FINLAND - The Bank of Finland has warned uncertainty about its ageing population and potential future tax rises of over 5% could destabilise the entire welfare state and lead to a future reduction in social services and transfers.

In a discussion paper on 'Population ageing and fiscal sustainability in Finland: a stochastic analysis', authors Jukka Lassila and Tarmo Valkonen pointed out like most Nordic countries Finland has given "a large promise to all citizens concerning their welfare", but this has made private pension and health insurance is "rather insignificant" as a result.

It added "unexpected changes in public services and transfers could potentially be very harmful for many people. In our view, this is the real sustainability problem that Finland faces".

The research from the Bank of Finland said although current tax rates are "unlikely to yield sufficient tax revenue" to finance public expenditure with an ageing population, the problem would not be especially large if developments are as expected.

That said, it admitted "there is a small, but not negligible, probability that taxes will need to be raised dramatically, perhaps by over 5 percentage points. Such outcomes, if realised, could destabilise the entire welfare state".

To try and improve the sustainability without increasing taxes too much, the report put forward three policy options for the large public sector but focused, in particular, on the statutory private sector earnings-related pension system (TyEL): 

Longevity adjustment of pension benefits - which will come into effect on 'new'  old-age Finnish pensions from 2010; Introducing a notional, or non-financed defined contribution (NDC) pension system, and Require pension funds to increase investments in equities to get higher returns.

Lassila and Valkonen suggested the first two options would reduce the expected problem and narrow the sustainability gap distribution, while the third option would limit the sustainability problem, but could result in a "substantially larger variation in the value of the funds without adjusting tax rules or benefits".

The research suggested the "most straightforward policy recommendation would be to immediately either increase taxes or cut public expenditures" but added this has the risk of "saving too much" in addition to being "politically very difficult".

Under the longevity option, pensions could be adjusted to the expected longevity of the cohort at the time of retirement, which would usually decrease contribution rates and provide "substantial insurance" to public finances, albeit the discussion paper pointed out this option increases the uncertainty in replacement rates and "significantly weakens the defined benefit nature of the Finnish pension system and brings in a strong defined-contribution flavour".

The introduction of an NDC system would meanwhile also provide 'insurance' to public finances by "removing the public arrangement of sharing demographic and economic risks between generations and leaving these risks directly for individuals to face and, hopefully, to prepare for", although it stressed it does not imply the re-division of risk is a good thing.

The report noted the third option of increased risk-taking in pension funds was discussed in Finland in 2005-2006 by "a group of financial expert, pension actuaries and administrators", with the aim of improving the sustainability of by allowing higher risk equity positions.

It added an amendment to the solvency rules of pension funds was suggested at that time in a working group report, and simulations using this new rule - which were implemented in 2007 - showed it would enable pension companies to increase the share of equities by 10%.

"Here, we go further and ask what the implications for the overall public sector sustainability are, if we raise the share of stocks in the pension fund portfolios from current 40% to 67%. This shift is assumed to be permanent," the report stated.

The research also noted the same tendencies are "clear in many countries where the public sector holds significant amounts of financial assets or the pension systems are partly or fully-funded. Asset yields have, on average, been good in recent years, increasing the hopes in the minds of many that more risk-taking will be a crucial factor in solving the fiscal threats caused by ageing populations".

That said, the research concluded although increasing allocations to equities would improve fiscal sustainability, this would be at the expense of increased financial risks as the returns could be more volatile.

Instead, the Bank of Finland report suggested "investing more in equities appear to be more effective in cases where the sustainability problem is small, and less effective when the problem is large", adding "improvement in sustainability by risk-taking is possible, but necessitates a comprehensive evaluation of the current risk position and future risks."

Concluding the report, Lassila and Valkonen said: "We concentrate on policies that tackle, besides the expected imbalance, the problems associated with outcomes worse than expected. This means designing rules that adjust public expenditures with the economic environment smoothly and predictably. All these policies have strong implications on how demographic or economic risks are shared between different groups in the economy."
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