Economic theory sheds interesting insight as to why people save. Households save because of their desire to smooth their consumption. It makes sense for people to have a stable lifestyle. This basic observation dates back even to the times of the Bible – remember when Joseph advised the pharaoh to encourage storage during the seven years of abundant crops to make up for the subsequent seven years of famine?
According to the theory of consumption smoothing, people should borrow when they are young and when their income is low. During middle age they should then repay the loans and save for their old age, something which is made possible as a result of their higher income. During old age they should then run down their savings, at a time when their pension income is low. It is optimal for people to behave in this way. Consumption patterns should be based on people’s lifetime income and not be limited by their current income.
Although the pattern of savings should follow this path, there are also structural features which would tend to reduce the necessary amount of savings compared to decades ago. Indeed, a financially sophisticated economy gives people more confidence in their ability to borrow and hence diminishes the need of one of the motives for savings, namely for precautionary purposes.
An interesting issue which has been largely ignored is the return on people’s savings. So far the focus has been mainly on the protection of savings – ensuring that if someone has saved a given amount, at least he is guaranteed that an equal amount of money back. In economic terms this is, however, a false guarantee. What matters is the real value of money and not the nominal amount.
If you save €1 today and someone promises you to give you €1 again in 30 years’ time, it should be immediately obvious to that person that he is making a raw deal, because in the meantime the purchasing power of money would have been largely eroded.
Furthermore, in terms of risk allocation, if savers are not also guaranteed a fixed return, they will face the risk of uncertain returns.
Standard theory suggests that it is optimal for risk to be borne by the party which is more able to absorb risk. This is why the fact that financial institutions in Malta offer long terms savings plans whose returns are largely variable – rather than fixed – is a deficiency. Moreover, the benefit of having financial institutions take a leading role in pension plans is due to their ability to diversify risk better than an individual could and in this way obtain a better risk-return combination.
Any threat that the pension income will not be sufficient in future is not credible: this cohort will be strong enough to vote for higher pensions
But if financial institutions end up building portfolios dominated to a large extent by Malta Government Stocks, this would defeat the purpose, since an individual can easily replicate such portfolio at a much lower cost. When households buy MGS, they buy at the announced price while financial institutions bid for the remaining amount, which in general translates into a higher price, and thus a lower return.
Do people need tax incentives to encourage them to save? A liberal economist would argue that people don’t save enough because they are convinced that they will be bailed out in future. The arithmetic supports this argument. In future, pensioners will be a significant proportion of the Maltese population, and hence of the electorate. In 2013, people aged 60 plus were already almost a quarter of the total population. In future they will undoubtedly be a strong lobby group. Any threat that the pension income will not be sufficient in future is not credible: this cohort will be strong enough to vote for higher pensions.
Viewed in this way, that is why international watchdogs such as the EU Commission and the International Monetary Fund occasionally sound the alarm and emphasise the need to act now on pension reform.
This type of reasoning also casts some doubt on the efficacy of voluntary pension schemes.
The forthcoming introduction of the third-pillar pensions in Malta, which basically means the possibility for people to benefit from tax deductions if they commit themselves to regular saving in predefined financial instruments, will be an interesting economic experiment to gauge the extent to which economic incentives alone are sufficient to change behaviour. Those who are financially literate will be able to assess the benefits and costs of foregoing current consumption for higher pension income in future, and act accordingly. But what about those who are less financially literate? Will they be able to make a wise decision? Informed decisions pre-suppose adequate knowledge. There needs to be adequate and unbiased information campaigns to explain the issues at stake. If such campaigns and tax incentives fail, the only remaining solution would be mandatory saving through second-pillar pensions.