Pensions: what are the indexation rules under an annuity scheme?

Blanchet, Didier

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Pensions: what are the indexation rules under an annuity scheme?

Didier Blanchet

April 2024

This paper examines the options available for indexation rules that combine the neutralisation of sensitivity to growth with the objective of financial stability. The aim is to carry out an evaluation to determine whether it is possible, within an annuity-based scheme, to replicate the type of rule introduced in 2017 in the Agirc-Arrco supplementary points-based scheme.

Reference IPP Policy Brief No. 106

Quote this publication

Blanchet, Didier (April 2024). ‘Pensions: what indexation rules apply in an annuity-based scheme?’, IPP Policy Brief, No. 106. Institut des politiques publiques (IPP).

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Presentation

Projections of the pension system’s financial equilibrium face two sources of uncertainty: firstly, regarding the sustainability of some of its revenue sources; and secondly, regarding the trend in its expenditure. As regards expenditure, a major source of uncertainty stems from its sensitivity to assumptions about productivity growth.

In a system where pension scales are predominantly indexed to prices, the relative level of pensions changes in a way that is more favourable to pensioners when growth is slow or even negative, and vice versa when it is rapid. This applies both to temporary shocks and, more permanently, to sustained shifts in growth trends.

Full re-indexation to wages would eliminate this asymmetry, but it would result in a sharp increase in pension expenditure.

Key Results

Indexing pensions to prices leads to divergent trends in wages and pensions in response to shocks or shifts in growth. It makes projections highly sensitive to the assumptions made regarding productivity growth.
Indexation to wages eliminates this problem but requires other measures to be taken to manage the response to demographic changes: the indexation must take into account both changes in the ratio of contributors to pensioners and any possible or desired changes in the contribution rate of the working population.
In a points-based scheme, these adjustments must be applied to the service value of the point, as its purchase value is fully indexed to wages.
In annuity-based schemes, a two-fold adjustment is required: for the index-linking of pensions whilst in service, and for the annuity rate which determines the replacement rate upon retirement. This adjusted annuity rate would, however, be applied to an average of past individual wages revalued in line with the average wage rather than with prices.
Hybrid solutions may be considered. A degree of price indexation may still be necessary to protect pensioners’ purchasing power from overly severe shocks, although this would mean that part of the problem of sensitivity to growth would remain.

Method and Data

The analysis and comparison of the various indexation rules described in this note are based on a model providing a highly stylised representation of an annuity-based system. Entitlements vary between generations, but, within each generation, we consider an average individual whose pension would be managed entirely in accordance with the rules of the general scheme.

Whilst this individual is in work, they receive the average wage for the current year. When they retire, their initial pension is proportional to the average of their 25 best-paid years. By default, these so-called ‘accounted for’ salaries (SPC) are revalued in line with prices, and price indexation also applies to pensions after they have been drawn, as required by current rules. The aim of the model is to test the effects of various methods of reverting to wage indexation for the first and/or second pensions.