Estonia’s PAYG pension system is suffering from a shortfall between contributions and payments. The need for reform is apparent as the gap is steadily growing. Average salary calculated by the government is EEK 3,700 (E236). The mandatory retirement age is 60 for men and 55 for women. In 1996 a quarter of the population was retired and in 1997 nearly a quarter of the government budget was consumed by pension payments. In 2000 it will consume EEK6.3bn and amounts to 7.5% of the GDP. Pensions as a share of GDP are comparable with other European countries.
The government has long been aware of the steadily rising problems. Social security issues and especially pension agreements need to have political consensus. The system has to stay in place for generations and has to be accepted by all levels of society.
This consensus has been hard to find. Changes in government have meant changes in the proposals. The latest amendment meant radical changes. PAYG is once again, as far as we can see, the main issue. Restrictions have also been applied to the sales of foreign insurance policies.
The government in 1997 approved the principles of the new system on the basis of a pension reform with a three pillar system. It remains to be executed but changes has been made in the state pension system by the State Pension Insurance Act of 1998, amended in May 2000.

Pillar I: the state pension. The state pension is payable as monthly social insurance benefit in cases of old age, disability or loss of provider. It is calculated on a formula basis. It calculates that the average salary for this purpose is EEK6,000. If all criteria are met, EEK1,550 or roughly 25% of salary, is paid. The benefit can be received by a permanent resident, temporary resident or refugee. The mandatory retirement age is to be 63 but it is optional to receive benefits before this. The system is based on solidarity and paid from the state’s pension budget, a PAYG system. The Social Securities Charges Act establishes that the contributions for pensions shall remain at 20%, the same as before. The total social security charge will also remain at 33%. Of the 20%, 16% will go to the state pension budget.

Pillar II: supplementary pensions. The calculator and registrar of pensions will be the State Pension Insurance Register. It covers both pillars one and two.
The second pillar is proposed to be a solely defined contribution (DC) system. The contribution will be 4% and it can be invested in insurance contracts and other investments such as mutual funds. However, from 1 August, 2001, the law will require the registration of intermediaries or financial services providers in Estonia

Pillar III: individual supplements. Individual contributions are made through insurance contracts. According to the law there are no restrictions on the amount spent but taxable deductions can only be made for domestic pension contracts. There is an effort to make the employees doing mandatory supplements to the 4% for pillar two. To make the system work an additional 2% is needed, argues the government. As a carrot, the government is proposing to give employees 10–15% tax relief on payments made.
The life insurance industry is still in its early stages of development and there are only a handful of life companies. Many are controlled or are partially owned by insurance corporations within the EU. As far as we can discern there are only with-profit contracts and no unit-linked contracts at all. Most of the contracts seem to be mainly life or disability with little savings. In-house salesmen mainly sell the contracts. There are foreign life insurance contracts sold in Estonia by what you might call ‘brokers’. Friends Provident and Eagle Star are the first choice.
We contacted William M Mercer, Watson Wyatt, State Street Global Advisors and Frank Russell Co. None are operating in Estonia or intend to do so in the foreseeable future. Mercer however has a presence in the commercial arena through Marsh McLennan. Juan Arizitia Matte from Chile has been in Estonia recently. He has been consultant and adviser to 11 countries regarding pensions reform. He was part-architect of Chile’s world-renowned system.
The broker situation in Estonia is both simple and complex. There are no rules or regulations regarding selling of insurance products or giving advice. This is due to the fact that industry and the legislation is so young. There is however informal registration with the insurance inspection authority to which people notify their intention to conduct business and send in their credentials. If the inspectorate finds them reputable they will include them in their yearbook and put their name on the Inspection’s homepage. This is not to be seen as a registration or licensing, merely an information to clients and insurance companies.
There is a big need for education, professional skill, regulation and liability insurance. Therefore insurance salesmen have started the Estonian Broker Association, whose spokesman and chairman elect is Andrus Järve of Majesteedi. According to Järve the association’s foremost goal is to achieve legal status and recognition from the government, clients and insurance companies. It intends to become a member of BIPAR, the international broker association. The association’s first goal is to oppose the law regarding non-selling of non-Estonian contracts, which they believe contravenes EU agreements or at least will be banned if Estonia wishes to join the EU.
In an earlier article in IPE’s May issue we outlined the previous version of the pensions, which would have given Estonia one of the world’s most advanced defined contributions (DC) systems, with full investment freedom and no limitations on the nationality of the financial services provider. This proposed law could have provided a stable, dependable system, which is exactly what the country needed. Underfunding problems would have been solved and the value of the pension accounts would have been in the stakeholders’ hands.
Of course, there was one major problem and that would have been the rules regarding the transition to the new system. The debate regarding winners and losers in the new system would be a political nightmare and could possibly overturn governments. This is not an unfounded fear, as in neighbouring Sweden the winner/loser debate is still raging.
What happened in Estonia? As far as we can discern the last amendment is a radical retreat to a solution looking very much like proposals for mainstream Europe. Instead of 20% DC it will only be 4% DC and 16% PAYG. We can only speculate as to this radical change. Factors might be the Swedish lessons fear of a winner/loser debate and different ideological viewpoints. Matte, in an article in the Aripäev, said that the proposed system will not hold in the long term. It will not hold even if the government gets its citizens to enhance the contributions to 2%. There is altogether too large a PAYG segment, says Matte. He if anybody should know. However calculated it will collapse – if not now, then in the not too distant future. However, rescue is at hand. The law and the proposal left many question marks regarding how to interpret its content and above all how to execute it. Even the legislators have not set the levels for pillar two and are still debating how to combine the first two pillars.
Our advice is to tread very carefully and to enhance the DC content as far as political considerations can go. We very strongly advise against using tax incentives to enhance contributions to Pillar II. It will only lead to complexity within the tax law. Sweden can definitely not be seen as a role model but just the opposite.
Estonia has taken a turn towards protectionism in wishing to exclude non-Estonian insurance contracts. Nobody has been able to tell us exactly what the registration means, full operations or only a notification. Maybe the government wishes to protect its insurance industry until it matures or it is afraid that premiums would leak to offshore companies. The strange fact is that the beneficiaries of this policy are the EU insurance corporations that partially own or control the Estonian insurance companies. Other EU companies will be excluded. This is something that we think has been overlooked. If Estonia wishes to be first in line when the EU opens up this law will then have to be amended. Our suggestion is to adopt the Swedish interpretation of the EU rules. EU/EES insurance companies have to be under supervision by its own FSA. If tax deductibility is desired a branch office is necessary. Non-EU/EES policies may be sold but only through a licensed Swedish broker. They have a filing obligation regarding offshore sales to the government. This way the insurance inspection would be able to control the marketing and the Internal Revenue Service would have access to the accounts.
We sincerely hope that the legislators return to the previous proposal and make Estonia a shining example.
Erik Inkapool is with, a firm of lawyers and consultants,, and Alexander Inkapool acts as a consultant