In 1991 as the Soviet Union was convulsed by what were to be its death throes, Latvia readopted elements of the pre-World War II constitution in force when it experienced its first period as an independent nation state. That was the easy part. In the years that followed the country’s priority was to find a way to deal with the almost 50% of the population that were ethnic Slavs, brought into the country during the post-war Soviet period both to man the factories created to meet the requirements of communist ideology and to alter the ethnic balance to ensure that Latvia never again drifted out of Russia’s orbit.
Since then the ‘national question’ has dropped down the political agenda as Latvia pursued entry into the EU and Nato to ensure it never again got drawn into Russia’s orbit. But while no longer a major preoccupation, the national question has left its stamp on Latvian politics, with a plethora of centrist and right-wing parties generally being Latvian and national in outlook and the leftist parties broadly appealing to the Russian minority.
And the Soviet years left other legacies. “When Latvia became independent we left a Soviet Union that had given lots of money to pay pensions,” says Vladimirs Makarovs, a member of the right-wing national Fatherland and Freedom Party (TB/LNNK), welfare minister from late 1994 until mid 1999 and a creator of Latvia’s pension reform. “Statistics from Soviet times show that Latvia’s budget received subsidies, especially for pensions. The retirement age was very low, 55 for women and 60 for men, and for some categories, those in strenuous occupations, it was 10 or 15 years earlier. It means that we are an elderly nation, with a high number of pensioners.”
For the post-Soviet governments the situation was untenable. However, as an OECD report* points out, initial reforms failed because, in an attempt to show that independent Latvia could provide more than the former Soviet Union, they soon ran up against the reality of a declining and volatile economy and a new capitalist ideology that gave rise to mounting unemployment, hyperinflation and structural changes. This rendered the 1991 pension reform obsolete.
“At the beginning of independence we paid a flat-rate pension to everybody,” recalls Makarovs. The reform did not survive, but it can be viewed as “a good try”, according to the OECD study. And it saw the introduction of the social insurance contributions that were the first step towards the social insurance system that forms the basis of the current first and second pillars.
A further attempt at reform was made after the first post-independence general election in 1993. “The then welfare minister, Janis Ritenis, was from the Latvian community in Australia where he had worked in a private insurance company,” says Makarovs. “He proposed a totally funded system, which was impossible in Latvia where the number of pensioners was approximately 25% of the population.”
Involvement by the ILO and later the World Bank led to the design a new system. “By 1 March 1995 we had designed a four-pillar pension system,” says Makarovs. “The first PAYG pillar was for those who were or were about to become pensioners, then there was a mandatory funded second pillar, a voluntary private funded third pillar to which employers and employees could contribute, and a fourth pillar intended to provide a transition for those who were receiving a pension before the reform started.”
“The World Bank consultants were Swedish,” says Dace Brencena, now executive director of Open-end PF SEB, a third-pillar fund, but then a project manager with the State Treasury. They suggested adopting the notional defined contribution (NDC) idea developed for an earlier Swedish pension reform.
And that was symptomatic of a weakness in the process, highlighted by the OECD. The reform’s ideology and underlying principles were new to Latvian society and the experts and politicians failed to explain them adequately as it was more the World Bank experts’ reform than their own, according to the OECD report. The lack of public awareness of the reform principles and the reasons behind them contributed to mistrust and led to numerous attempts to revert to the old system, the report adds.
“Many of the laws implemented up to 1996 were not really appropriate for the situation,” says Silva Bendrate, member of the parliament for the conservative New Era (JL) Party who sits on the parliamentary social and employment matters committee. “The law on pensions was amended nine times. People who had worked for 30 years or more were to receive a tiny pension.”
Makarovs defends the system. “The parametric reform of the PAYG system has worked very well,” he says. “We increased the retirement age to 62 and doubled the minimum insured period to 10 years for those who wanted to retire early, separated the social insurance pension budget from the state budget, and we said that each year the government has to announce the minimum and maximum state pension payments. And we adopted a formula, based on ‘g’, the demographic outlook that predicts how long each year’s cohort will receive a pension and to which the pension budget could be calculated.”
“The second pillar is based on the first pillar PAYG system,” says Brencena. Employers pay 35% of employees’ salaries to the social security system. Of this 20% of a gross salary goes to pensions, 18 percentage points to the PAYG system and two percentage points to the funded second pillar. The only thing the individual has to do is to choose the investment manager for their fund.”
Those aged under 30 were required to join the new funded scheme and those 50 and over could not, but people aged between 30 and 49 could choose whether to remain solely in the PAYG system or to belong to both the public and the funded schemes. In 2007 the second pillar contribution will double to 4% of a gross salary, rising to 10%, or half of the employer pension contribution, by 2010.
The uptake was not as extensive or as rapid as in neighbouring Estonia, where the first schemes were registered in 2002 and by 2004 more than 450,000 of the 600,000-string active workforce had subscribed to a fund. “The number of persons who have opted to join the state-funded pension scheme at the end of 2005 was 304,662, or 45% of those eligible to join, up from 224,219 (33%) at the end of 2004,” says Jana Muizniece, director of social insurance department of the welfare ministry.
The third pillar consists of private funds offered by six pension insurance companies, many of which also offer second pillar funds. Third pillar plans can be bought by companies, employees or a mix of both. Currently, only 5% of Latvian companies offer third pillar provision to their employees.
And the fourth pillar? “That was to be funded from the proceeds of the privatisation process,” says Makarovs. “But there were problems at the economy ministry in the early 1990s because, unlike Lithuania which continued to support its biggest enterprises and which as a result continue to exist, Latvia followed the IMF approach and our biggest enterprises crashed. The politicians responded with a policy of looking for anyone to take the enterprises for one lat and then develop them. So they privatised at very low prices and this was a mistake by the economy ministry because there were some enterprises that could have been developed.”
Bendrate says: “The amount of property that was available for privatisation in Latvia was about three times that available in Estonia. But we achieved one third of the Estonian proceeds and so we did not have the capital for a fourth pillar. And what happened to the privatisation money? There was an element of inefficiency and corruption in the whole process. They didn’t achieve as much income as maybe they could, and some of money went into private hands, going to people who were close to certain political parties and oligarchs.”
There have been four general elections since Latvia regained independence in 1991 but over that period it has had 12 governments, all centre-right. Often the collapse of an administration was accompanied by allegations of corruption. In 1997 the Diena newspaper reported that half the cabinet and two-thirds of parliamentarians were in violation of anti-corruption legislation passed the previous year that banned senior officials from holding positions in private businesses.
The fifth general election will be held in October but inflation rather than pension reform is the issue of the moment. Indeed, the political parties appear to have accepted the basic shape of the current system.
“When politicians speak about pensions at election time they usually talk about the first pillar and the amount paid to pensioners and they normally express a wish to pay more,” says Sergejs Medvedevs, vice-president Parex Asset Management, which offers second pillar funds. In fact the average monthly first pillar payout is LVL83, that’s about e120, and is around 38% of the average wage and that may just cover the bills for rent and utilities, leaving nothing for other necessities like food and clothing. And that’s an important social issue because those people are living in very poor conditions and they survive because they have children, an allotment where they can grow vegetables and perhaps an additional source of income.”
For many they are considered a lost generation who anticipated Soviet-style security, are too old to benefit from the funded system and for whom little can be done.
“These are not a lost generation, they are not lost people, they include my parents,” says Bendrate. “So when we came into office in 2003 one of the first things that we did was to raise the minimum pension. Even so, those people who get a minimum pension only get LVL80-90. There are some 500,000 pensioners and 300,000 of them fall into this minimal pension group while a further 100,000 get LVL90-110. There is a group who retired during the independence period and they get something like LVL130-150. The basic existence limit is regarded as LVL114, so some 80% of pensioners are effectively below the poverty line. “In 2003 we had a deficit in the social security system of LVL86m but in the course of recent years it has moved to a surplus. So we should think about how to use some of this surplus to help the so-called lost generation.”
Muizniece confirms the social insurance budget is in surplus. “Demographically, we will have the effects of an ageing population in the future, but at this moment the people born in the baby boom some years ago are entering our labour market and as things stand now it will stay in surplus for 20 years.”
Makarovs accepts pensions are low. “We are a badly developed economy and our GDP is very low,” he says. “If you check how much of our GDP is used for pensions you will see it is a similar proportion to other countries. The pension is low, but wages are low too. And what politicians must always understand is for whom they are undertaking reforms, for those who are already pensioners or for those who are working now? For me it was very important that we paid more attention to those working because our interest was to bring them out of the black economy which until the mid-1990s was some 40-45% of the economy, as if they are in the black economy they are not paying social tax. At the time of the reform we made the point that if social insurance contributions were paid for people who were working we could increase pensions but we could not if people continued to work illegally.”
Muizniece says that steps are being made to assist the worst off. “For example, this year we introduced an additional amount for those with an insurance period of more than 30 years. We index lower pensions more than higher pensions, with indexation occurring twice a year, with low pensions being indexed to a combination of the price index and the wage index, but middle pensions we index only to the price index.”
But for Bendrate this is not enough. “In gearing up for the next election I am in discussions with Valdis Dombrovskis, our former finance minister, who was previously with the central bank and is currently one of our party’s two MEPs, about how we can move this situation forward and what we should be thinking about for the next period,” she says. “We have agreed the principle that we would like to move even more money into the funded system, although we haven’t yet decided the details, and at the same time we would like to improve the lot of the so-called lost generation. We feel a responsibility for this group of people and we consider that a percentage of them are our voters. What we have concluded is that those whose pension did not exceed LVL105 should get an additional LVL0.19 for every year they have worked, which could give up to LVL8. But this would cost the social budget a further LVL30m.”
Makarovs has seen it all before. “In 1998 the right-wing parties, including mine, said that there was a surplus social insurance budget and increased pensions, he remembers. “The social insurance budget then tipped into deficit and I reminded my colleagues that we had told them there would be problems and that now they could see the results.”
And the welfare ministry has other plans. “We are now discussing establishing a reserve fund to invest the surplus and save this money for the future,” Muizniece says. “We would like to invest in the economy and to receive a return that would cover inflation. We have drafted the concept of the reserve fund and given it to the government but unfortunately the finance ministry disagreed because it would like the money to be invested only in state securities. But these give a return of only 3% and inflation is higher.” Inflation in Latvia is approaching 7% and rising.
*Pension Reform in the Baltic
Countries, OECD 2004