The fiscal impact of pension reform: economic effects and strategy Ewa Lewicka Kiev – May 27, 2004

Types of financial consequences of pension reform Long-term: –reduction of long-term pension system liabilities (implicit debt) Short and medium-term: –increase or decrease in the public finance deficit due to pension related expenditures (explicit debt)

What is pension system implicit debt? Implicit debt is the measure of liabilities undertaken by the pension system –Can be measured as the present value of future pension transfers In developing and industrial countries this debt is increasing rapidly

Assessing the implicit debt is a crucial for the reform It allows to measure actual obligations towards current and future generations Shows the level of cash flows to be allocated to repurchase these liabilities When liabilities are due, implicit debt becomes explicit –It influences the public sector deficit and the public debt level

How to cope with future liabilities? To prevent public finance collapse: –surplus should be generated to cover increased liabilities of the pension system –in OECD member countries necessary surplus is around 4 percentage points of GDP Pension reforms can generate such surplus –If the reform design allows to reduce implicit debt, Introduction of partial funding –Reduces implicit pension debt –May increase explicit pension debt, if overall contribution level is not increased

Implicit debt in selected countries In most of the countries, the IPD is much higher than the explicit public debt According to estimates: –IPD exceeds 200% of GDP in France and Italy –It is above 150% in the UK and Germany Implicit pension debt in transition economies in 2002 Note: assuming 4% discount rate Source: Holzmann et al (2001)

Primary balance needed to offset the impact of ageing Estimated annual primary balance needed to reduce the public debt to zero by 2050 Countries that have reformed their pension systems (Poland, Sweden) or countries that have balanced systems (the UK) have lowest primary balance needed Poland, following the pension reform is the only country that does not need a primary balance to be generated On contrary – pension reform generates surpluses Source: OECD

Transition costs In multi-pillar pension systems –A part or the entire contribution is transferred to pension funds –Current pension payments require financing –A transition deficit occurs The size of the deficit depends on: –the contribution amount –number of persons covered by funded system Options to finance the deficit: –current revenue from tax or other sources (for example privatisation – as in Poland) –pension savings or public expenditure savings –increased explicit debt

Misunderstandings regarding reform costs Transfer of a portion of contribution to funded pension scheme is not a cost –It reveals a portion of the implicit debt and –It reduces future public finance obligations Increased funding requirements can be offset by higher debt, purchased by pension funds Pension funds assets invested into equities stimulate investment and economic growth It is better to turn a portion of pension liabilities into savings now than to have much greater problems with redeeming such obligations in the future

Short and medium term consequences of the reforms In order to improve short and medium term financing of the PAYG pension systems, the following steps can be taken: –increasing contribution levels, –improving compliance and execution, –reducing pension promise by changing retirement pension formula, –increasing the retirement age, etc. Financing transition costs from savings in the PAYG pension system increases current financing burden – reaching the balanced scheme requires more time –pension system savings and costs should not increase the burden of the present productive generation –these should spread some of the burden also to the future generations Financial gains will depend upon the reform type –each country planning pension reform should compare effects, knowing the reform effects gained in a given country

The new pension system in Poland: New Polish pension system is: –defined contribution –with two accounts: non- financial and financial The old-age contribution was divided into: –NDC 12.22% of wage –FDC7.3% of wage Rates of return: –In the NDC are linked to the wage fund growth –In the FDC depend on the financial market returns Persons below 30 (in 1999) have both NDC and FDC accounts Persons aged 30 to 50 had a choice of one (NDC) or two (NDC+FDC) accounts –53% of them chose to have two accounts Persons over 50 years of age are in the old system

The new pension system in Poland: Actual retirement age was raised –from 55 for women and 59 for men to 60 for women and 65 for men –early retirement was eliminated –equalisation of retirement ages for men and women at the age of 65 by 2023 was recently proposed All pension rights accrued under old pension scheme form the initial capital, credited to the NDC account –Initial capital is indexed the same way as NDC accounts State guarantees include: –Minimum pension guarantee that tops-up the pension from both NDC and FDC account –State becomes a final guarantor of the minimum rate of return under the FDC component

State budget subsidies to Social Insurance Fund year per cent of GDP supplementary subsidysubsidy covering transfer to FDC Source: ZUS

Poland –Long-term effects Estimated value of pension liabilities as per cent of GDP until the year 2050: –Before the reform 462% –After the reform 194% –Reduction of liabilities 268%

Demographic and system dependency rates

Pensioners by the type of the pension system Source: ZUS (2004)

Expenditure and revenue of the pension system

Summary of medium-term financial effects of the reform Full transition to the new pension system will take several decades Calculations show that the deficit in the system will be reduced and after a transition period, the system will be financially stabilised –further improvements are expected due to the changes proposed in 2004 in pension indexation and retirement age The deficit is temporarily increased by creation of the buffer fund - the Demographic Reserve Fund –In percentage points of contribution is transferred to the DRF –At the end of 2003, assets of DRF were about 0.4% of GDP, invested mainly in government bonds –DRF will be used to finance deficits in the old-age NDC scheme after 2009

Summary Designing pension reforms should be preceded by: –assessing the implicit debt –communicating the level of pension obligations to the society It is necessary to ensure that financial consequences of the reform, both negative and positive, do not burden a single generation of working people but are allocated evenly Multi-pillar systems provide an opportunity to faster reduction of the public debt and can generate higher pensions, compared to the parametric changes under the PAYG systems The sooner the PAYG systems are balanced out the sooner burden for the working population is decreased The size of the funded system: –should be the result of an assessment of the capacity to finance the gap in the PAYG part –it requires appropriate financial market infrastructure