Work ‘til You Drop: Is This The Next European “Welfare?”

As Europe’s population ages, its widespread entitlement commitments will generate huge burdens on governments’ budgets.

The economic consequences are easy to foresee: just think of how pension and health expenditure, whom almost everybody is entitled to, could be financed. But what about the political consequences of an aging population? As the population ages in a democratic system, it will become increasingly difficult to reform entitlements of which an increasing number of people are taking advantage.

Forget about economic efficiency: the path of reforming the welfare state would be blazed by political constraints, leading somewhere rather unappealing, especially for future generations. Should we call this majority dictatorship — or rather, elderly dictatorship?

Take the case of pensions. In most European countries, pensions systems are unfunded: revenue collected annually for social security is what is being shared by those who are entitled to receive pension. An aging population implies that, ceteris paribus, more pensioners should be sustained by fewer workers.

How can we defuse this ticking bomb?

The best way to address the pension long-term unbalance would be moving to a funded system based on private retirement accounts. But allowing a worker to switch his social contributions to an individual account, in total or in part, implies lesser resources to be shared by current retirees. And financing the promised pensions by issuing bond is obviously not a possibility for a continent overwhelmed by public debt.

This means that such a reform would have little possibility of being implemented in Europe, as retirees in most European countries rely on pensions as their largest source of income: in France, Germany, Italy, and Spain an unfunded, public retirement system covers all employees and provides them with 75 percent of their retirement income. In United States, this first pillar of the pension system is less sizeable and provides, on average, 45 percent of a retiree’s income.

While the older electorate exerts more political pressure on policy makers to obtain larger and more generous systems, adopting a more efficient, funded system may benefit only the smaller group of young individuals entering their working lives: not enough to find a majority of the voters.

If the current unfunded system must be kept, three reforms are possible: increasing employees’ contributions, reducing benefits, or postponing retirement. But the first would give a coup de grâce to European companies’ competitiveness by further increasing the high cost of European labor. The second would not be politically feasible. Who could win elections promising to cut pensions to which an increasing portion of the electorate was entitled?

Among others, economist Vincenzo Galasso maintains that the only politically feasible reform to cope with aging will be postponing retirement. Old- and middle-aged individuals would oppose any retrenchment to the current system (not to speak about switching to private retirement accounts), as they will almost exclusively enjoy benefits in their remaining time horizon. In fact, past contributions to the system do not affect the agents’ voting decision, since they could not be appropriated by the voters, were the system to be abandoned, and thus represent a sunk cost.

Looking at the last pension reforms implemented in Europe, those predictions may soon come true. In order to eliminating the budget deficit by 2013, the Italian government passed at the end of 2011 an austerity plan. As a main measure, central pension expenditures were cut by increasing the retirement age for most of the workers.

By postponing the retirement age, Europe may actually succeed in coping with the pension debt. But the losers will be the people. In Spain, Italy, and Germany, the mandatory retirement age for men is already 65. Between 2010 and 2050, the old-age dependency ratio (projected population aged 65 and over as a percentage of the projected population aged 15-64) in the EU 27 will double from 25.9 to 50.2 percent, according to Eurostat. In a few decades, at what age will it be possible to retire, while the old-age dependency rate will be just as double as the current one: 70, 72, 75? Some are forecasting even 80 for some countries.

That’s another good reason to switch to private retirement account: you choose when it’s time for you to retire.

Today, what European welfare is promising to younger generations is rather unappealing: working until, say, 75 if you want, in form of pensions, a part of the capitalized value of the contributions you paid during your entire career! Imagine if in 2050 an alien came to visit us on Earth. How could a European explain to this alien that, if she wants to have back money that was previously hers, she just can’t stop working until someone else okays it? Would the alien believe that Europe is a land of free people?

Neither should we.