Revolution for self-employed
In common with many European countries, Belgium’s public pension schemes are PAYG; also in common with other European countries, future demographic projections show clearly that these schemes will come under huge financial pressures. A recent report of the OECD hghlighted the effects of longevity as the major challenge for Belgium’s economy in future decades.
These difficult perspectives do not offer a lot of possibilities of improving existing benefits. And at the same time, public pensions for self-employed are often very low, far lower than pensions for private sector workers and civil servants.
Historically, public pensions for the self-employed were flat amounts not related to revenues (the ‘Beveridge’ approach), as opposed to private sector workers where pensions of the first pillar are based on a ratio (60% for a single person or 75% for a couple) of average life-time revenues (the ‘Bismarck’ approach). In the 1980s self -employed pensions were reformed, leading to a system similar to the private sector mechanism. Of course, the new formula only applies to the years of activity prior to the reform; and the pension amount is also decreased in order to take into account the absence of employer contribution.
Even if the reform does lead to better pensions for the self-employed, levels are still below target. In this context, the Belgium government has decided to improve the social status of self-employed. Pensions is one of the key issues in the debate: how to improve the retirement conditions of the self-employed with limited budgetary means?
If we look at traditional solutions used in Belgium for private workers in order to increase pension levels, two strategies become apparent: a ‘parametric reform’ of the public scheme and ‘encouragement measures’ for the second pillar.
Parametric solutions aim at modifying some elements of the pension formula inside existing public schemes. This strategy has been partially adopted recently for the self-employed by increasing minimum levels of pension. This will lead to better absolute amounts, but is just a part of the picture.
Another approach is to convince people to join second pillar schemes in order to complete the public pension by an occupational one.
In Belgium, these supplementary schemes for workers are at the employer’s discretion. Nevertheless, a recent law (‘LPC/WAP’) has tried to encourage such schemes, improving the legal rules and creating sector pension plans. Though it is too early to have a clear idea of the value and effects of these new legal rules, for now the visible effects are very limited.
Supplementary pensions also exist for the self-employed and have been recently reformed; but once again, the absence of an employer drastically limits the possible amplitude of a second pillar.
For this reason, it has been decided to create something quite new and revolutionary in Belgium for the self-employed: a public mandatory defined contribution (DC) scheme fully funded, but also a full member of the social security landscape. We could call it the second tier of the first pillar…or alternatively, the first tier of the second pillar.
This new system is a part of the Belgium social security strategy and takes into account its compulsory and universal character. Initially, each self-employed person will pay a contribution equal to 1% of their professional income, and these contributions will be invested until retirement. At retirement, the amount achieved will be used to purchase an annuity. The initial 1% contribution will increase, with a target of 4-5% seeming reasonable.
Funds will be invested on the financial markets using institutional investors like insurers as intermediaries (no public fund), and the system will offer a minimum rate of return guarantee for the affiliates. Some operational procedures still have to be decided on.
This new scheme offers a new perspective on Belgian pensions logic; for the first time it associates the principle of a social security system with a fully-funded technique with investment privately managed. The main advantage of this combination is clear: offering the universal coverage of a public system while diversifying the sources of funding by using the efficiency of the financial markets opposed to the demographic threat of the PAYG system. The PAYG mechanism and fully funded schemes have their own qualities but also their own risks. Joining them inside the first pillar obeys to classical principles of diversification in finance just like a portfolio of assets well balanced between equities and bonds.
Of course the success of such a system will largely depend on its practical modalities. Four fundamental key issues need to be addressed:
q Real confidence in the system: a fully funded system existed in the past in Belgium for the self-employed but disappeared in 1976 when the social security moved from fully funding to PAYG. All the money accumulated was taken to help the PAYG system. This threat to the new system must be avoided; the provisions must be managed privately and not by the state. And contributions must be presented to the self-employed not as a new tax burden, but as an investment opportunity;
q A well balanced return mechanism: in a fully funded scheme, the return of the assets is of course crucial; taking into account the social security dimension of the plan, the authorities have decided to introduce a compulsory minimum rate of return. This idea must be carefully implemented in order not to kill any possibility of investment in long-term assets like equities, which are more risky in the short-time term;
q A strict limitation of the management costs: management costs can significantly deteriorate the return of the system. Taking into account the big number of participants and the simplicity of the scheme, economies of scale must be considered in the management of the funds (such as group insurance vehicles);
q Viability for all the parties involved in the process: the rules must be equilibrated between the state, the affiliates and the insurers. The private financial sector must play an important role in terms of financial management and provider of guarantees. These services must be correctly remunerated, transparent and regulated.
The creation of this new pillar illustrates the shift from the traditional paradigm of the three pension pillars to a more sophisticated ‘multi-tiered’ philosophy.
The second and the third pillars in a voluntary framework remain an essential part of any well-developed pension system, but first pillars must be consolidated and diversified by using different tiers of funding.
Let us hope that this new scheme is a success and quickly followed by similar initiatives for other categories of workers.
Pierre Devolder is professor at Université Catholique de Louvain (Institut des Sciences Actuarielles)