Easing the burden on pension systems by investing in health

Pension systems worldwide are facing increasing strain due to rising life expectancy and improved health. A team of economists has proposed an innovative pension model linked to the health of the population, which could ease the burden on public finances.

Life expectancy at birth has almost doubled in the last century: in 1900, the average life expectancy in OECD countries was 45 years, but by 2019, it had risen to 81 years1 . This increase is resulting in a higher proportion of elderly people in the population. In France, for example, 21% of the population has reached the age of 65. In the European Union in 2018, almost one in two people over that age reported having a sensory, physical or mental disability or impairment. As the population ages, the need for long-term care increases, in particular due to the rise of chronic illnesses, leading to significant costs and considerable financial pressure on pension systems.  In 2017, on average, 1.5% of the OECD countries gross domestic product (GDP) was spent on long-term care2, and health and social care services provided to dependent people requiring ongoing care accounted for 60% of healthcare expenditure in 20213.

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    Source: OECD Health Statistics 2023, Eurostat 2023 for EU/EEA countries.

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  Source : Source: Eurostat Database 2017.

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  Source: Eurostat Database 2021

Different pension models

Public health and pension systems - in particular pay-as-you-go pension systems - are facing major challenges in addressing the growing needs of an aging population while ensuring their well-being and quality of life. In a pay-as-you-go pension system, part of the salary of working people finances a pension fund, used immediately to support current retirees. However, this system is being undermined by the inversion of the age pyramid, and the increase in the ratio of retired people to working people.

Governments have developed solutions to curb the additional costs associated with an ageing population. In France, which has a pay-as-you-go pension system, the government is seeking to raise the retirement age, a policy that has faced widespread public opposition. In the UK, workers are encouraged to contract private supplementary pensions. In the United States, the system is contributory and primarily offered through employer-sponsored plans. Under this system, workers contribute a fraction of their income, which is later paid out as annuities upon retirement.

With regard to meeting the increasing costs associated with the loss of autonomy later in life, several options have been examined, including the purchase of private insurance in the event of the loss of autonomy. This solution remains marginal, however, and demand for these financial products is low. Another possibility would be to incentivise families to look after their dependent seniors by providing them with some financial assistance. However, this solution may entail significant costs, both monetary, by taking caregivers away from the labour market, and non-monetary, with substantial psychological and physical costs for caregivers.

In their research “Conditioning Public Pensions on Health: Effects on Capital Accumulation and Welfare”, published in 2024 in the Journal of Population Economics, the economists propose a third solution, that is, a pension model indexed to the average rate of dependency of the elderly in the economy. Improving the health of the elderly would reduce the cost of running pension and health programs, even as life expectancy increases. On the one hand, the government would invest in public health to reduce the average dependency rate of the elderly in the economy, and on the other hand, pensions would be indexed to that dependency ratey: a system referred to as the ‘disability-augmented pension’. The study analyses how designing jointly a health system and a pension system can have positive impacts on capital accumulation, economic growth and well-being.

Investing in curative health

Using an overlapping generations (OLG) model, this article analyses the consequences of considering a pay-as-you-go pension system that would depend on the average health of the elderly population.

 Individuals live two periods: an initial period when they are working and saving, followed by a retirement period when they spend their savings and receive pension benefits. The proposed public health system would fund curative care for the elderly (such as nursing-home care or at-home care), while the pension system would continue to finance the spending needs of the elderly. The novelty resides in that pension entitlements partly depend on the average health of the elderly population. Workers pay contributions comprising both a fixed component and a variable one directly linked to the average health of pensioners. This introduces a mechanism for adjusting contributions according to the average level of elderly dependency in the society.  If the health of older people improves, pension contributions fall, as do pension entitlements.

Picture by Mitch Hodge on Unsplash

Under such a pension system tied to the average dependency rate, investment in  long-term care makes it possible to reduce pension expenditures as a result of better health among the elderly. This, in turn, reduces pension contributions of the young, and encourages them to save more for retirement. This also stimulates capital accumulation, economic growth and ultimately, society’s well-being, particularly in economies where individuals place a high value on health in the old age. Nevertheless, this positive effect on capital accumulation is contingent on ensuring that the tax used to finance healthcare is not too important as otherwise it would discourage savings through lower  disposable income.

Finally, the model focuses primarily on curative care, which accounts for around 60% of total healthcare spending in OECD countries. Spending on long-term care, which includes both medical treatments as well as specific expenses to improve the quality of life of the elderly, plays a direct role in reducing the dependency rate and improving the health and well-being of the retirees. Indeed, by investing in infrastructure such as long-term care facilities, training for qualified caregivers, and access to appropriate medical treatments, the authors show that improving elderly health can also alleviate the financial strain on pay-as-you-go pension systems.