Pension Reform in a Mature Welfare State – Danish Experiences Lars Haagen Pedersen June 8, 2007

The Scandinavian Welfare model Public transfer income and services: Universal entitlements based on objective criteria Equality issues are central (transfers are indexed to wages) Large public production of individual service High level of standards for public provision of welfare services Financing Direct and indirect taxation of income

The social contract The public sector redistributes income over the life cycle The responsibility of individuals in the working ages towards children and the elderly is institutionalized in the public sector Enables and requires a high labour market participation rate of both men and women. Implies high tax rates by international standards High sensitivity to changes in demography

Aims of the retirement reform Maintaining the share of life in employment with increasing life expectancy (i.e. a constant labour force relative to population) Maintaining the current level of social pension relative to wage income

Age distribution of net contributions to the public sector per individual, 2004

Dependency Ratio and Old Age Dependency Ratio

Danish pension system Voluntary early retirement scheme from 60 years for individuals in the labour market Disability pension for individuals up to 65 years with diagnosed reduced ability to work Universal social security pension for individuals from 65 years Fully funded labour market related pensions (DC- schemes) Private pension schemes (DC-schemes)

Distribution of 50 – 80 years old population in 2004

Primary and total public budget relative to GDP

Baseline: Macroeconomic levels in 2040 in the projection compared to 2004 Real GDP has grown 92.8 percent Employment is reduced by 7.2 percent Private consumption has grown percent Public consumption has grown percent Fiscal sustainability requires an annual reduction in public expenditures of 4.0 percent of GDP

The retirement reform I The legal pension age of the VERP and the social pension is indexed to the life expectancy of a 60 year old average individual. The legal pension age of the VERP is increased by a ½ year in each of the years 2019 to The legal pension age of the social pension is increased by a ½ year in each of the years 2024 to 2027

The retirement reform II Starting in 2025 the legal pension age of the VERP is increased according the increase in life expectancy of a 60 year old in the period from The increase is announced in The legal pension age of the social security pension is increased according to the same increase in life expectancy – in 2030 (This keeps the pension period of the VERP constant). Legal pension age is increased by 0, ½ year, 1 year each fifth year after the initiation in 2025

Indexation of the legal pension age

Resulting labour market participation rates in 2005, 2030, 2050

Share of life in employment

Expected period as retiree

Employment effects

Primary and total public budget

Macroeconomic levels in 2040 given the retirement reform compared to 2004 Real GDP has grown percent (92.8 percent) Employment is reduced by 0.3 percent (7.2 percent) Private consumption has grown percent (106.4 percent) Public consumption has grown percent (119.8 percent) Fiscal sustainability requires an annual reduction in public expenditures of 2.2 percent of GDP (4.0 percent)

Time inconsistency? Current generations of voters close to retirement age are exempted from the gradual increase retirement age – whereas future generations of voters will experience this gradual increase Changes in the retirement age are introduced by ”jumps” in the retirement age of up to 1 years. This generates large annual changes in labour supply and potential problems in case troughs in business cycles.

Conclusion The retirement reform solves the problem of a declining labour supply (relative to population) The retirement reform solves approximately half of the fiscal sustainability problem in Denmark by maintaining a constant share of transfers to GDP The part of the sustainability problem that follows from the increased individual public services is not solved