The UK Overlapping Generations model (UK OLG)

To investigate the effect of demographic trends on asset demand and rates of return, we have used the UK Overlapping Generations model (UK OLG). This is a new tool for analysis the OBR and HM Treasury jointly developed, as described in a recent working paper. ^a

OLG models are useful for analysing long-term trends in fiscal policy and the macroeconomy because they explicitly model the effects of having people of different ages living in the same economy. This can provide insights, for example, on how tax revenues reflect changing patterns of income and consumption over a lifetime, and how government spending, including on the state pension, is affected by demography. The model can also run different scenario simulations to assess how a change in economic, demographic, or fiscal parameters affects the economy.

OLG models recognise the ways that households change their behaviour over their life cycle, explicitly considering retirement, finite lifespans, and bequests and inheritance. In UK OLG, consumers are fully forward-looking and differ by age, income, and asset levels. The model can therefore illustrate the effects of shocks that affect age groups differently. Combined with uncertainty about life spans, this results in asset profiles which reflect life-cycle and precautionary savings, as well as consumption smoothing. In the results, households typically build up assets through their working life and then run them down in retirement. Households at different ages have different earnings and asset accumulation histories.

There are two versions of the model in terms of how it estimates equilibrium average rates of return. One version sets returns on saving equal to a prevailing global rate (‘open economy’), while the other sets the rate to match domestic saving against domestic investment (‘closed economy’). We use the closed-economy version of UK OLG, both because domestic investors own the majority of gilts, and because freely solved equilibrium rates of return are more
informative for our analysis than forcing a fixed global rate. Ageing populations are also a global phenomenon across developed economies, so we would expect similar dynamics to affect global asset demand and pricing.

The model is calibrated to match recent UK economic data, as Chart A shows. Data is taken primarily from a range of ONS sources. Statutory tax rates, tax thresholds, fiscal targets, and pension contributions are set consistent with current government policy. And average welfare payments by age are taken from the OBR’s long-term projections.

Chart A: Income distribution and life cycle asset profiles in the UK OLG model