State of reform

State Pensions

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Desperate to regain control of the economy, governments all over the world have been embarking on costly tax-cutting and financial restructuring programmes. While the tangible benefits of this have yet to be felt, the costs are becoming all-too-obvious: gaping holes have started to appear in the balance sheets of some of the world's largest economies.

The International Monetary Fund estimates the G20 group of most-developed nations will spend as much as 1.5% of GDP on recovery measures this year alone.

Unwilling to levy too much of a tax burden on voters, who are already feeling the pinch of the credit crunch, governments have been hunting around for other ways in which they can get their finances in order. Dealing with the cumbersome weight of public pensions may offer one possibility.

The debate over how to make public pensions more sustainable, in light of increasing life-expectancy and falling birth-rates, was well-established long before the onset of the financial crisis in September 2007. The sudden emptying of public coffers has simply brought things into sharper focus.

But, as governments struggle to find ways in which they can cut future benefits while leaving existing promises intact, they find themselves increasingly brushing up against an angry electorate that is hostile to change. A mismatch has developed between, on the one hand, the short-term outlook of national governments, and on the other, the inherently long-term nature of pension liabilities.

It is far from certain that incumbent politicians, whose popularity has suffered as a result of the crisis, possess the political courage needed to carry out some pretty tough reforms.

Political will

A recent public backlash against reforms in Ireland shows how careful governments have to be in instigating change. Faced with dismal economic prospects this year - the central bank foresees a 6% contraction in the economy in 2009 - Ireland has been exploring ways of saving money. At the end of February, the Irish parliament, the Dail, approved the introduction of a new pension levy for public sector workers. Under the levy, 7.5% of public workers' gross salary will be taken to pay for their pension. The government claims that this will save EUR1.4 billion a year.

Almost immediately, thousands of workers took to the streets to protest at what they saw as an attempt by the government to claw back some of the pension that they had promised as a way of funding its economic recovery packages.

According to Ed Whitehouse, head of pension policy analysis at the Organisation for Economic Co-operation and Development (OECD), the Irish government's actions could well be the first example of governments using pensions as a way out of financial problems. "Our concern is that there are going to be lots of short-term responses to the problem of pension reform. National pension policy is always going to be a problem because it has a long-term horizon while government priorities tend to be short-term," he says.

All over Europe, countries are wondering how they can tinker with the public pension system, while avoiding the kind of backlash that is now being seen in Ireland. In Hungary, politicians know there is a need to sort out the creaking pensions system, which is a complex mix of the pay-as-you-go social insurance pillar that existed prior to the fall of the Soviet Union in 1991 and the private pension pillar that began in 1997. But, with a good chance that the country will go to the polls this year, politicians are keeping noticeably quiet about a wider reform that could be on the cards.

A series of possible parametric reforms are being investigated by the Hungarian Ministry of Social Affairs and Labour. "Our priority for the moment is to try to keep people in the workforce for longer, by limiting early retirement options and increasing the statutory retirement age," says Krisztina Kiss, a policy official within the Pension Insurance Unit. At the moment, the statutory retirement age is 62, but workers are able to retire on a full pension several years before this - and many choose to do so.

With Hungarian unemployment so high - 7.5%, according to latest data from the OECD - there is a clear need to boost active participation in the workforce and, according to Kiss, extending the retirement age is a part of this strategy. Lengthening working life can also help reduce public pension liabilities, by postponing the date when payments start. Kiss notes that the system dependency rate is likely to increase significantly in the coming years. At the moment, 76 pensions should be financed from 100 contributions of active age people, but this number is projected to rise to 85 by 2030 and 103 by 2050, if the system remains unchanged.

But is tinkering around the edges of the pension system sufficient? Kiss admits that the ministry is looking at a much-needed wide-ranging shake-up of the system; but, fearful of an unforgiving electorate, the government is revealing nothing until it has given full consideration to any changes.

A government old-age consultative panel was established in 2007, with the intention of looking at an overhaul of the whole system. "There is a continuous reform of the pension system in Hungary taking place, but many of these changes are only on the surface," says Agnes Matits, an independent actuary who sits on the panel. She explains that one of the main intentions of the consultation is to develop an effective dialogue with the government to make sure that short-term alterations do not make it harder to implement systemic reforms.

Private pensions

An option for governments that want to scale back their pension payments is to provide incentives for people to leave the public scheme and start saving privately. This has happened recently in Italy, where in 2007 the government introduced a package of tax incentives to persuade workers to put their compulsory annual indemnity contribution into private pension funds, rather than give it to the government (see box). Hungary has also been trying to get people to start saving. Since 1998, new workers have been obliged to join the funded private scheme. For those who started working before then, the private scheme is optional. The government says roughly two thirds of those employed are also members of private pension funds.

Unfortunately, over the past year of economic unrest, those who put their savings into private pension funds have seen the value decline sharply. Pension funds within the OECD area registered losses of nearly 20% of their asset value (in nominal terms) between January and October last year (see chart). Funding levels are now down by an average of 10%.

For those savers who are still some way from retirement, this is not a real problem, as equity markets are certain to recover. But in some countries, where pension funds have unwisely given too much of an equity bias to older savers (as is the case in Italy), this has caused significant losses for a minority of people. It has also undermined governments' messages that this is the right thing to do.

The fall in Italian pension (5.6%) has been significantly lower than in other OECD countries, largely because of the tight investment restrictions that are in place. Nonetheless, the one million Italians that were encouraged by the government to take their savings out of the TFR and put it in the private sector feel upset with even this small loss, and have been protesting that they were wrongly advised.

"The policy of the Italian government is to encourage the development of the second pillar private pension system," says Antonietta Mundo, head of the actuarial statistical department at Istituto Nazionale Previdenza Sociale (INPS), which administers public pension funds. "But the problem is that people are reluctant to give up a guaranteed contributory scheme for benefits that are uncertain and follow the stock exchange."

Matits, of the Hungarian pensions consultative panel, is also concerned that performance in pension funds has been far weaker than expected over their first decade - and says this is a problem that must be urgently addressed if the government's aims are to be realised.

Breaking the pensions promise

At the end of February, the British government came under fire after admitting that it is taking legal advice about whether it can default on its pension responsibilities. The admission came in response to a request made under the Freedom of Information Act by independent consultant John Ralfe, which asked for "any papers since January 2003 showing whether the government has taken advice or has a view on the legality under European law of, effectively, defaulting on public sector pensions, by changing the terms for benefits already earned".

The Treasury responded by saying that it did hold the relevant papers, but would not release them on the grounds that this would impede its "ability to obtain full and frank legal advice". The Treasury's investigations may be worrying for UK pensioners, but Lans Bovenberg, a respected Dutch economist at Tilburg University and founder of Netspar, a pensions think tank, considers it unlikely that a government would seriously consider defaulting on its current pension obligations, but it might think about 'implicitly defaulting' by extending the retirement age or changing the way in which pensions are indexed.

Dutch law, for example, allows discretionary indexation of both private and public schemes, during unfavourable economic conditions (see Life & Pensions, July/August 2006, p18). This use of this steering mechanism is well understood but now in the face of plunging cover ratios schemes are considering rolling back past accruals, not just present-day inflation (see 'Absorbing the shock', p16).

In other countries, a debate is taking place about changing the method of indexation, which could conceivably add more to liabilities. In Hungary, public pensions are indexed using Swiss indexation (50% net wage increase, 50% inflation), so-called because this method has been used to index public pensions in Switzerland for a number of years. National legislation dictates that private pensions must at least match the indexation of the public pillar. Matits argues that it is unfair to index so heavily to wages, when in the current climate they remain so low. However, in normal economic times wage inflation outstrips price inflation considerably, which undermines her argument.

Kiss says plans are now being made to adapt the system to adverse economic conditions. Under the new proposal, indexation will be determined by the rate of GDP growth. Under 2% growth, indexation will be entirely linked to consumer prices. Between 2% and 3%, 80% will be according to consumer prices and 20% to net wages. Between 3% and 4% growth, the split will be 60-40. Once growth rises above 4%, Swiss indexation will resume - the plan is laid out, but it is less clear when conditions will enable it to be put into action.

The case of Italy

Italy's high demographic imbalance, along with its crippling public debt, has highlighted a particular need to reform the public pension system. The International Monetary Fund (IMF) puts the country's debt at a staggering 105% of Gross Domestic Product (GDP), among the highest in the world. The country's high life-expectancy and falling birth rate only makes things worse. The OECD projects that, by 2050, Italy will have an old-age dependency rate -the ratio of people older than 65 to those of working age (15-64 years old) - of 69%. The OECD average is 42%.

These trends mean that Italy's generous state pension system is not sustainable in the long term. The OECD calculates Italy spends an amount totalling 13.8% of GDP on its public pension system, the highest level among its members (see chart). But there are strong voices in the country that oppose change. Prime Minister Silvio Berlusconi's first government collapsed in the mid-1990s over an attempt to cut pension benefits. Lamberto Dini, his successor who eventually pushed through a series of reforms, worked hard to get the trade unions on-side first. These days, Berlusconi, once again serving as Prime Minister, is moving much more cautiously.

The Italian public pension system is largely administered by the Istituto Nazionale Previdenza Sociale (INPS), although disability pensions are looked after by a separate body. INPS administers around 19 million public pensions and pays out roughly EUR161 billion in pension benefits each year, according to its latest annual report.

Italy's public pension system is entirely unfunded, with benefits accumulating on a pay-as-you-go basis. In 1996, Italy switched over from a defined-benefit system to a notional-accounts (NDC) system. The level of contributions that the employer and employee make are reviewed each year according to a five-year moving average of GDP growth. "We want to maintain an actuarial equilibrium between contributions and benefits," explains Antonietta Mundo, head of the actuarial statistical department in INPS. At present, employees contribute 9.19% of gross earnings, while employers put in 23.8%

Contributions earn a rate of return related to GDP growth: 2% for lower wage earners (up to EUR35,144 per annum), falling away to 1% for higher income brackets. At retirement, the accumulated notional capital is converted into an annuity based on a transformation co-efficient depending on life-expectancy at retirement and the age at which annuitisation takes place. Current levels of the transformation coefficient are between 4.014%, for those aged 57, and 4.999%, for those older than 65.

The level of pension indexation, which is linked to price inflation, depends on the size of the pension pot. Smaller pensions enjoy full indexation, whereas higher pensions index between 75% and 90% of inflation.

The INPS also administers the Trattamento di Fine Rapporto (TFR), an optional social security benefit available to all workers, not just those in the public sector. The TFR is intended to provide some security for workers who lose their jobs, but it can also be used to top up pension savings.

The TFR can be thought of as an extra month's salary in the year. Accordingly, contributions are based on a one thirteenth of the total salary, which equates to around 7.69%. At the moment, the employer puts in 6.91% of the salary, with the employee making up the rest. This accumulated pension pot is annually re-evaluated according to a 1.5% interest rate plus 75% of inflation. TFR funds also come with an attractive guaranteed annual growth rate of 3.1%.

Workers can access the TFR when they change jobs or when they retire. Many use it to see them through difficult times if they lose their job.

Since 2007, workers have been able to opt out of the TFR and use the money to purchase other investments. Mundo says that around a third of Italian workers chose to do so. Prior to 2007, the TFR was in the hands of the employers, and was often used to shore up company balance sheets. But since then, the INPS has taken it over for companies that have more than 50 workers. Mundo explains that the rationale behind this was to help boost the private-savings sector, by giving workers the option to transfer out, but critics have argued that it was simply a budget-balancing exercise.

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