Cyprus in storm warning
The pensions system in Cyprus is currently structured around the three-pillar system with the third pillar (individual provision) playing a minor role. The first two pillars comprise:
q The mandatory Social Insurance Scheme and Social Pension scheme (first pillar);
q The Supplementary Pension Schemes and Provident Funds (second pillar);
q The current social insurance scheme consists of two parts: the basic part, a flat-rate benefit replacing 60% of the lower part of insurable earnings, and the earnings related part, replacing excess insurable earnings at an accrual rate of 1.5%;
q The system is financed by contributions of 6.3% from employees, 6.3% from employers, 4% from the state and 11.6% for the self-employed;
q Current replacement rates are rather low, at around 50% for people earning up to the insurable earnings limit (currently circa €45,000 annually). Obviously, higher earners can only replace a lower part of their earnings from the state system and need therefore to build up additional provision.Of the active insureds of the state system (circa 335,000), only 42% have some form of additional pension provision.
q Supplementary mandatory pension schemes for the employees of the central government, local authorities, the semi-public organisations and the self-employed (doctors and lawyers). Normal retirement age is 60 but with unreduced early retirement allowed from 55. As of 2006, the retirement age for civil servants will gradually increase to 63. The government is currently attempting to implement this also to the semi-public sector. Schemes (except for the central government) are financed on a fully-funded approach. These include the Cyprus Telecommunications and Electricity Authorities with their two funds totalling circa €950m and both funded at around 90% on an IAS19 basis;
q Supplementary lump sum schemes collectively agreed for the employees of the banking sector, offering lump sum benefits of around 75 monthly salaries after 36 years. These are book-reserved schemes;
q Supplementary voluntary provident funds offering mainly defined contribution (DC) in lump sum benefits in the private sector. Most plans have a flat rate contribution structure with contribution rates of 11.3% on average, split equally between employers and members. Total DC plan assets are estimated to be circa €1bn.
As one of the few countries with no pension reforms for the last two decades, the major concern for the pension system in Cyprus is its sustainability in the face of the ageing population. Contribution rates do not seem to be sufficient to maintain the financial balance beyond 2010, the Social Insurance Scheme will require further reforms.
Currently the government has taken
an active position regarding the pension system and several steps have been planned in order to improve the adequacy of pensions and the financial sustainability of the system. These include the gradual increase of the social insurance contributions, the increase of the minimum qualifying period for pensions under the social insurance scheme, the reconsideration of the method of indexation of the basic part of pensions and the right to an early pension between the ages 63 and 65.
In addition, the increase of the notional incomes of the self-employed persons is being considered, in order to make their insurable income become more representative of their actual income. Further, the government has raised the retirement age for the civil servants pension scheme and is currently attempting to apply this to local authorities and semi-public institutions. This is considered to be the first step before retirement age hikes in the state system in the near future.
The above steps, however, are only a part of what needs to be done to modernise the system and ensure that it can successfully meet its primary targets of adequacy and sustainability. In particular, the government’s national strategy for adequate and sustainable pensions focuses mainly on the first pillar and fails to address measures and incentives that could encourage additional provision via the second and three pillars.
The people most likely to suffer from the state benefit reforms are those in the private sector. This due the inequalities that exist between private sector employees and employees in public, semi-public sector and banking sectors as far as retirement ages, total replacement ratios and contributions are concerned.
The poverty risk is particularly high for this sector as the provident funds offer lump sum payouts in the case of job mobility, thus leading to an outcome, where in case of repetitive changes of employment no pension capital is accumulated. Furthermore, the private sector plans to offer lump sum benefits, with no requirement or option to convert to retirement income.
Another peculiarity of the system, is that these provident funds operate on a EEE taxation system whereas pension schemes follow the EET system (ie, pensions are taxed as income). This cultivation of a lump sum culture has served very little in the encouragement and development of alternative retirement income provision. These are issues that the government ought to address as part of its overall reform process.
Also, as noted also above, only 42% of the actively insureds in the social insurance system have some form of additional provision. The other 58% should also be a major priority for the policy-makers who could utilise extensive communication strategies and implement incentives to encourage provision build-up to achieve wider coverage.
Significant investment losses on domestic equity investments in the recent past raised concerns over the current governance and decision making structures of the supplementary plans. The Directive 2003/41/EC, which is expect to pass onto local legislation before the end of the year, is an excellent opportunity for the government to, introduce a sound regulatory framework that will set the foundations for the development of an effective second pillar.
Defined benefit (DB) plan sponsors are also faced with significant challenges. All DB plans are currently integrated with the social insurance scheme and will see their liabilities increase as a result of reduced state benefits and increases in state retirement age.
Sponsors will need to consider carefully the risks inherent in their current plan designs in the light of the new landscape and assess their options for future benefit provision. DB plans’ investments are heavily mismatched with their liabilities (95% invested in cash and government bonds (mainly short term)) and are thus exposed to significant interest rate and inflation risks. Current investment objectives are not aligned with the current funding objectives making it highly unlikely for ongoing funding levels to be maintained with the current asset allocations.
Philippos Mannaris is head of Hewitt’s retirement and financial services practice for Cyprus clients, based in Athens