The Spanish Parliament has passed a law establishing the basis for calculating annual indexation rates for state pensions, together with a sustainability – or “intergenerational equity” – factor to be introduced at a later date.

The new law breaks the traditional link between pension increases and inflation in the country.

The changes, following demands from Brussels for reform, are aimed at capping government spending and balancing the social security budget.

At present, the replacement ratio for Spanish pensioners is close to 74%, according to the OECD.

The law has had a stormy passage through the legislative process, partly because of opposition from the Socialist Party and the unions.

But it cleared the final parliamentary vote just before Christmas, complying with the European Commission’s end-of-year deadline, and took effect from 1 January.

Previously, pensions were guaranteed to rise in line with inflation.

The new revaluation index guarantees a minimum annual increase of 0.25% but no more.

Inflationary increases will only be added if certain economic conditions are met.

The indexation formula includes factors such as the nominal income of the social security fund, the number of pensions being paid out and a percentage of the social security deficit or surplus.

The figures used will include averages for past years and estimates for future years.

At present, these factors are largely negative, preventing any inflationary increases in pensions.

However, future governments will be able to establish more generous uplifts when the economic situation improves.

The maximum increase will be consumer price index (CPI) inflation for the previous year, plus 0.5% (increased by the Senate from the government’s proposed 0.25%).

The new ceiling on individual state pensions will be €2,554.49 per month, as from 1 January.

This will rise each year in line with the general increase in pensions, but not, as was the case before, in line with inflation.

For the 2014 calendar year, state pensions will be increased by 0.25% as from 1 January.

The same rules also apply to pensions for work-related injuries and illnesses; extraordinary pensions awarded to victims of terrorism; and pensions paid to individuals who have worked outside Spain.

In its statement, the government said: “The aim is to respond to public mistrust and guarantee adequate pensions for the pensioners of today and tomorrow, with similar patterns of behaviour in the level of pensions.”

The sustainability factor, which is based on retirement age and links the level of pensions to life expectancy, will apply from 2019.

It will be used to establish the initial level of pension for those about to retire.

Every five years, the factor to apply to new pensioners will be revised.

Two control mechanisms have been established to assess the effect of the measures.

The Spanish government will present an evaluation report to the Congress of Deputies and social partners every five years to confirm that the level of pensions is sufficient.

The government is also setting up an Independent Authority for Fiscal Responsibility to supervise the stability and sustainability of government budgets as a whole.

As part of this role, the authority will give an opinion on the level of pensions calculated by the Ministry of Employment and Social Security, as well as the determination of the pensions revaluation index applicable each year, and the sustainability factor.

Jon Aldecoa, consultant at Novaster, said: “This is a strong mechanism to control spending, and it will have a big effect on medium and long-term pension levels.

“People under 50 will have to supplement their pensions with occupational or personal pensions. But right now there is a big private pensions coverage gap.”

Aldecoa added: “These mechanisms will heavily reduce the replacement ratio of the pension, compared with final salary, over 15 or 20 years. So adequacy is not guaranteed in the medium term.”

Jaume Jardon, pensions manager at Deloitte in Barcelona, said: “Ironically, the effect of the new revaluation index for this first year seems to be contrary to that expected, since the increase in pensions will be 0.25%, while inflation will be around zero.

“However, as long as the new rules are applied year by year, they will be more successful than the previous framework in containing costs.”

But he added: “The formula is not easy for workers and pensioners to understand, so there is scope for confusion.”