Earlier this year Estonia’s mandatory second pillar passed its third anniversary. When it was launched the prospects were not very auspicious. The government of the day had decided that there should be no limitations on the proportion of a portfolio the second pillar funds could invest abroad, but stockmarkets had crashed.
Against the background of a national tradition of unstable governments and revolving-door administrations there had been a heated debate over the details of the scheme within the governing coalition and the opposition parties were attacking key elements of the scheme. And opinion polls suggested the country was divided down the middle on the whole idea.
“If the population is getting older the Bismarkian system doesn’t work and you then have the choice of whether to change or not,” says Eiki Nestor, vice-chairman of the Social Democratic Party and minister of social affairs in 1994-95 at the time of the pension reform. “But you must be aware that if you do introduce changes there is the possibility that your government will get voted out. However, if you don’t you threaten your country’s future.”
Legislation on the first and third pillars had already been passed in 1998. New features were added to the PAYG-based state pension pillar, including a commitment to gradually raise the retirement age to 63 for both men and women, while the voluntary funded pillar allowed people to opt for either special third-pillar insurance contracts or voluntary pension funds, with the state encouraging participation by providing tax incentives. As an OECD report on Baltic pension reform1 noted recently, the third pillar “was implemented before the second pillar in order to gain experience in managing pension funds and solving problems that might arise with such schemes”.
The first pillar is funded by a social tax levied on employers who pay 33% of each employee’s gross salary. Of this 20 percentage points go to the state’s PAYG pension system and
13 points are allotted to health
The debate within the reform cabinet centred on the funding of the second pillar and the indexation of the first.
A decision had been made to reject occupational schemes. “This reflected a general understanding that social security is not a job for enterprises,” says Veiko Tali, deputy secretary general for financial policy at the finance ministry, which oversees the second pillar funds. “They should focus on entrepreneurship, making profits, and there is no requirement for shareholders to provide social security. Employers are already overburdened with the 33% social tax. In addition, occupational schemes could be a barrier to labour market mobility. And if enterprises are left with large long-term liabilities to pensions it makes the economy less flexible and less innovative and can delay the bankruptcy process.”
The second pillar contribution level was set at 6% of a participant’s gross wage, consisting of the diversion of four percentage points of the 33% social tax paid by an employer, which would be offset by a reduced state pension, and the payment of the additional 2% by an employee.
“We and the conservative Pro Patria Union had no problem with this but the free-market_liberal Reform Party were against anything that could in any way be seen as increasing taxation,” recalls Nestor. “So they baulked at the suggestion that members should pay an additional 2% contribution in addition to the portion of the social tax. So we made the second pillar voluntary except for new entrants to the labour force, and that way they could eat the 2%.”

Consequently, while only those born in or after 1983 were obliged to join the second pillar funds, and those aged over 60 were barred from switching to them, the rest of the labour force had a choice to join, taking 4% of their salary out of the state system and adding a further 2%.
“Our initial estimate of how many would make the switch was based on the experience of other countries,” says Nestor. “In Poland, for example, it was only 50% of the working population. And when we made an opinion poll it suggested we were also facing a disaster. It found that while the second pillar was popular with the supporters of the coalition parties, opposition voters opposed it.”
The OECD report on Baltic pension reform noted that the original projection was that at least 50,000 people would join the new system in its first year, and that it was hoped that the number of fund members would reach 250,000 by 2007, five years after its inception.
But in the event, the initiative proved to be an unexpected success. “During 2004 it exceeded 300,000,” says Nestor.
The takeoff was assisted by Estonia’s so-called e-state project, the making available key information about public services on the internet. As a recent report for the EU from the ministry of social affairs notes: “During the launching of the second pension pillar in 2002, the government initiated an extensive information campaign to inform the population about the choices and possibilities as well as risks related to the new pension system.”2
“Our idea was that the government should explain to the people about going into the second pillar but that what kind of funds were available was not our business,” says Nestor. “But we put special regulations in the law about how to make a choice and requiring that when funds inform you about their offerings they must also tell you that there are other funds with other schemes.”
And membership of the funds has continued to grow. “Of the 600,000 people actively participating in the labour force, 453,000 have subscribed to second pillar funds, putting EEK4bn (e256m) into the system, and this is rising by EEK2.5bn to EEK3bn a year,” says Raivo Sormunen, editor and analyst at Estonian business newspaper Äripäev. “This is a huge amount for Estonia where GDP was EEK139bn in 2004. It’s also a political factor and one that politicians have to take into account. It’s a very loud political voice.”
But other loud voices have been heard. At the time of the reform the opposition focused its attack on the liberal investment regulations. “The other parties said the system meant that ‘they’ could use our money wherever ‘they’ want,” says Nestor. “But we rejected the idea that pension funds should be obliged to buy state debt. In our little country it would be stupid. It would be like Enron, with everything in one company and therefore vulnerable to the company going bust.”
But subsequently the leading sceptic, the populist Centre Party, changed tack. “It developed the slogan ‘Eiki Nestor stole the 4%’,” says Nestor. “Now that they are in government, I take great pleasure in asking them whether they have given it back.”
However, the question is still on the agenda. “Three years after the beginning of the second pillar the 4% is still a political issue,” says Sormunen. “The reallocation of the 4% means that some EEK2-3bn does not go into the state system and as a result there is less money for first pillar pensioners.”
And this has switched the focus of the pensions debate back onto the first pillar and opened a new front to be exploited by the Centre Party, which with Jaak Aab at the ministry of social affairs is now overseeing the state pension scheme, while party leader Edgar Savisaar is at the economy ministry.

Under the reforms first pillar pensions should be adjusted every 1 April according to an indexation process.
“We compromised on the indexation of the first pillar,” says Nestor. “The social_democrats wanted to link it to increases in the social tax. But [then-finance minister and Reform Party leader and current EU_commissioner] Siim Kallas wanted to link it to inflation. The biggest problem was to explain to the other ministers why at a time of stringent budget cutting we needed an index at all, and I twice lost a vote in cabinet. But this meant the end of the second pillar because how could we have explained to existing state pensioners the loss of the 4% without promising indexation? Before the third vote in cabinet I compromised with Kallas and we agreed on a modification of the Swiss model – taking the average of inflation and social tax increases – and the government accepted this. But the compromise was a mistake.” By not giving full indexation the reform government left the door open “to populists to manipulate voters, and it is not necessary”, adds Nestor.
The result has been that for the past two years as well as lifting pensions by the indexation increase the government has added extra money by making ad hoc additional payments, saying that pensions are low and the system has the money.
And it certainly does. According to the latest ministry of social affairs report, the first pillar budget surplus increased in the first two years after the launch of the second pillar, with social tax revenues exceeding expenditures on state pensions. So despite social tax transfers to the individual second pillar accounts there were no direct transition costs.
This was a result of Estonia dazzling economic performance. “There is growing prosperity in Estonia, GDP is growing and the standard of living is visibly improving,” says Tõnno Vähk, CEO of LHV-Seesam, one of the pension fund management companies. Official data show the extent of the improvement, with GDP growth averaging an annual 5-6% between 1995 and 2004, hitting 7.8% in 2004 and forecast at 6.0% for 2005. In turn growth in the economy has resulted in a surplus in the budget and a surplus in the social security system as contributions from employers increased.
And Vähk points out that the pension reform has contributed to this benign picture. “The attractiveness of the second pillar has coaxed enterprises out of the grey economy and growing employment and increasing prosperity has boosted receipts from the social tax and kept it in balance despite the loss of the 4% to the second pillar,” he says.
Mihkel Õim, executive chairman of Hansa Investment Funds, agrees. “A recent analysis examined whether those who opted to join the new funds or those who stayed in the state system had benefited most,” he says. “It found that performance favoured those who had switched, as returns on the funds had been excellent. But the first pillar had also been boosted as social tax receipts increased with a rise in employment as a result of economic growth and moves from the grey economy. So state pensions have risen by 35% over the period.”
But officials point out that this figure includes the ad hoc rises and that such increases are then built into the system and take on a life of their own, posing a potential long-term threat to the system. The social affairs ministry report noted that in 2004 direct transfer costs came to EEK133bn, or around 0.1% of GDP, which was financed from the surplus of social tax revenues from previous years. It added that expenses on state pensions in 2004 amounted to EEK9.2bn, or some 6.6% of GDP, and that by the end of 2004 total first pillar reserves amounted to EEK2bn, or 1.4% of GDP. But according to finance ministry forecasts, pension reform transition costs will exhaust the existing first pillar reserves
by 2006 and in 2007-2012 the
state pension insurance budget
will need additional subsidies
on account of other state budget
“Some parties do not see the logic of the key pension reform, that it is a burden shared by the older, middle aged and young sectors of the population and that if you compensate for the 4% it means that the elderly are not sharing any of the burden at all,” says Tali. “The main issue is how to find resources to finance the transition. We are exhausting the reserves accumulated over time but we have been aided by the fact that the buoyant economy and the impact of the reform itself have meant that the social tax is delivering higher than expected receipts. However, if the costs increase we must find resources from within the budget or resort to borrowing.”
Indeed, it is clear that the pre-compromise battle lines staked out by Nestor and Kallas in the indexation debate are re-emerging as political fault lines and could provide a flashpoint in coming election campaigns, with local elections being held in October and a general election due by March 2007.
While Tali says that he sees no need for any major changes in the first, second or third pillars, he adds that the first pillar indexation could perhaps be made less earnings related. “The first pillar was designed so that two-thirds of payments were earnings related and one third flat rate,” he says. “But we now have an earnings-related element in the second pillar so we could reverse the proportions, having one-third earnings related and two-thirds basic.”
That may look good on a position paper but it is hardly going to be an ornament on any election programme.
As social ministry officials point out, there are some 400,000 pensioners and they represent a potential political force.

1Pension Reform in the Baltic Countries OECD Private Pensions Series 5 (2004)
22005 National Strategy Report on Adequate and Sustainable Pensions; Estonia, ministry of social affairs (July 2005)