The Irish say that they are either ahead or behind the continental Europeans when it comes to pensions liabilities – it depends on how you look at it. From a demographic point of view, they have a 15 to 20 year period to prepare, whereas many of the mainland Europeans, particularly the biggest counties, are more or less up against it.
Despite being the least under pressure of all European countries, they seem to be among the most determined to take immediate steps. As one senior civil servant in Dublin puts it: “If we do not take action, we are faced with two things – a worsening of benefits or penal rates of taxation”.
Perhaps, it is only the Irish who have the luxury of planning, as the tumbrils bringing many countries in Europe to this very place of benefit and tax rates execution are already rattling on their way.
There is nothing smug about how the Irish are approaching the issue, they regard pensions as a key issue that needs concerted national action. What stung them into activity was a 1996 report from the Economic and Social Research Institute think-tank, which pointed out that half of the working population had nothing other than the then none too generous state pension to retire on.
This led to the National Pensions Policy Initiative (NPPI), under sponsorship of the Department of Social, Community and Family Affairs and the Pensions Board, the pensions regulatory authority’s weighty report in 1998 with its three main recommendations.
Board chief executive Anne Maher reviews the progress since then: “The report recommended that the social welfare pension be increased to 34% of the average industrial wage to protect the lower paid. While the government did not accept that recommendation, it has given higher pension increases to pensioners than others, with a 14% rise over the past two years, so that currently the pension is 29.5% of the industrial average”. Stated government policy is to increase this to £100 per week in the next couple of years.
The NPPI report recommended that supplementary second pillar pensions be continued on a voluntary basis, with a new vehicle the Personal Retirement Saving Account (PRSA) be introduced to encourage greater provision. “A new pensions bill is being introduced next year and it will bring in a framework for the PRSA”, says Maher. She points to the big stick in the background that if the voluntary approach does not increase pensions coverage sufficiently, after a review in five years’ time, a compulsory second pillar may be the next stage.
But where there has been most excitement has been on the moves towards funding the state’s own liabilities. “In the report, we felt funding would be essential to provide for earnings-related pensions in the future”, she comments. “The board very much welcomes the government’s moves on fiunding.”
Indeed, the government, which accepted practically all the report’s recommendations other than those relating to the social welfare pension levels and indexation, immediately set up an internal working party to look at the funding question.
There are two strands to the funding debate within Ireland. One was on the public service pension side, which is the subject of a commission of inquiry set up originally in 1996, with the remit of looking at the whole area of public servants pensions. This is due to give its final report later this year, but in its interim report in 1997, it was pretty neutral on the question of funding of the public sector’s pension arrangements.
The second related directly to the NPPI report and the implications of raising pensions to the figure of 34% of average industrial wages over a period of five to 10 years, and ideally be indexed to earnings.
At the Department of Finance there were reservations about being committed to the 34% rate and to the question of indexation. Department official Joe Mooney, who repesents the department on the Pensions Board and on the NPPI committee, says the department dissented from that in the report. It was concerned about tieing future administrations’ hands.
“Our demographic assumptions took two scenarios, that pensions would rise in line with price rises, or in line with earnings”. The difference between the two scenarios is staggering over the years to 2056. “If indexing is just line with prices, the social welfare pension outgoings in total would fall from 4.6% of GNP to 2.6%, with the replacement ratio falling from 27% to less than 10% of average industrial earnings over the 60 years. The question is how sustainable that fall would be politically with the growth in grey power”. On the other hand, if pensions were linked to earnings, the total pensions outgoings would rise from the current 4.8% to over 8% of GNP over the next 60 years.
He adds: “When you look at the implications of the recommended 34% pension level, overlaid with the demographic evolution, the cost implications are even worse, with the pension costs rising longer-term to 10% of GNP. This would be a heavy burden if the Pay-as-You-Go system was maintained.”
It was in this scenario that the idea of funding, or ‘prefunding’ as it is referred to, came into the picture, as outlined in the NPPI report. “The idea is that in the good times, with reasonable demographics, you should start putting money aside which should be invested.”
Following the report, an interdepartmental committee was set up covering a number of departments, which Mooney is chairing, to examine the issue of funding in depth. “We had decided that funding was a good idea and were getting down to the mechanics of what would be involved, when we were overtaken by another group.”
This was the Budget Strategy for Ageing Group, or ‘B-STAG’ as it is called, comprising only of Department of Finance officials. It produced a report in June to the Minister of Finance Charlie McCreevy. Mooney, who is also a member of this internal finance group, says: “The driving force was the general economic situation and the knowledge that there would be a good out-turn budgetary wise for the year, together with the imminence of the revenues from the Telecom Eireann privatisation”.
The BSTAG report’s avowed aim was to bring forward proposals quickly. The basic question it posed was what share of GNP would have to be set aside each year to 2056 in order to equalise the impact on the government budget over this period of extra Social Welfare pensions, public service pensions and health service costs arising from ageing compared with current expenditure.
It is estimated that an extra 1.4% of GNP annually would be needed for Social Welfare pensions, 0.7% of GNP to meet extra public service pensions over the period due to more pensioners, and 1.4% to meet extra health service costs. So an extra 3.5% in total would have to be set aside each year to offset the increasing age burden.
The BSTAG group came down in favour of pre-funding, rejecting the alternatives of trying to meet these costs from the sale of assets through privatisations or to rely on future economic growth.
The 3.5% of GNP, seen as that amount required, was ruled out as being impracticable even with the 2% of GNP budget surplus expected for 1999, and the group went for an amount Ir£520m(E660m) equal to 1% of GNP. As the cost of Social Welfare pensions is expected to be double that of public service pensions, the ratio should be 2:1 in the allocation of funds, though for this year the split is Ir£320m and Ir£200m respectively.
The group followed the NPPI report recommendation in opting for a ‘reserve fund’ for the social welfare payments. This provides for a the transfer of money for a specified period and at the time when the costs of pensions exceed a certain proportion of national income, withdrawals will be made to help reduce the costs of pensions at the time. “The reserve fund approach seeks to equalise or smooth the rising burden of costs over a period of time, rather than attempting to fund all future costs”. The group also suggested that “a very substantial share of all privatisation proceeds” should go prefund ageing costs.
On the public service pension costs, the figures are no less dramatic, in that the amount of these benefits are expected to double from 1997 to by 2012 and quadruple by 2027. As a proportion of GNP, these are static until 2010, but are expected to rise from 1.6% of GNP to 2.4% in 30 years’ time, says the BSTAG report.
To establish a fund now to meet all past pension liabilities would cost Ir£20bn and is discarded as impracticable. To move gradually to full funding is also dismissed, as it would require some £780m of expenditure as well as continuing on the PAYG payments. Instead, the group opted for a fund that would meet the cost of the increases to pensions in payment, which are linked to current public service pay increases. It is estimated that payment of an annual contribution of £250m towards a fund would meet the full costs of pensions increases from a vesting date of 1 January next year for existing and future staff.
The group notes that this will have little impact on the state’s PAYG costs of public service pensions, indeed it would increase them for the period that the contribution costs exceeds the eventual benefits outflow from the fund.
Because of the budgetary and accounting advantages, the BSTAG says the scheme must be a properly constituted pension fund, with levels of contributions determined on an actuarial basis and that there must be an independent investment mandate for the management of the resources of the fund.
In July, the month after receiving the B-STAG report, finance minister Charlie McCreevy, who has long been a convert to promoting increased pension provision, accepted its main proposals and announced these would be put into effect, by committing the 1% of GNP and said that a tranche of the telecoms privatisation proceeds would be allocated to the two new funds to be established. He recognised that these sums would only meet a third of the extra costs that the ageing population would bring.
The legislation would be in place by the middle of next year, but promised that in the meantime the “appropriate sums would be set aside”. The policy issues, such as the management of the funds, had to be determined in the run up to the legislation.
Within the finance department, a group has been set up to manage the implementation of the funds, with top priority status. Assistant secretary at the department Joe McGovern points out: “The minister wants the legislation setting up the funds as soon as possible, so in the next year they could be up and running”.
A number of issues have to be sorted out in relation to the ‘trigger mechanism’ as to when and how the Social Welfare fund payments start. “The management of the funds raises a whole raft of questions as to the form of management and what the government can or cannot do.”
He points to a recent OECD report, which noted that state-backed pension funds tend to underperform. “This is mainly because they are put into certain assets, or have restrictions put on them, particularly on the assets that can be invested outside the country. This creates a tension at least with the investment returns. So among the big issues for us will be where should this investment take place and how exactly these fund will be managed. For example, how much of a company you can own before you run into other problems, such as and ethical and governance issues.”
“But we are working on the basis that it is to be managed commercially in order to optimise returns”, says McGovern. The department is highly aware of the immense interest in the asset management industry, but is adamant that no decisions have been taken on this side.
Another government organisation, the National Treasury Management Agency, which has the responsibility of managing the national debt and recently had its powers widened to include other investment management activities, has been speaking of its potential role in the management of the new funds. It is not likely to be directly investing the assets, but hiring outside managers, possibly on multi-manager basis, with a portion being on an indexed basis. Because of the size of the Irish stock market, there could be limitations on the extent of domestic investment.
The dry comment at the finance department on the NMTA is that “sometimes the statements they make are their own statements”.
The scale of the undertaking means that not only is it something the department is unlikely to have had to cope with before, but also that no organisation has had to deal with funds of such potential magnitude in Ireland.
It is hard to put a size on what the funds may come to at their peak. But we are certainly talking about very large sums of money, bigger than anything that is currently in Ireland on the pension fund side. The public service retirement fund could have a value of around Ir£5.5bn, and if the 1 to 2 ratio is maintained as envisaged between it and the Social Welfare fund, so the ultimate could be over £16bn. Currently, total Irish pensions assets are around the £30bn area.
Another crucial area for the department is the devising of structures so that the funds can only be used for the purposes they were set up. The B-STAG report recommended that this be set out in the legislation, including the mechanis to be used to draw down funds. The group also emphasised the need to maintain the funding as “a non discretionary commitment to be met each year regardless of economic, budgetary or circumstance – there must be sustained, annual, payments into the funds, once established”. The Commisssion on Public Service Pensions probably has had some of its its thunder stolen on the funding issue, by the government’s actions, though the minister says that its findings will be part of the considerations when drafting the legislation.
There can be no doubting of the commitment of the government and its finance minister in particular to the rigours of such a programme. They have certainly nailed their flag to the mast of pension funding. McCreevy has no doubts about the significance of what he is doing in European terms, when he points to the difficulties other EU countries are experiencing by not providing adequately in better economic times for demographic changes. He remains “resolutely determined that Ireland will not make the same mistake in the state pension area”.