by Jim Rose in applied welfare economics, macroeconomics Tags: Edward Prescott, fatal conceit, offsetting behavior, Other people are stupid fallacy, pretense to knowledge, retirement savings, time inconsistency

Which is better? Save for your retirement through the share market or save to own your own home and then present yourself at the local social security office to collect your taxpayer funded old-age pension?

Under this fine game of bluff, you bleed the taxpayer in your old age and pass on your debt-free home to your children.

This strategy is rational for the less well-paid. The family home is exempt from Income and asset testing for social security. If you lose you bet, sell your house and live off the capital.

For ordinary workers, this is a good bet. The middle class might prefer to live in a more luxurious retirement.

For ordinary workers, whose wages are not a lot more than their old age pension from the government, a government funded pension is a good political gamble. The old-age pension for a couple in New Zealand is set at no less that 60% of average earnings.

Compulsory savings for retirement requires the middle class to do what they can afford to do and would have done anyway.

Compulsory savings for retirement requires the working class to do what they can less afford to do.

Instead compulsory retirement savings deprives them of an old-age pension paid for by the taxes of the middle class.

In Australia, ordinary workers are required by law to save 9% of their wages for their retirements at 65 before they have had a chance to save for a car or a house or the rest of the condiments of life the middle class take for granted.

Edward Prescott argues for compulsory retirement savings account albeit with important twists because it is otherwise irrational for many to save for their retirement:

The reason we need to have mandatory retirement accounts is not because people are irrational, but precisely because they are perfectly rational — they know exactly what they are doing. If, for example, somebody knows that they will be cared for in old age — even if they don’t save a nickel — then what is their incentive to save that nickel? Wouldn’t it be rational to spend that nickel instead? …Without mandatory savings accounts we will not solve the time-inconsistency problem of people under-saving and becoming a welfare burden on their families and on the taxpayers. That’s exactly where we are now.

Prescott’s proposals are age specific. Those younger than 25 are not required to save anything because they are more pressing priorities such as buying cars and other consumer durables:

Before age 25, workers would have no mandatory government retirement savings.

Beginning at age 25, workers would contribute 3% vis-à-vis the current 10.6%.

At age 30, that rate would increase to 5.3 percent.

At 35, the rate would equal the full 10.6 percent.

Upon retirement, there would be an annuity over the remaining lives of the individual and spouse

Most of all, the retirement savings must go into private savings accounts. These savings remain assets of the individual and therefore the compulsory savings requirements is not a tax and does not discourage labour supply, as Prescott explains:

Any system that taxes people when they are young and gives it back when they are old will have a negative impact on labour supply. People will simply work less. Put another way: If people are in control of their own savings, and if their retirement is funded by savings rather than transfers, they will work more.

Prescott’s Nobel Prize jointly with Finn Kydland was for showing that policies are often plagued by problems of time inconsistency. They demonstrated that society could gain from prior commitment to economic policies.

Of course, as Tyler Cowen observed, forced savings schemes are easily offset by people rearranging their affairs, and they have their entire adult life to do so:

How much can our government force people to save in the first place? You can make them lock up funds in an account, but they can respond by borrowing more on their credit cards, taking out a bigger mortgage, and in general investing less in their future.

People do not save for their retirements not because they are short-sighted, but because they are far-sighted. They know that governments will not carry out their threats and other big talk about not providing an adequate old-age pension.

The only way that governments can commit to not bailing people out who retire with no savings is to make them save for their own retirements over their working lives.

Some will be against this compulsion. Their opposition to compulsion cannot be based on opposition to the nanny state because that is faulty reasoning.

These opponents of compulsion and everyone else in the retirement income policy debate are playing in a far more complicated, decades long dynamic political game where ordinary people time and again out-smart conceited governments who pretend they know better:

The government has strategies. The people have counter-strategies. Ancient Chinese proverb