Defusing the pensions bomb
The problem of the pension time bomb can be solved without funding public schemes or moving away from unfunded public schemes to fully funded private ones.
A Merrill Lynch report, ‘European Pension Reforms’, identifies three major debates being conducted in Europe (and the rest of the world) regarding the provision of retirement incomes. The first is whether or not to fund public retirement schemes. The second is about how much of future retirement income provision should be left to the public sector and how much can be taken care of by the private sector. The third debate is between defined contribution and defined benefit pension schemes, the two different ways of organising retirement income.
Although defusing the pension time bomb has a very strong financial aspect, some decisions are more social/political and relate to what role the state should play in the organisation of retirement income. In addition, any government runs the risk that if attention is only paid to the financial aspects of the problem, the financial pension time bomb is replaced by a social one. The perfect solution is a combination of public and private pensions that work together, is financially viable, pays a fair pension and covers the entire population.
Most pension systems in Europe are based on public schemes. With some large differences between countries, on average 80–85% of pensions are provided by public schemes, 5–10% from occupational schemes and only 1–2% from personal pensions. With the exception of Denmark, Finland and Sweden, public pensions are almost entirely based on unfunded pay-as-you-go (PAYG) systems. The workers of today pay for the pensions of the pensioners of today. The combination of declining labour market participation rates (especially in the 55–65 age group), which magnifies the demographic ageing problem, and expectations of future ageing of the population will make most public retirement schemes expensive to run. Major reforms are necessary.
In 1990 there were on average 4.8 persons in the working age group that helped contribute to the retirement income of each pensioner in Europe. This ratio is expected to change to 2.6 persons for each pensioner by 2030. The ageing of the population will therefore put extreme pressure on most public social security or pension systems that are not fully funded.
Although the financial world is waiting for the announcement of major pension reforms in European countries, the report argues that a lot has been done already. There are six different major strategies (not mutually exclusive) that a government can follow and the Merrill Lynch European Pension Model shows that it is not realistic to solve the pension problem by any single measure. Only a combination of measures will eradicate the negative financial effect of ageing on state pension schemes. It is clear, from the measures taken since 1990, that many governments are following this “combined option strategy”.
One good reason why we are not fully aware of what has been achieved already is that pensions are politically a very sensitive subject. Governments do not want to make too much noise about the savings they have made on pensions. A trickle of measures is politically easier to achieve than one major reform and could also be more effective, as shown below.
To calculate the financial effects of the different strategies we used a simplified model for the whole of Europe that includes estimates of the present age distribution (base date 1990) and estimates for 2030 as well as estimates of average participation rates for men and women. The model includes a PAYG public pension system with a contribution rate of 13.76% of average salaries and a pension payment of 43% of average salaries. Total pension contributions equal pension payments as the “European” government does not run a surplus or deficit on the pension scheme (the base case scenario).
The model calculates that if we inflict all the pain on the working population, the pension contribution rate has to increase from 13.76% in 1990 to 25.86% in 2030 to fully compensate for the ageing of the population (increased contribution scenario). If we place all the pain with the pensioners, the model calculates that the pension payments will drop from 43% of average salaries in 1990 to 22.9% of average salaries by 2030 (lower pension benefit scenario).
The most effective way of solving the pension time bomb is to increase the average effective retirement rate. In some European countries the participation rate of citizens between 60 and 65 has dropped to below 20% and there is an implicit tax on working after the early retirement age. Removing these disincentives to work after the early retirement date already goes a long way in solving the pension problem as it not only reduces the number of retired people but also increases the number that pay for the pensions at the same time.
The attractiveness of this measure is in its effectiveness as well as its non-financial appearance. It is interesting to note that in 1983 in the US the official retirement age was raised from 65 to 67, with very gradual implementation. Although the statutory retirement age in most countries in Europe is 65, the average (effective) retirement age is closer to 61. We estimate that if one raises the effective retirement by four years, the elderly support ratio will drop from 4.8 in 1990 to 3.9 in 2030 as this moves around 6% of the population out of the retirement age group back into the working age group. In this scenario the pension contribution rate will have to go up from 13.76% in 1990 to 17.17% by 2030 to keep pension payments at 43% of average salaries.
One other way of solving the problem is to enlarge the group of people that work and therefore pay pension contributions. One can increase the size of the active population through immigration of working age people from outside the European area as well as increasing the activity rate.
The first measure is only effective if one assumes that all immigrants find work and will not retire before 2030. Increasing the activity rate of the working age group is most effective in countries where the female activity rate is very low. Immigration, as well as the increase in the activity rate needs to be quite substantial to solve the pension problem on its own.
In the “partial funded scenario” a funded scheme is introduced in 1990, financed by an extra pension contribution of around 3.5% a year. The fund helps the state pay the public pensions from 2010 onwards. The model uses a long-term rate of return of the fund of 5%. This solution is useful as it keeps the total contribution rate below 18.5% of salary.
To change from a public PAYG system to a partially funded public scheme can be done and over the longer term will bring benefits. However, in the short term this means a heavier burden for the present generation of workers, who have to continue paying for the old system as well as helping to build up the fund for the future. To change from the public scheme to private funded schemes has financially the same effect as funding the public scheme. The table shows that in the model the pension payments still need to be lowered from 43% to 37.5% of average salaries to balance the books.
The final scenario, the “combined option scenario”, is a logical consequence of what has been discussed before. Here we combine all the measures discussed earlier, but much less aggressively, and we specifically exclude the funding scenario. We have raised the average retirement age by three years. We have introduced limited immigration (5% of the population over 40 years) and have increased the overall activity rate from 65% to 69%. To match pension contributions with pension payments the pension had to be lowered to 37% of salary while the pension contribution had to be raised from 13.76% to 14.77% of average salaries.
The model shows that by combining several scenarios the pension problem can be brought under control without starting to fund public pensions or introduce funded private pensions. Many state pension schemes in Europe are more viable now after the reforms implemented between 1990 to 1999. Many governments are indeed tackling the problem as described above by combining many of the options.
Some reforms do include funding or partial funding but it is not sure that funding will be part of all reform proposals, as funding by itself does not solve the problem. It is therefore likely that the present unfunded public schemes will continue to play an important role in the provision of basic pensions in Europe in the future.
Private funded schemes will grow but in some European countries will only play a role as a supplementary or a top-up scheme and will not replace the public schemes. If this scenario materialises pension assets in Europe will not grow as fast as some expect and competition to manage these assets will only increase.
Jan Mantel is an independent consultant and author of ‘European Pension Reforms’, published by Merrill Lynch