The Challenge of Our Times – Life Expectancy

One of the great achievements of the twentieth century was a dramatic rise in life expectancy. Even in the past 50 years, life expectancy has risen in most western economies.

However, increased life expectancy and declining birth rates have caused many to worry about the impact of an ageing population. Frequently, we hear about ‘a demographic time bomb’ and the fear future generations will struggle to meet an ever increasing number of retired workers and pension commitments.

One key measure of an economy’s growth potential is the dependency ratio. That is, the ratio of non-working-age people (who are dependent on society) to working-age people (who individually and collectively care for the dependents). An aging population causes the dependency ratio to rise, meaning that there will be an increased burden on a shrinking working population.

However, some argue that it is a mistake to base calculations solely on a fixed retirement age of 65. If life expectancy increases dramatically, a sensible policy response would be to allow some increase in the retirement age. In Australia, we are currently seeing initial steps down this path, with the retirement age moving to 67 by July 2023, although these steps are tentative and are frequently regarded as politically controversial.

Nevertheless, based on existing policy settings, we can expect to see the following consequences of an aging population:

Increase in the dependency ratio. If the retirement age remains fixed and life expectancy increases, there will be relatively more people claiming pension benefits and less people working and paying income taxes. The fear is that it will require high tax rates on the current, shrinking workforce.

Increased government spending on health care and pensions. Also, those in retirement tend to pay lower income taxes because they are not working. This combination of higher spending commitments and lower tax revenue is a source of concern for western governments – especially those with existing debt issues and unfunded pension schemes.

Those in work may have to pay higher taxes. This could create disincentives to work and disincentives for firms to invest, thereby reducing productivity and growth.

Shortage of workers. An ageing population could lead to a shortage of workers and hence push up wages causing wage inflation. Alternatively, firms may have to respond by encouraging more people to enter the workforce through offering flexible working practices.

Changing sectors within the economy. An increase in the number of retired people will create a bigger market for goods and services linked to older people (e.g. retirement homes).

On the other hand, not all is doom and gloom. For example:

A declining birth rate also means a smaller number of young people. This will save the government money because young people require education and pay little, if any, taxes.

A lot depends on the health and mobility of an ageing population. If medical science helps people live longer, but with poor mobility, there will be less chance to work. If people live longer and can remain physically active for longer, the adverse impact will be less.

Immigration could be a potential way to defuse the impact of an ageing population because immigration is primarily from people of working age.

Increasing the retirement age is one solution to an ageing population. But, the effect of a higher retirement age will not be felt equally. Those with private savings may be able to still retire early, but those with low income paid jobs are more likely to have to keep working. Also, the impact of longer working life will be felt more by manual workers who will find it harder to keep working.

A big issue is whether spending commitments are funded or unfunded. Many western governments fund their pension plans through pay as you go, rather than saving national insurance contributions. This could lead to gaps in spending commitments. Australia is relatively well positioned in this respect, thanks to our long-standing system of compulsory superannuation contributions.

Economic growth. A big factor in determining the impact of an ageing population is future rates of economic growth. There is a concern, as we have discussed previously, that western economies have entered a period of secular stagnation – falling growth rates. This decline in economic growth will increase the pressure on public finances from an ageing population. Strong economic growth increases tax revenues and makes it easier to fund pension commitments.

Inequality. Another problem with an ageing population is that it could exacerbate inequality. With increased reliance on private sector savings, there could be a division between those with a good private sector pension, and those who rely on a diminishing state pension. Also, inequality could be exacerbated by the state of the housing market, with homeowners in a much better position than those who have to continue to rent into their retirement.

The appropriate response to the challenge of ageing populations is certainly not despair and pessimism. Indeed, as we have so often said before, Australia is uniquely positioned to take advantage of this, the Asian twenty first century. But a clear-headed realism and a willingness to adapt to change is critical.