Mind the gap

Pressure on pension systems is forcing governments to rethink their pension policies. To avoid an income gap for future retirees, policy makers must address sustainability and find useful definitions of adequacy. 

By Renate Finke


At first glance, “adequacy” seems a simple word, one whose definition can be readily understood. Merriam-Webster describes it as “sufficient for a specific requirement." But don’t be mistaken, this seemingly harmless word is becoming loaded with complex meanings even as experts discover how ill prepared we are to actually define it. And, as they struggle to determine its parameters, chart the components of personal income and wealth, and measure the social standards that could contribute to an understanding of adequacy, the word itself is assuming the potential to become one of the most explosive in pension politics.


Expressed another way, adequacy is the question: “How much is enough?” Ask that in the context of pensions and you immediately touch upon a topic sensitive to millions of current and future retirees: “How much will I receive in my retirement benefits?” Unfortunately, and there is no other way to couch this, most of us whether retired or retiring in the future will experience a significant gap between what we could reasonably expect to receive based on past experience and what we will actually receive in the hand.


Anger at pension reforms has spilled out onto the streets in Paris, Athens and even Beijing, and unless politicians tread warily, we will undoubtedly see it elsewhere. However, if politicians bow to popular pressure – and all voters are potential members of the retiree lobby group – the danger is that they will defer decisions that could ultimately save the retirement system. 


How did this situation arise? German chancellor Otto von Bismarck can be considered the godfather of European social security. In 1889, he introduced an old age provision system as a means to buy social peace. It was primarily meant to be an insurance in case of invalidity and only a subsidy for old age. But as the legal retirement age was 70, double the then average life expectancy of 35 for men, hardly anyone received a pension. Most contributors failed to reach the age to receive benefits, but if they did they found the amount paid out only just above starvation level.

Filling a gap: English artist Ben Wilson has found his own unique style by using small pieces of chewing gum as canvasses for his miniature paintings.

Filling a gap: English artist Ben Wilson has found his own unique style by using small pieces of chewing gum as canvasses for his miniature paintings.

From sustainability to adequacy

Retirement age is by now a standard 65 years in most western countries. More significantly, life expectancy has risen from 48 for people born in 1950 to 69 for those born today. In more developed countries life expectancy has gone up from 66 to 78 (UN, 2010). This means a growing portion of the population in developed nations is now living up to 30 years longer than the retirement age.

Unlike Bismarck’s time, the scales have tipped in favor of retirees. What was designed as a way to alleviate old-age poverty has morphed into a guarantee under state (first pillar) pay-as you-go schemes. Such PAYG schemes are based on intergenerational solidarity, with today’s workers paying the retirement of the previous generation.

However, with the aging of society and the retirement age “fixed” at 65, we face the prospects of ever fewer workers left to pay obligations. Over the last two decades, governments have undertaken a wave of reforms to try and rebalance the scales. While improving the sustainability of the system, these reforms have often left tomorrow’s retirees with a lower replacement level from first pillar pensions than today’s retirees.

In many countries, the result is a gaping hole in workers’ retirement provisions. Among European Union (EU) savers eligible for retirement between 2011 and 2051, the annual pension gap is €1.9 trillion ($2.5 trillion), UK insurer Aviva estimated in Mind the Gap (2010). The largest shortfalls were observed in the United Kingdom and Germany. British and German workers would have to increase their yearly savings by €12,300 ($16,180) and €11,600 ($15,260) annually to close the gap.

In the United States, the Employee Benefit Research Institute (EBRI), which developed a national measure of adequacy in 2003, estimates that Baby Boomers (individuals born 1948-1964) and Generation Xers (born 1965-1974) are lacking $4.3 trillion (Retirement Income Adequacy for Boomers and Gen Xers, 2012). Workers born between 1948 and 1954 would have to save an additional $22,000 per individual for married households, rising to $34,000 for single males and $65,000 for single females, EBRI says. To compensate for decreasing pension levels, governments provide incentives to foster funded occupational and private pension plans. A process of balancing out the different pension pillars more evenly will continue with the first pillar moving from PAYG to funded systems, while in the second pillar (occupational) the trend from defined benefit (DB) to defined contribution (DC) schemes will continue.

Yet, policymakers and regulators still need to define the equilibrium between sustainability and adequacy. The question of how today’s workforce can achieve a retirement income adequate to maintain a reasonable standard of living is still open. If not correctly handled, it could mean future retirees experience an income gap or even fall into old-age poverty – the very scourge the pension system was originally designed to prevent.

In emerging Asia, the challenge is different. Countries there began establishing formal pension systems on the multi-pillar approach after rapid industrialization, economic growth and urbanization. Yet, the introduction of formalized systems for old age provision has a slightly different focus than reforms in developed countries. Adequacy means increasing the coverage of formal pension systems and including large numbers of informal workers.

The Asian Development Bank notes that coverage of the labor force ranges between 13 % in Vietnam to 58 % in Singapore. They suggest measuring adequacy with both replacement rate and coverage (ADB; Enhancing Social Protection in Asia and the Pacific; 2010).

Different perceptions of adequacy

So what is an adequate retirement income? While Merriam- Webster’s offers a straightforward definition of adequacy, interpretations placed upon the word differ widely. In the context of pensions, adequacy is often defined by reference to a social standard, such as the poverty line, as Pensions Europe chairwoman Joanne Segars points out (see page 15). Or it can be expressed as a percentage of pre- retirement income or as a benchmark to maintain standard of living.

As to the poverty line there are several approaches: an absolute poverty line is used in the US; a relative standard and a subjective standard. In Europe a relative poverty line is defined at 60% of the national median equivalized disposable income, although some countries even set the level at 50%.

Another approach to define adequacy is replacement rates, that is, understanding retirement income as a percentage of pre-retirement income. But even this term is not clear-cut. The problem is how the notion of replacement rate splices together with the concept of pre-retirement income. 

In continental Europe, where the first pillar aimed to maintain a standard of living, the replacement rate focused on the first pillar. But as systems are reformed and the three pillars become complementary, more sources of retirement income have to be taken into account. Some approaches go further and include income generated from non-retirement savings accounts – but what the actual replacement rate may be is still open for interpretation. One flaw in the concept is that it can be tweaked by governments so that it considers income levels at retirement, but disregards income development over the entire retirement phase. This raises the issue of indexing of retirement income. Depending how indexing is handled, an income shortfall can arise and have particularly devastating effects as the savers’ life expectancy and inflation increases (see article on “Retirement Repression” on page 24). As a general rule of thumb, experts often consider a replacement rate of 70% of pre-retirement income as adequate. This is based on the idea that retirees require less income than non-retirees as the costs for raising children or buying real estate are already covered. However, other researchers define adequacy at a higher level. For instance, the OECD (Resources During Retirement, 1998) has shown that the replacement rates in Germany, France, Italy, the Netherlands and Switzerland, when all pillars are considered, add up to approximately 80% of pre-retirement income. This was slightly lower in the United Kingdom. Considering the different pension systems, these results suggest strong substitution occurs among the three pillars. While this definition probably holds for most average earners, target replacement rates should probably be higher for low- income groups and the income mix derived from each of the three pillars defined differently.

Obviously, results depend on pre-retirement income and using replacement rates as a benchmark may be misleading in countries where workers choose or are forced to reduce their workload prior to retirement. In these cases, the targeted replacement rate may understate the standard of living to which retirees are accustomed.

The cost of maintaining living standards

The European Commission was one of the first organizations to raise the issue of pension adequacy in a 2010 green paper. In a subsequent report, Pension Adequacy in the European Union 2010-2050 (2012), it states that adequate pension systems should enable “individuals to maintain, to a reasonable degree, their living standard” (see pages 19-20).

The Commission’s approach obscures one of the key challenges: defining an adequate retirement income at entry age and maintaining it over time. Following the Commission’s approach, an individual’s expenditure before and after retirement as well as the expected income stream should be considered. A comparison between both should yield the degree of adequacy. Yet, this leaves out longevity risks, investment risks and uninsured health care risks. And while there are reasons why retirees' overall expenditure is lower than non-retirees, costs such as health care or leisure may be higher. Consequently, necessary expense levels are partly determined by health-care coverage, services, subsidies or in-kind benefits provided by governments. The European Commission points out in its report that “a full assessment of the adequacy of pensions will therefore require taking into account the access to free or subsidized resources of economic value, including subsidized owner-occupier housing." This perspective underlines the many dimensions governments have to consider in designing a system to maintain an adequate standard of living for the elderly. And even if one can agree on a definition of adequacy, there is still the open question as to how to achieve such an income with the greatest possible certainty.

This question has become even more critical after the recent financial crisis and increasingly volatility of financial markets. Particularly difficult will be to define adequacy in terms of various socio-economic groups and for women, whose life course often involves long absences from the workforce.

While social protection has undoubtedly improved since Bismarck’s times, identifying and closing the pension gap will remain on ongoing challenge. 

As with all content published on this site, these statements are subject to our Forward Looking Statement disclaimer:



Claudia Mohr-Calliet
Allianz SE
Phone +49.89.3800-18797
Send e-mail