FISCAL IMPACT OF PENSION REFORMS Kiev, May 2004 Luis Fernando Alarcón Mantilla PRESIDENT ASOFONDOS DE COLOMBIA Luis Fernando Alarcón Mantilla PRESIDENT ASOFONDOS DE COLOMBIA

AGENDA 1.The Problem 2.The Cash–flow Impact 3.The Implicit Pension Debt 4.The Political Economy of Pension Reforms

“Defined Benefits (DB) Systems” become financially unbalanced, and require transfers from the Central Budget. The Reasons: Design Problems Demographic Change Institutional Rigidities Legal Considerations Political Pressures These, and equity consideration, have motivated reforms. THE PROBLEM

To create “Defined Contribution (DC) Systems” which, by definition, are financially balanced. However, the so called “fiscal impact” or “fiscal cost”, has become the main obstacle to pension reforms. What is the problem? THE PROBLEM

AGENDA 1.The Problem 2.The Cash–flow Impact 3.The Implicit Pension Debt 4.The Political Economy of Pension Reforms

Ft: Transfer from the Central Budget to the pension system, in period t. THE CASH–FLOW IMPACT

At the beginning, Ft increases because: It´s necessary to pay people already pensioned. New Contributions go to DC system. Recognition Bonds are fully paid when people become pensioned.

THE CASH–FLOW IMPACT However, which curve has a higher PV depends on: Discount rate (interest on Government Debt) Assumptions on salaries, coverage, demography, etc. How unbalanced the DB system is. Time Horizon.

THE CASH–FLOW IMPACT Tipically the incremental cash needs require: Stronger fiscal adjustment and issuing new public debt. New sources to buy the new debt: Savings of DC system. For the economy as a whole, the short-term scenario may be quite similar. The choice for the Government is. Implicit vs. Explicit financing. Implicit debt vs. Conventional debt.

THE CASH–FLOW IMPACT Conventional practices are biased against Pension Reforms: “the current accounting systems can be said to unjustly penalize reformer countries when multilateral institutions such as the IMF focus on current déficit and convencional debt targets”. (Holzmann, Robert Palacios, y Asta Zviniene. “Implicit Pension Debt: Issues, Measurement and Scope in International Perspective”, The World Bank, Social Protection Discussion Paper 0403, March 2004).

AGENDA 1.The Problem 2.The Cash–flow Impact 3.The Implicit Pension Debt 4.The Political Economy of Pension Reforms

THE IMPLICIT PENSION DEBT IPD: Present Value of pensions to be paid, based on accrued rights. According to present practices IPD is not recorded in the public sector balance sheet. However, usually IPD >> Public Conventional Debt.

THE IMPLICIT PENSION DEBT Source: Holzmann, Robert Palacios, y Asta Zviniene. “Implicit Pension Debt: Issues, Measurement and Scope in International Perspective”, The World Bank, 2004 Public Debt, Pension Spending and Implicit Pension Debt.

THE IMPLICIT PENSION DEBT There is an ongoing discussion on this issue: FMI - “the treatment of pension Schemes in Macroeconomic Statistics: And Electronic Discussion Group”. Central Topic: the nature of pension debts.

THE IMPLICIT PENSION DEBT According to the Government Finance Statistics Manual: “ it is considered that social security schemes do not result in a contractual liability for the government, i.e., there is no direct link between the contributions made and the benefits eventually paid. Indeed, it is not uncommon for governments to change unilaterally the structure of benefits (e.g., by changing the circumstances under which the benefits become payable or the amount of the benefits)”.

THE IMPLICIT PENSION DEBT As one contributor to the EDG puts it: “... Pension obligations are not like debt, because pensions can be changed by statute at any time... Stick with what is legally required, such as paying debt...” (Henry Aaron, the Brookings Institution) More attention is needed on specific characteristics in different countries.

THE IMPLICIT PENSION DEBT In Colombia, when somebody fulfill the requirements to get a pension (DB System) acquire a right, Constitutionally protected. That means that the Minister of Finance can go to jail if defaulting on those payments. It would be easier to default on the Government Bonds. When legal adjustments have been made on DB System parameters, the changes apply far into the future.

AGENDA 1.The Problem 2.The Cash–flow Impact 3.The Implicit Pension Debt 4.The Political Economy of Pension Reforms

THE POLITICAL ECONOMY OF PENSION REFORM To reform DB System in developing countries is becoming harder. There are strong pressures to reverse reforms already made. For developing countries, to agree on an Economic Program with IMF is life or death. To have acces or not to the financial markets. Higher or lower spreads.

THE POLITICAL ECONOMY OF PENSION REFORM But current practices imply: Stay on DB pension systems Reform priority: short term cash, e.g. increase contributions For already reformed systems partial or total reversal is a magnificent way to “improve” fiscal position Not to make the true fiscal adjustments. On my view point this is the single most important issue for pension reform.