Germany

-

-

11.8

5.0

-

-

-

-

-

-

Hungary

7.1

1.6

6.0

1.2

1.2

0.3

-

-

-

-

Italy

-

-

14.2

-0.3

-

-

-

-

-

-

Japan

13.7

3.0

7.9

0.6

-

-

5.8

2.4

-

-

Korea

3.1

8.5

2.1

8.0

0.3

0.0

0.7

0.5

-

-

Netherlands

19.1

9.9

5.2

4.8

1.2

0.4

7.2

4.8

5.4

0.0

New Zealand

18.7

8.4

4.8

5.7

-

-

6.7

4.0

7.2

-1.3

Norway

17.9

13.4

4.9

8.0

2.4

1.6

5.2

3.2

5.5

0.5

Poland

12.2

-2.6

10.8

-2.5

1.4

-0.1

-

-

-

-

Spain

-

-

9.4

8.0

-

-

-

-

-

-

Sweden

29.0

3.2

9.2

1.6

1.9

-0.4

8.1

3.2

9.8

-1.2

United Kingdom

15.6

0.2

4.3

-0.7

-

-

5.6

1.7

5.7

-0.9

United States

11.2

5.5

4.4

1.8

0.2

0.3

2.6

4.4

3.9

-1.0

OECD total

16.9

5.5

7.4

3.4

1.6

0.2

6.0

3.3

6.2

-0.9

Based on the assumption of unchanged policy, taking into account legislated but-not-yet implemented reforms.

Source: Dang et al. (2001), Fiscal Implications of Ageing: Projections of Age-Related Spending, http://dx.doi.org/10.1787/503643006287.

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The 2015 Ageing Report by the European Commission (2015) also confirmed that age-related expenditure is likely to increase in several European countries. The report showed that the age-related expenditure as a percentage of GDP is expected to increase by between 2.5 and 6.8 % of GDP in ten member states (Finland, Austria, Czech Republic, Netherlands, Slovak Republic, Germany, Belgium, Luxemburg, Malta and Slovenia). It also shows that a fall is projected for eight countries (Hungary, Greece, Latvia, France, Denmark, Cyprus3, 4, Italy and Spain), but that this may be related to reforms that have already been processed or planned.

Government revenues such as taxes and premiums may also be affected by demographic changes, because, in an ageing society, a relatively smaller number of people will pay income taxes and social premiums. The impact of this decrease is, however, expected to be less than the budgetary consequences on the expenditure side (Office for Budget Responsibility (OBR), 2015). An important indicator in this respect is the old age dependency ratio, introduced above, which basically shows how many retirees will need to be supported by the younger population. In the last few decades, the ratio has already showed a sharp increase, and it is expected to increase further in the coming decades. As can be derived from Figure 9.6, the rise is sharpest for Japan with an increase from 10.0 in 1950 to 81.1 in 2050, but for the other countries the increase is also significant.

Figure 9.6. Dependency ratio: population in retirement age (65+) to working age population (20-64)
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Source: OECD (2017a), “Labour Force Statistics: Population projections”, OECD Employment and Labour Market Statistics (database), http://dx.doi.org/10.1787/data-00538-en.

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As the dependency ratio increases, a question arises as to whether government policies are sustainable. Will the government be able to continue its policies without incurring large burdens on future generations by running into structural deficits and concomitant increases of government debt? Many social programmes run on the basis of intergenerational transfers, whereby the working population pays for the benefits of current pensioners. These programmes are usually set up in such a way that they are sustainable as long as the demographic structure of a society remains generally the same. However, with an ageing society and an increasing dependency ratio, the burden on future generations may increase.

If taxes and social contributions are no longer sufficient to cover the expenses of governments, government deficits will increase. Temporary increases can be endured, but structural high levels of deficits, due to the above demographic shifts, may cause the increases to become unsustainable. Government may need to restore the fiscal balance by either increasing taxation or by cutting expenditures, for example by reducing the benefits of pension schemes for future beneficiaries, or by tightening access to social programmes by changing the eligibility criteria. The longer it takes before action is taken to restore the fiscal balance, the larger the impact on government debt and the larger the burden will be on future generations. Several countries have already pursued such reforms in anticipation of some of the effects of an ageing society.

Governments’ balance sheets usually do not reflect the costs related to an ageing society. These costs often concern non-legal obligations that arise from expectations created by past practices, or by current government programmes or promises. These obligations are indirect or contingent, and are not included within the asset boundary of the 2008 System of National Accounts (2008 SNA). To be able to make an assessment of the sustainability of government finance, it is therefore important to have more insight into these types of future obligations. Including them on the balance sheet, if only as a memorandum item, would provide analysts with a more comprehensive overview of government finances.

Another possible way to capture the impact of an ageing society is to use forecasts on government spending and revenues, and combine those forecasts with current government debt levels. For example, calculations by the OBR in the United Kingdom (2015) showed that the projected increase in public spending (excluding interest payments) as a share of GDP will result in public spending gradually exceeding receipts, as a consequence of which the primary balance, i.e. public sector deficit excluding interest payments, will turn negative over time. Consequently, public sector net debt will first drop from 80 % of GDP in 2014-15 to 54 % in the early 2030s (while the primary balance is still positive), after which it will rise again to 87 % of GDP in 2064-2065; see Figure 9.7. The increasing trend is expected to continue from that point onwards. Although these types of calculations have to rely on several (sometimes rather strong assumptions) such projections (with the appropriate caveats and sensitivity analyses) may indeed provide useful insights in sustainability of government finance and the need for any structural reforms.

Figure 9.7. Projections of public sector primary balance and net debt for the United Kingdom
Percentage of GDP
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Source: OBR (2015), Fiscal Sustainability Report, http://budgetresponsibility.org.uk/docs/dlm_uploads/49753_OBR-Fiscal-Report-Web-Accessible.pdf.

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3. Demographic changes and pension schemes

The continuous increase in the dependency ratio has a profound impact on pension schemes, particularly pay-as-you-go pension schemes that rely on workers to pay contributions that fund the benefits of current retirees. For those schemes, an increasing dependency ratio implies that a smaller number of people has to come up with means to fund the benefits of an increasing group of retirees. As many social security pension schemes are pay-as-you-go schemes, many governments have already implemented pension reforms to mitigate the effects of an ageing population and to maintain the financial sustainability of their pension schemes. However, continuing increases in the dependency ratio may require additional measures. On the other hand, funded schemes, in which contributions are used to accumulate funds for the contributor’s future retirement benefit payments, may also be affected by demographic changes, particularly in the case of an increase in life expectancy. The accumulated funds may then turn out to be insufficient to cover future benefits, which will have to be paid out for a longer time period than initially foreseen.

Because of the possible impact of an ageing society on the sustainability of pension schemes, pension statistics have received a lot of attention in recent years and are a common topic of discussion among politicians, policy analysts, and the media alike. As different types of schemes may be affected in different ways, this section provides an overview of the various types of schemes, and the calculation and recording of the related entitlements according to the 2008 SNA. This section also explains how the current recording may hamper comparability of pension liabilities and household retirement resources across countries, and how the recording may obscure the possible impact of an ageing society on the sustainability of pension schemes and government finances.

Types of pension schemes

In most countries, there is a variety of pension schemes that collectively ensure a minimum level of income for all retirees while enabling workers to save and invest a portion of their earnings to attain a particular level of income or wealth upon retirement. Pension schemes can be categorised along several different dimensions, including how they are sponsored, how they are funded, and the manner in which they provide benefits.

The first important distinction which is made in the 2008 SNA is between social insurance schemes and individual pension schemes. A social insurance scheme is a scheme where the benefits received are conditional on participation in the scheme, and where at least one of the following three conditions is met: participation in the scheme is obligatory; the scheme is a collective one operated for the benefit of a designated group of workers; or, an employer makes a contribution to the scheme on behalf of an employee (regardless of whether or not the employee makes a contribution). On the other hand, individual pension schemes concern retirement schemes that are taken out by individuals on their own initiative, such as life insurance, and in which there is a direct link between the contributions and the benefits. Social insurance schemes are further subdivided into two categories. The first category concerns social security pension schemes which are schemes that are offered to the population as a whole (or a large segment of the population) and that are imposed and controlled by the government. Pension schemes that are based on an employer-employee relationship, that are part of the conditions of employment, constitute the second type of social insurance schemes. These are known as employment-related or occupational pension schemes. An alternative typology that is frequently used for the breakdown into these three types of pension schemes is the classification into so-called “pillars”. In this typology social security pensions constitute the first pillar, employment-related schemes the second pillar, and individual schemes the third pillar.

It is important to note that the distinction between social security and employment-related pension schemes is not the same as classifying schemes as public or private. Pensions are public or private depending on the type of institution that provides the schemes, i.e. the sponsor. Consequently, a public pension scheme can refer to a social security scheme but also to a pension scheme provided by the government to its employees. Conversely, a private pension scheme is a plan provided by an institution outside of the general government sector, although a private employer can still be obliged to contribute to a social security pension scheme as well. In addition, the categorisation of public versus private does not necessarily define the sector in which the liabilities are recorded. Recording will depend on who is responsible for managing the scheme. It may, for example, be the case that a public employment-related pension scheme is managed by a financial corporation, a so-called “autonomous pension fund”, in which case the obligations would be recorded in the financial corporations sector. If the government manages the scheme itself, the obligations would be recorded within the government sector.

Pensions can also vary by the manner in which they provide benefits. Most pension schemes take the form of either a defined benefit (DB) or a defined contribution (DC) scheme, although hybrid schemes also occur. In a defined contribution pension scheme, the benefits are determined by the contributions made by the beneficiary and the returns generated from the accumulated funds. In contrast, under a defined benefit pension scheme, the level of benefits payable to each beneficiary is determined by a formula which can include factors such as retirement age, average salary, and years of employment. An important consideration between DB and DC schemes is the assignment of risk. With a defined contribution scheme, the level of benefits payable to beneficiaries is determined by the accumulated funds from past contributions and investment returns, so the pension sponsor and pension manager do not face any risk of insufficient funding. The beneficiaries bear the risk of receiving lower benefits if the pension fund experiences lower investment returns. With a defined benefit scheme, the pension sponsor or pension manager bears the financial risk that contributions and/or investment returns are insufficient to pay for the pre-determined level of benefits. The most common risks are longevity risk, which is the risk that pension beneficiaries will live longer than projected in the calculation of contributions and benefits; and investment risk, which is the risk that the invested funds will not generate an investment return to match the levels projected in the calculation of contributions and benefits. Partly as a consequence of an ageing society, a shift can be observed towards more defined contribution schemes, in which the risk is borne by the covered population.

Pension schemes can also vary by how they are funded. A fully funded pension scheme will have sufficient resources set aside to pay for the benefit entitlements that have accrued to date. A defined contribution pension scheme is by definition fully funded, as the benefit levels are determined by the funding that the scheme has accumulated from past contributions and from investment returns. However, defined benefit pension schemes can operate on a fully funded, partially funded or pay-as-you-go basis. Under a pay-as-you-go pension scheme, no funds are being accumulated; instead, the benefits of current beneficiaries are paid from the contributions of current contributors. A lot of social security schemes are set up in this way, although an increasing number of countries is changing to partially funded schemes, to mitigate part of the impact of an ageing society. Such schemes operate as a hybrid of the two approaches, thus paying for benefits using a mix of both accumulated funding and investment returns from past contributors as well as contributions from current contributors. As was explained before, increasing dependency ratios may particularly affect the sustainability of pay-as-you-go systems and partially funded schemes.

The misalignment between the timing of the premiums and benefits in pay-as-you-go (or partially funded) pension schemes often complicates the assessment of the sustainability of those schemes. As pension obligations are recorded on an accrued-to-date basis, the (implicit) liability is recognised when a worker has provided the relevant service (e.g. a year of employment, including the payment of the required contributions), and thus increases its benefit entitlement. On the other hand, the future contributions that will pay for these benefits will only be recorded once they are actually paid in the future by the then working population. As a result, on an accrued-to-date basis these pension schemes may show significant liabilities without any (or only partially) corresponding assets. That is why for sustainability analyses of pay-as-you-go schemes, future contributions are often also taken into account, to obtain a longer term overview of incoming and outgoing flows. It is understood that this provides a better overview of the sustainability of these schemes (which is discussed later in this chapter).

Table 9.2 provides a summary of the different classifications that can be used to classify pension schemes. As plans can be categorized according to multiple dimensions, the table provides an overview of categories that are not mutually exclusive.

Table 9.2. Overview of the various classifications of pension schemes

Distinguishing factor

Types of pension schemes

“Pillars” of pension funding

Pillar 1: social security: offered to the population as a whole (or large segments) and imposed and controlled by government

Pillar 2: employment-related: based on an employer-employee relationship, and part of the conditions of employment

Pillar 3: individual plans: initiated and funded by individuals, apart from employer or government

Sponsoring institution

Public sponsorship: sponsored by the government (for general citizenship or government employees)

Private sponsorship: sponsored by the private sector

Benefits

Defined benefit: benefits determined by a formula which can include retirement age, average salary, years of employment, etc.

Defined contribution: benefits determined by a past contributions and investment returns on accumulated funds

Hybrid: benefits partly determined by a formula, and partly by contributions made and their returns

Funding

Fully funded: sufficient resources accumulated to pay for accrued-to-date entitlements

Pay-as-you-go: pension benefits of current retirees are paid for by contributions from current contributors

Partially funded: benefits are paid for using a mix of accumulated funds and contributions from current contributors

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The measurement of pension entitlements

For sustainability analyses and the assessment of the impact of an ageing society, it is important to monitor the value of the pension entitlements for the various types of schemes. In estimating the value of the entitlements, it is necessary to distinguish between defined benefit and defined contribution schemes as their entitlements are measured in different ways. For defined contribution schemes the measurement of the entitlements is relatively straightforward. Since the benefits are determined by the level of funding available at the time of the beneficiary’s retirement, the pension liability is simply equal to the accumulated assets in the pension fund. The measurement is more complicated for entitlements of defined benefit schemes, as their benefits are dependent upon a number of future developments not known at the time that the benefit entitlement accrues. Estimates need to be made based on projections of wage growth, expected age of retirement and life expectancy, expected number of years of contributions, and other factors that determine the present value of future cash flows. The total value of pension obligations owed by a pension fund is usually calculated as the net present value of the sum of all estimated pension benefits to be paid in the future to all individuals participating in the scheme.

A simplified representation of the present value of an individual’s pension entitlement can be shown as follows:

picture

The summation represents the present value of pension benefits for an individual. The summation would begin for the year in which the individual is expected to start receiving pension benefits and end at a year T sufficiently far in the future beyond which the individual is not expected to live (i.e. the conditional probability of survival is close to zero). The future benefits of each year need to be discounted to estimate the value of the pension obligations in the current year (or base year). The total sum of the liabilities associated with the scheme equals the value of the pension entitlements for all participants of the scheme.

As noted before, the value of the pension liability for defined benefit schemes is based on several factors that must be projected far into the future. Future salary and number of years of contributions before retirement will typically determine the amount of the pension benefit. The indexation factor, a method of adjusting future benefits for inflation and/or growth of real income, will likely be based on future inflation or wage growth projections. The conditional probability of survival will be based on future life expectancy. The results of these calculations can be highly sensitive to small changes in some of the factors, particularly the discount rate. For example, Table 9.3 shows the sensitivity of pension liabilities for changes in the discount rate and the real wage growth rate in estimates of the social security pension scheme in Portugal. The calculations were initially performed using a discount rate of 3% and a wage growth rate of 1.5%. Increasing the discount rate to 4% leads to a 14% reduction in the estimated pension liability, while decreasing the discount rate to 2% leads to a 19% increase. An increase in the wage growth rate to 2% leads to a 9% increase in the estimated pension liability, while a decrease in the wage growth rate to 1% leads to a 3% decrease.

Table 9.3. Sensitivity of the estimates of pension obligations for Portugal
Percentage change in social security pension liability due to change in wage growth and discount rate

Discount rate (%)

0

1

2

3

4

5

6

Wage growth rate (%)

0

 57

 28

 7

 -8

-21

-30

-38

0.5

 64

 33

11

 -6

-19

-29

-37

1

 71

 38

15

 -3

-17

-27

-35

1.5

 79

 44

19

Base

-14

-25

-34

2

102

 60

31

 9

 -7

-20

-30

2.5

113

 68

36

13

 -5

-18

-28

3

125

 76

42

17

 -1

-15

-26

3.5

153

 96

56

27

 6

 -9

-22

4

172

109

65

34

11

 -6

-19

Source: Kaier and Müller (2013), New Figures on Unfunded Public Pension Entitlements across Europe – Concept, Results and Applications, https://static.nzz.ch/files/8/4/6/317-3_1.18125846.pdf.

 http://dx.doi.org/10.1787/888933590283

Using the aforementioned approach to estimate the liabilities of a defined benefit pension scheme, the methodology to conduct these calculations can vary in several ways. The two most notable variations are: i) differences in wage assumptions used to project the level of benefits; and ii) differences in the scope of the population included in the calculations. Regarding the variation in the wage assumptions used to project the level of benefits, the valuation of pension liabilities can vary depending on whether Accrued Benefit Obligations (ABO) or Projected Benefit Obligations (PBO) is applied. Defined benefit pension schemes normally provide a benefit that is based on each member’s salary (such as final salary, lifetime average salary, or average salary for a set period of years). As the salary level that will ultimately determine each member’s pension benefit is not yet known until they retire, an assumption must be made using either the ABO or PBO method. The ABO method uses each pension member’s current salary as the basis for estimating their future benefits, while the PBO method uses a projection of the future salary on which each member’s pension benefits would be based at the time of their retirement. For this reason, estimates of pension liabilities based on PBO will be higher than those based on ABO.

Regarding the variation in the scope of the population, some models for calculating pension liabilities use the accrued-to-date method (also known as the closed group without future accruals method), which includes only the benefits that current members (hence, closed group) have earned up to the present period in the calculation. As the 2008 SNA is based on accrued-to-date recording, this is also the underlying principle for calculating pension entitlements in the national accounts. Other models go further by also including future accruals for current members (closed group with future accrual), which means that benefits projected to accrue in the future for current members of the scheme are also included in the calculation. The open group method also includes future pension members in the scope of the calculations (hence, open group), projecting the demographics of future generations of workers, and future labour needs, in order to estimate the benefits of future generations. In this case, the long-term obligations of the pension scheme are estimated by adding projected benefits of future generations to the accrued and projected benefits of current members. Open group estimates of liabilities are normally presented in conjunction with estimates of assets (i.e. projected contributions) in order to view the net asset/liability position of the pension scheme from a long-term perspective.

As an example, Table 9.4 provides the actuarial balance sheet of the Canada Pension Plan (CPP) under each of the three approaches. The CPP is a partially funded, public, defined benefit pension scheme. It started as a pay-as-you-go scheme but was reformed into a partially funded scheme in the 1990s, to cope with the challenges posed by the ageing society. Its current assets of CAD 175 billion are 17.4% of its obligations of CAD 1 trillion, estimated under a closed group (excluding future accruals) basis. However, when the future contributions and benefits of current workers are included in the balance sheet, the CPP has assets amounting to 63.4% of total liabilities. When the contributions and benefits of future generations are included on an open group basis (projecting as far out as 150 years), the pension scheme has assets that are nearly equal to liabilities.

Table 9.4. Actuarial balance sheet for the Canada Pension Plan at 31 December 2012
Billions of CAD

Closed group

Open group

Excluding future accruals

Including future accruals

Including future accruals

Assets

 Current assets

175

175

175

 Future contributions

-

804

2 071

Total assets

175

979

2 246

Liabilities (pension obligations)

 Benefits accrued to date

370

370

370

 Benefits accruable due to future contributions

635

1 175

1 885

Total liabilities

1 005

1 545

2 255

Asset excess (shortfall)

-830

-566

-9

Total assets as a percentage of total liabilities

17.40%

63.40%

99.60%

Source: Billig (2016), Compiling the actuarial balance sheet for the Canada Pension Plan – methodological overview, www.osfi-bsif.gc.ca/Eng/Docs/OCA-Assia-Billig-03092016-notes.pdf.

 http://dx.doi.org/10.1787/888933590302

This table provides an example of a partially-funded pension scheme that is financially sustainable in the long-term. While the closed group approaches indicate obligations that are far in excess of assets, they do not capture the pay-as-you-go nature of the pension scheme. The open group approach reflects the concept that future generations of workers will pay contributions that will fund the benefits that current generations of workers have accumulated. This does not mean that the closed group figures are incorrect; they are provided so that users can assess the current state of the pension scheme’s finances and identify the implications of pension policy for the current generation of workers.

The closed group without future accruals method is the most suitable approach for estimating the pension obligations that a government has accrued up to the current period, and therefore its results are the most comparable to explicit debt and other stock figures recorded in the financial accounts and balance sheets. Accordingly, this is the method applied for estimating pension entitlements/obligations in the national accounts. However, this approach does not include future accruals, or the future generations that, in a pay-as-you-go scheme, will pay the contributions that will fund the benefits to be paid in the future. As a result, the open group method is best suited to assess the long-term financial sustainability of a pension scheme.

The recording of pension entitlements in the 2008 SNA

The 2008 SNA has particular provisions for recording pension entitlements. Employment-related schemes lead to the accrual of pension entitlements/obligations under the 2008 SNA, whereas this is not the case for social security pension schemes. The main reason for this distinction is that governments can alter the basis on which the entitlements are determined for social security schemes. However, as the distinction between social security and employment-related pension schemes may not be that straightforward, it is not always clear whether to include entitlements in the central framework of national accounts. As a consequence, the different treatment of these types of schemes may obscure comparisons of pension entitlements and household retirement resources across countries. To ensure comparability, as of the end of 2017 the pension entitlements, transactions and other flows associated with social security and government employee pension schemes are to be recorded in a supplementary table showing the extent of pension schemes included and excluded from the 2008 SNA sequence of accounts.

Table 9.5 summarises the treatment of pension schemes according to the 2008 SNA, based on the pension sponsor and type of pension scheme. Here, as noted above, one should be aware of the fact that in a significant number of countries, the government sponsors a major part of employment-related pension schemes, including those of employees in the private sector. These schemes may be intertwined with the social security schemes, resulting in the absence of any pension obligations in the financial accounts and balance sheets of the central framework of national accounts.

Table 9.5. The recording of pension schemes based on the sponsor and type of scheme

Pension sponsor

Type of pension scheme

Recording practice

Non-government

Defined contribution

Central framework

Defined benefit

Central framework

Government

Defined contribution for government employees

Central framework

Defined benefit for government employees

Central framework

Social security

Supplementary table

Pension schemes and the interpretation of government debt

Current practices for recording pension entitlements in the financial accounts and balance sheets can make it difficult to analyse and compare government debt and assess the state of a government’s finances. When using data from the financial accounts and balance sheets, users should be aware of these limitations and seek additional information where appropriate. There are two caveats that should be considered. First, the assumptions that are used in estimating the value of pension entitlements can vary from one pension scheme to the next. A change in a key factor such as the discount rate, real wage growth rate, inflation rate or mortality rate can lead to significant changes in the estimated value of entitlements for defined benefit pension schemes. One should thus check for any supplementary information provided with the pension data (e.g. a sensitivity analysis can be especially useful) and be mindful of how differing assumptions can affect the additivity and/or comparability of data.

Second, social security pension schemes are not recorded in the central framework of the national accounts, and neither may any employment-related schemes that are considered to be intertwined with social security. As previously discussed, this is because of the fact that governments can modify the terms, and therefore the value, of the pension entitlements, which makes the associated liability less tangible than a liability stemming from a legal contract. The implication is that when analysing government debt (or the pension entitlements as part of household retirement resources), users should look for any supplementary information on financial obligations pertaining to social benefits in order to verify whether there are any other government-sponsored pension schemes that have not been recorded in the central framework of national accounts.

Table 9.6 demonstrates how different pension arrangements in OECD countries can impact the comparison of government debt recorded in the financial accounts and balance sheets. Column 1 lists the total liabilities of the general government in 2012 as recorded in the central framework of national accounts. Some countries, such as Australia, Canada, Iceland and the United States included the liabilities of unfunded or partially funded defined benefit pension schemes for government employees in their figures for total government liabilities, whereas others did not. To account for this, the unfunded part of the pension liabilities (shown in column 2) is subtracted from total liabilities to provide an adjusted figure in column 3. Even after this adjustment, government debt levels are not fully comparable, because countries with (partially) funded government employee pension schemes and/or (partially) funded social security pension schemes will have accumulated assets. To adjust for this, the accumulated funds of employment-related and social security pension schemes are subtracted from column 3 to provide a fully adjusted figure for government liabilities in column 8. The table shows that these adjustments may lead to significantly different levels of government debt for several countries. For example, the liabilities of the Canadian government drop from 109.7 % of GDP to 38.9 % when adjusting for employment-related and social security funds, and from 129.5 % to 71.8 % for Iceland. Other countries for which the impact is substantial are the United States, Sweden, the Netherlands and Switzerland. Taking into account differences in pension arrangements in ranking countries according to their government debt levels may thus lead to significantly different results.

Table 9.6. Pension systems and their impact on government debt, 2012
Percentage of GDP

Total liabilities (1)

Unfunded pension liabilities (2)

Total liabilities excluding unfunded pension liabilities (3 = 1-2)

Accumulated funds related to employment related pension schemes, inside GG (4)

Accumulated funds related to employment related pension schemes, outside GG (5)

Total liabilities, after full adjustment for employment related funds (6 = 3-4-5)

Accumulated funds related to social security pension schemes, inside GG (7)

Total liabilities, after full adjustment for employment related and social security funds (8=6-7)

Australia1

57.9

25.8

32.1

5.4

..

..

0.0

..

Austria

86.0

0.0

86.0

0.0

0.0

86.0

0.0

86.0

Belgium

106.4

0.0

106.4

0.0

0.0

106.4

0.0

106.4

Canada

109.7

13.6

96.1

0.0

44.4

51.7

12.8

38.9

Chile

18.6

0.0

18.6

..

..

..

2.2

..

Czech Republic

55.7

0.0

55.7

0.0

0.0

55.7

0.0

55.7

Denmark

59.3

0.0

59.3

0.0

0.0

59.3

0.0

59.3

Estonia

13.3

0.0

13.3

0.0

0.0

13.3

0.0

13.3

Finland

64.0

0.0

64.0

0.0

0.0

64.0

0.0

64.0

France

109.3

0.0

109.3

0.0

0.0

109.3

1.8

107.5

Germany

88.5

0.0

88.5

0.3

0.0

88.2

0.0

88.2

Greece

167.5

0.0

167.5

0.0

0.0

167.5

0.0

167.5

Hungary

90.0

0.0

90.0

0.0

..

..

0.0

..

Iceland

129.5

25.8

103.7

0.0

31.9

71.8

0.0

71.8

Ireland

127.8

0.0

127.8

0.0

0.0

127.8

0.0

127.8

Israel2

68.2

0.0

68.2

0.0

..

..

0.0

..

Italy

142.2

0.0

142.2

0.0

0.0

142.2

0.0

142.2

Japan

216.5

0.0

216.5

9.8

..

..

2.2

..

Korea

34.8

0.0

34.8

0.0

..

..

0.0

..

Luxembourg

30.2

..

30.2

..

..

..

..

..

Mexico

..

0.0

..

0.0

0.0

..

0.0

..

Netherlands

82.7

0.0

82.7

0.0

47.8

34.9

0.0

34.9

New Zealand

47.6

5.2

42.4

0.0

1.4

41.0

0.0

41.0

Norway

34.7

0.0

34.7

0.0

13.5

21.2

0.0

21.2

Poland

62.3

0.0

62.3

0.0

0.0

62.3

1.0

61.3

Portugal

134.6

0.0

134.6

3.3

0.1

131.2

6.5

124.7

Slovak Republic

56.9

0.0

56.9

0.0

0.0

56.9

0.0

56.9

Slovenia

61.6

0.0

61.6

0.0

0.0

61.6

0.0

61.6

Spain

92.6

0.0

92.6

0.0

0.0

92.6

6.1

86.5

Sweden

49.0

2.3

46.7

0.0

18.9

27.8

27.0

0.8

Switzerland3

46.3

0.0

46.3

0.0

31.1

15.2

5.4

9.9

Turkey

..

0.0

..

0.0

0.0

..

0.0

..

United Kingdom

101.6

0.0

101.6

0.0

13.7

87.9

0.0

87.9

United States

122.2

20.1

102.1

0.0

30.0

72.1

0.0

72.1

1. Based on Government Finance Statistics. Data not fully consistent with SNA but the difference in total liabilities excluding unfunded pension liabilities is less than 1% of GDP.

2. The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities. The use of such data by the OECD is without prejudice to the status of the Golan Heights, East Jerusalem and Israeli settlements in the Westbank under the terms of international law.

3. 2011 data for Switzerland.

Source: OECD (2014), OECD Economic Outlook, Volume 2014/1, http://dx.doi.org/10.1787/eco_outlook-v2014-1-en.

 http://dx.doi.org/10.1787/888933590340

Retirement resources of households

Notwithstanding the importance of pensions and their financial significance for governments, employers and households, it should be noted that pensions represent only a portion of how households build up resources for retirement. Households accumulate retirement resources through a variety of instruments, including pension entitlements, saving deposits and other investment vehicles, and various non-financial investments such as dwellings. Figure 9.8 displays the level and composition of household assets and liabilities on a per capita basis (in USD) in 2013 for a sample of six countries for which data was available.

Figure 9.8. Household assets and liabilities per capita in USD, 2013 *
picture

1. Data on non-financial assets other than dwellings was not available for Norway and Sweden.

Source: OECD (2017b), “Financial Balance Sheets, SNA 2008 (or SNA 1993): Non-consolidated stocks, annual”, OECD National Accounts Statistics (database), http://dx.doi.org/10.1787/data-00720-en; and “Detailed National Accounts, SNA 2008 (or SNA 1993): Balance sheets for non-financial assets”, OECD National Accounts Statistics (database), http://dx.doi.org/10.1787/data-00368-en.

 http://dx.doi.org/10.1787/888933589219

The figure shows that pension entitlements represent a small portion of a household’s total assets. Across the six countries, pension entitlements averaged 12% of total household assets. The share of pension entitlements was the highest in Australia at 22% of household assets, and lowest in the Czech Republic at 3% of household assets. Moreover, life insurance and annuity entitlements only account for a small part of household assets with an average of 3% of total assets across the six countries. Other financial assets (representing holdings in currency and deposits, debt securities, equity and derivatives) averaged 36% of total assets, while dwellings averaged 28%. However, both these other financial assets and the value of the dwellings are normally not dedicated entirely to the purpose of retirement.

It also has to be considered that these household assets do not include entitlements derived from social security pension schemes, as they are not recorded in the central framework of national accounts. As was explained earlier in this chapter, the importance of these types of pension schemes varies across countries. Although the government may alter the benefits from these types of schemes, households usually assume the receipt of some benefits in the future and therefore will regard these entitlements as part of their retirement resources. Therefore, it is also important to look at the relevant amounts from the supplementary table. This will provide a better overview of household retirement resources and lead to better cross-country comparisons.

Key points

  • There is empirical evidence that demographic changes affect key economic figures like the saving ratio and net wealth. The monitoring of this phenomenon will become increasingly important with the projected ageing of the population in many countries.

  • Demographic changes also affect government finances; an ageing population will lead to increases in pension and health care costs, which will outweigh decreases in costs related to child and family benefits and education.

  • Pension schemes will also be affected by an ageing society, with the impact depending on the institutional setup of the schemes. Depending on the scheme, these changes may affect the sustainability of pension funds and government finances, and household retirement resources.

  • To have a clear understanding of the consequences of an ageing society for pension systems, it is important to look how the different types of schemes are affected by demographic changes. Financial accounts and balance sheets may provide useful insight in some of these consequences, showing possible changes in entitlements in relation to their accumulated funds. However, users have to be aware that different institutional setups may hamper comparability between schemes and across countries, sometimes requiring additional information to arrive at a comprehensive and comparable overview.

  • Sustainability analyses of pension schemes often do not only focus on the accrued-to-date entitlements in relation to the accumulated funds (closed group without future accrual), but also take into account future accruals and contributions by current and future generations (open group approach) to obtain a better overview of their long-term situation. This is particularly important for pay-as-you-go systems, in which accrued benefit entitlements will be paid by future contributions. As this may also affect fiscal sustainability analyses, one has to be aware of how different institutional setups of pension schemes affect results.

  • One should also bear in mind that the value of pension entitlements will depend on the benefit formula (i.e. defined contribution schemes in which the entitlements are equal to the accumulated assets in the fund, versus defined benefit schemes in which the entitlements are based on a benefit formula), and for defined benefit schemes also on the underlying assumptions with regard to future wage increases, life expectancy and the discount rate. As these assumptions may significantly affect results, sensitivity analyses may help in providing more insight in the impact of these assumptions and in arriving at more comparable results across countries.

References

ABS (2015), 5204.0.55.011 - Australian National Accounts: Distribution of Household Income, Consumption and Wealth, 2003-04 to 2014-15, Australian Bureau of Statistics, Canberra, www.abs.gov.au/AUSSTATS/[email protected]/DetailsPage/5204.0.55.0112003-04%20to%202014-15?OpenDocument.

Billig, A. (2016), Compiling the Actuarial Balance Sheet for the Canada Pension Plan – Methodological Overview, Presentation to the Eurostat/ILO/IMF/OECD Workshop on Pensions, 9 March, Paris, www.osfi-bsif.gc.ca/Eng/Docs/OCA-Assia-Billig-03092016-notes.pdf.

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Dang, T., P. Antolín and H. Oxley, (2001), “Fiscal implications of ageing – Projections of age-related spending”, OECD Economics Department Working Papers, No. 305, OECD Publishing, Paris, http://dx.doi.org/10.1787/503643006287.

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European Commission (2012), The 2012 Ageing Report – Economic and budgetary projections for the 27 EU Member States (2010-2060), European Union, Brussels, http://ec.europa.eu/economy_finance/publications/european_economy/2012/pdf/ee-2012-2_en.pdf.

European Commission (2015), The 2015 Ageing Report – Economic and budgetary projections for the 28 EU Member States (2013-2060), European Union, Brussels, http://ec.europa.eu/economy_finance/publications/european_economy/2015/pdf/ee3_en.pdf.

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Jappelli, T. and F. Modigliani (1998), “The age-saving profile and the life-cycle hypothesis”, CSEF Working Papers, No. 9, Centre for Studies in Economics and Finance, Naples, www.csef.it/WP/wp9.pdf.

Jappelli, T. (2005), “The life-cycle hypothesis, fiscal policy and social security”, Banca Nazionale del Lavoro Quarterly Review, Vol. 58, Banca Nazionale del Lavoro, Rome, pp. 173-186.

Kaier, K. and C. Müller (2013), “New figures on unfunded public pension entitlements across Europe – concept, results and applications”, Discussion Papers, No. 52, Forschungs Zentrum Generationen Verträge der Albert-Ludwigs-Universität Freiburg, Freiburg.

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OECD (2017b), “Financial Balance Sheets, SNA 2008 (or SNA 1993): Non-consolidated stocks, annual”, OECD National Accounts Statistics (database), http://dx.doi.org/10.1787/data-00720-en; and “Detailed National Accounts, SNA 2008 (or SNA 1993): Balance sheets for non-financial assets”, OECD National Accounts Statistics (database), http://dx.doi.org/10.1787/data-00368-en.

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Notes

← 1. The statistical data for Israel are supplied by and under the responsibility of the relevant Israeli authorities. The use of such data by the OECD is without prejudice to the status of the Golan Heights, East Jerusalem and Israeli settlements in the West Bank under the terms of international law.

← 2. Dang et al. (2001) explain that in OECD countries the per capita health care costs for people over 65 are three to five times higher than for those under 65.

← 3. Note by Turkey: The information in this document with reference to “Cyprus” relates to the southern part of the Island. There is no single authority representing both Turkish and Greek Cypriot people on the Island. Turkey recognises the Turkish Republic of Northern Cyprus (TRNC). Until a lasting and equitable solution is found within the context of the United Nations, Turkey shall preserve its position concerning the “Cyprus issue”.

← 4. Note by all the European Union Member States of the OECD and the European Union: The Republic of Cyprus is recognised by all members of the United Nations with the exception of Turkey. The information in this document relates to the area under the effective control of the Government of the Republic of Cyprus.