International Comparisons
Sustaining Pension Systems and Ensuring Adequacy: Is it Robbing Peter to Pay Paul?
Speech
March 2004
Theo Langejan
Chairman
Social Protection Committee of the Europena Union
A
Balancing Act: Achieving Adequacy and Sustainability in
Retirement Income Reform
Brussels, Belgium
Ladies and Gentlemen,
Over the past three years, the European Union has developed a much closer cooperation among Member States on pension issues. This policy area used to be completely out of bounds for the EU, and there is no intention to shift responsibilities from the Member States to the European Union. However, there is now a strong consensus on the usefulness of closer cooperation. The main reasons for this are:
- The realisation that we face similar challenges and that we therefore have much to learn from each other;
- The fact that the success or failure of one country can affect the others, for instance by destabilising the common currency or by reducing the pensions of migrant workers who, as a result, will have to rely on means-tested benefits in their country of residence;
- And, finally, the fact that we share similar values as regards the social protection of older people - something which is easily forgotten in view of the huge diversity of pension systems across the enlarged European Union.
The type of cooperation on pension issues that we have established at EU level is referred to as the 'Open Method of Coordination', a working method that is inspired by the policy coordination in the areas of economic and employment policies. We are looking at ways in which adequate pensions can be maintained - or, in some cases, achieved - in a financially sustainable way.
The Social Protection Committee, which I chair, played a leading role in the development of the open method of coordination. It was first applied to the goal of promoting more inclusive societies and combating poverty. We then moved on to the area of pensions where our colleagues from the economics and finance ministries who gather in the Economic Policy Committee had already started analysing the budgetary implications of demographic ageing.
We strongly felt, in the Social Protection Committee, that the challenge of ageing to our pension systems calls for a comprehensive approach, one that considers at the same time the social and financial aspects. What is the point of achieving financial sustainability by reducing pensions to such a level that we have once again problems of widespread poverty in old age? That would not be neither socially nor politically sustainable. Conversely, we also have to recognise that pensions can only be adequate in the long run if they are financed in a sound way. We could not have public borrowing at a level of five or ten percent of GDP every year to finance pensions.
With the comprehensive approach embodied in the open method of co-ordination on pensions we look beyond the narrow confines of public pension schemes and their parameters and try to identify policy strategies that can reconcile the apparently conflicting goals of social adequacy and financial sustainability. A major focus has been - and still is - the contribution of higher employment and longer working lives to both adequacy and financial sustainability. By looking at the interactions between social protection, employment and budgetary policies, we can break out of a debate on the future of pension systems that simply pitches the interests of one generation against those of another: the active against the retired, the young against the old, Paul against Peter. And it helps avoid the false idea that the future of adequate pension provision depends on the choice between financing pensions on a pay-as-you-go or on a funded basis.
At the heart of the open method of coordination is a set of common objectives which are shared by all Member States. In the area of pensions, we agreed on 11 common objectives, which, I think it is safe to say, can easily be subscribed to by the ten new Member States who will be joining the EU in two months. These common objectives were used by the Member States to structure the presentation of their national strategies for adequate and sustainable pensions in the second half of 2002. They are also the focus of common indicators that are still being developed and that are crucial for a better understanding of national policy strategies and their strengths and weaknesses. You can find all the details of this first round of national strategy reports on the Commission website and in particular in the Joint Report by the Commission and Council on Adequate and Sustainable Pensions of which some hard copies are available.
Let me briefly recall those eleven common objectives. They cover the three broad areas of adequacy, financial sustainability and modernisation.
Adequacy is of course the raison d’être of our pension systems. But what exactly do we mean by adequacy? And do Member States not have very different conceptions of what it means to have adequate pensions? I do not want to deny the fact that pension systems differ enormously from one Member State to another. But these difference concern the way in which broadly the same goals are pursued.
We have been able to identify three objectives under the heading ‘adequacy’:
The first objective refers to the need to prevent poverty and social exclusion among the elderly. The elderly should share in the economic well-being of their country and be able to take an active part in public, social and cultural life. This objective can be achieved through a universal flat-rate pension as we have in the Netherlands, Denmark or Ireland - provided the level of benefits is sufficiently high to keep people above a relative poverty threshold. In the area of social exclusion, we consider that people who have less than 60 % of the national median income are at risk of poverty.
But of course, pension systems in all countries do more than just providing a bare minimum to the elderly. This recognised by the second of our common objectives which concerns the possibility of maintaining one’s living standard after retirement. Most current and future Member States consider that this is, up to a certain earnings level, a task of the statutory public pension schemes - which are mainly managed by public institutions and financed on a pay-as-you-go basis. However, in Sweden and several acceding countries inspired by the Swedish pension reform, the statutory pension scheme is managed in part by the public and in part by the private sector. In the Netherlands and Denmark, it is left to the two sides of industry to establish occupational, or second-pillar, schemes which allow workers to maintain their living standard after retirement. In Ireland and the UK, public policy focuses strongly on creating opportunities for individuals to build up sufficient savings for retirement.
The last objective under the heading ‘adequacy’ invites Member States to promote solidarity both within and between generations. It invites us to look at the economic and social situation of older people compared to people of working age and thus at the way in which resources are shared between the active and the retired. But this objective also implies that we look at the way in which the resources of pension systems are shared among older people - or the distributional impact of pension policies.
The next group of five objectives concerns the financial sustainability of pension systems. These objectives refer to different and mutually reinforcing ways of securing the future affordability of adequate pension provision.
The first objective with regard to financial sustainability is to achieve a high level of employment. Demographic ageing causes a financial challenge to pension systems because it results in a less favourable balance between people in employment and people in retirement. We have considerable scope for raising employment levels in the EU and thereby sharing the cost of providing for the elderly more widely.
We are particularly interested in raising the employment rates of older workers - and this is reflected in the second of our financial sustainability objectives. Prolonging average working lives has a strong impact on the financial sustainability of pension systems. Employment incentives in pension and other benefit systems should therefore be strengthened and pension systems should no longer be used to patch up labour market problems. This has been a major focus of the Social Protection Committee's recent work and we have just finalised a report on how various social protection schemes could contribute to higher employment rates of older workers.
The Lisbon European Council set precise targets for employment rates to be reached by the EU as a whole by the year 2010. The overall employment rate should rise to 70%, the employment rate for women to 60% and the rate for people aged between 55 and 64 to 50%. And, finally, the average age at which people withdraw from the labour market should be raised by 5 years by 2010.
Another common objective concerns the link between pension systems and public finances in general. Clearly, unsustainable public pension schemes are a threat to sound public finances. The objective therefore calls for reforming pension systems with the aim of maintaining the sustainability of public finances. But, conversely, sound public finances allowing the reduction of public debt or even the creation of dedicated pension reserve funds provide a way for making room for manoeuvre in the preparation for the increased age-related public expenditure. Countries like Belgium, Greece and Italy spent more than 5% of their GDP on interest for public debt. So reducing debt from levels around or even above 100% of annual GDP to the limit set by the Maastricht criteria, that is 60% of GDP, can represent a huge step in terms of preparing for the implications of ageing for public finances.
The fourth financial sustainability objective refers to the need to strike a fair balance, in terms of financial burdens and pension benefits, between the active and the retired populations. Adjustments to the levels of benefits and contributions or taxes will determine how the burden of demographic ageing is shared between the active and the retired at a given moment in time. There were some discussions about whether we should also be concerned with fairness between successive age cohorts, for instance by trying to ensure that there is a more or less constant rate of return on pension scheme contributions over time. However, this proves rather complicated for reasons I will discuss in a moment.
The last objective under the heading ‘financial sustainability’ concerns funded pension schemes. They are expected to play an increased role in providing incomes for pensioners across the EU and in many acceding countries. Our common objective calls for a review of the management and regulatory framework for such pension provision to ensure efficiency, affordability and security against financial market risks.
The third and last group of common objectives concerns the modernisation of pension systems in response to the changing needs of the economy, society and individuals. Again, and just like financial sustainability, this is a condition for achieving the goals of adequacy.
The first objective calls for pension systems to be adapted to the requirements of modern labour markets characterised by increased flexibility and mobility. We have to ensure that part-timers, people in temporary employment, the self-employed and people who change jobs can obtain adequate pension coverage. This calls for universal coverage by pension schemes and for a good coordination between schemes so that people who move from one scheme to another do not lose some of their pension entitlements.
The second modernisation objective calls for pension systems to be examined from the gender perspective. The European Union has championed equal opportunities since the Treaty establishing the European Economic Community which required Member States to ensure that women and men receive equal pay for equal work. We also have directives on the equal treatment in social security schemes of men and women, but different retirement ages and differences in survivors' benefits are still possible under this legislation. Whether such different treatment is really still useful is another matter: it tends to be based on the assumptions that women look after the home and the family, whereas men earn the household's main income. Maintaining such different treatment of men and women in social security entails the risk of cementing old gender role models by penalising those families which break with the traditional male breadwinner model. However, we have to acknowledge that many women retiring today and over the next few decades will have earned less during their working lives than man, due to earnings differentials and more frequent and longer career interruptions in the case of women. So pension systems will have to pay special attention to the needs of women - who of course outnumber men among the retired. There are different ways of ensuring adequate incomes for older women: they include pension credits for career breaks, survivors' benefits and the sharing of pension entitlements in the event of a divorce.
The final objective calls for greater transparency and adaptability of pension systems. This is a precondition for maintaining confidence in them. A well-informed public debate and the development of a broad consensus on reforms require reliable information on the long-term perspectives of pension systems. But individuals should also have a clear idea about their own pension prospects so as to enable them to make any additional provision for retirement that they may consider necessary.
So far, I have not talked much about Peter and Paul - even though they are in the title of my presentation which asks the question whether pension systems are in fact robbing Peter to pay Paul. The common objectives put a lot of emphasis on redistribution by calling for a decent minimum income for all the elderly and for solidarity between and within generations. But this should not make us forget that the main purpose of pension systems is to ensure that Peter's and Paul's income can be spread over their entire adult lifetime.
Most people are perfectly able to earn a decent living for themselves and their children. But this income is earned during a limited period of time - typically between the 20 and 60 years of age. This represents a total of 40 years out of a total life span that is nearly twice as long on average. Women who are reaching retirement age today tend to have even shorter working lives on lower earnings - and a longer life expectancy. So pension systems have to make the income earned during one's working life last for another long period that can be longer than half the working life - much longer if, for instance, survivors' benefits have to be paid as well.
Pension systems are not just savings schemes which set aside a large proportion of an individual's income for the time after retirement. There are very important insurance elements involved as well. First of all, there is uncertainty about the age up to which an individual is able to work. This needs to be covered by invalidity insurance. Then there is the longevity risk - a risk worth taking, I would say - or the risk that one outlives one's retirement savings. And finally there is the risk of income loss due to the death of one's spouse; this risk is taken care of by survivors' benefits.
These are complex financial tasks - combinations of savings and insurance operations spanning, for many individuals, periods well in excess of half a century. These are time periods in which momentous political and economic changes occur so that planning becomes almost impossible. If we look back over the past 50 years, we had remarkable political stability in the current 15 EU Member States and on the whole very favourable economic conditions. But this is very exceptional. The acceding countries all experienced radical political change during the second half of the 20th century with many borders being redrawn. The Central and Eastern European countries also had to make the difficult transition to a market based economy.
During the preceding 50 years, the first half of the 20th century, Europe was ravaged twice by war and suffered economic crises on a scale that we have not seen since in Western Europe. Going back another 50 years in time, we are in the second half of the 19th century, a period marked by the industrial revolution and rapid urbanisation - the conditions that made the establishment of our social protection systems necessary because families and rural communities were no longer sufficient as social safety nets.
With such high degrees of instability and uncertainty over the time frames that are relevant for pension provision it is understandable why states play such an important role in pension systems. States are the only institutions that can survive the major upheaval that Europe experienced over the past century - or at least states can repair the consequences.
Governments also have an important role to play in ensuring that people start putting aside money for their retirement from an early age. It takes a considerable effort sustained over the entire working life to provide for twenty or more years of consumption after retirement. In the absence of compulsory pension schemes, many people would reach retirement age without having acquired sufficient pension rights.
Public pension schemes finally have the advantage of being cheap to run. They can be set up for the entire population, there are no marketing costs, there is no need to tailor pension products to individual needs and asset management is cheap because there are not many assets to be managed. In fact, contributions to a pay-as-you-go pension scheme are like an investment in the future labour force of a country: the return depends on future employment and productivity across the economy. It is difficult to achieve a wider risk spread within a given country than through a pay-as-you-go pension scheme!
So far I have argued that pension systems do not rob Peter to pay Paul assuming that both belong more or less to the same age cohort: the primary purpose of pension systems is not to redistribute between individuals, but to spread a given individual's income over time. The bulk of money going through a pension scheme serves this income spreading function, even though pensions systems do contribute to the general goal of social justice and redistribution, especially when a pension scheme delivers universal flat-rate benefits and is financed from progressive taxation.
But could pension schemes not operate another robbery on a massive scale - robbing not Peter to pay Paul, but robbing, let's say, Kevin and Jennifer, to pay Peter and Paul. Or, to put it in other words, taking large amounts of contributions from the young to pay the pensions of the old, without being able to guarantee good pensions for Kevin and Jennifer when they will reach retirement age. This raises the question of fairness of pension systems across successive age cohorts.
Again, I think it is useful to put this question into a longer historical perspective. Pay-as-you-go pension schemes could offer pensions to people who had never contributed to the scheme before. But did they get something for nothing from the younger age cohorts? The first beneficiaries of a new pay-as-you-go pension scheme had certainly made their contribution to the development of their country. And those who financed those first pensions with their contributions would certainly have accepted the responsibility for looking after their elders if the latter did not have enough resources to live on. Moreover, pay-as-you-go pension schemes were able to share the rapidly growing resources of a country recovering from the disaster of a war or major economic crisis in a fair manner between the old and the young.
Clearly, pay-as-you-go was the right choice at the time for countries which rapidly needed a modern social protection system that allowed younger people to move independently of their elderly parents and make the best use of the opportunities of a modern labour market. And pay-as-you-go was also the right solution to dealing with the massive destruction of assets due to wars or economic crises that would have deprived entire cohorts of the resources they would have needed for their old age.
We all know of course that demographic ageing will change the balance between contributors to, and beneficiaries from, pension systems. Some claim that this will provoke the financial collapse of pay-as-you-go pension schemes which they consider as the likes of pyramid investment schemes which pay the promised high returns to savers with the deposits of new savers - until the inflow of fresh savings stops and the whole scheme collapses.
Pay-as-you-go pension schemes certainly face the prospect of diminishing revenues due to shrinking working age populations, and they will have to serve increased numbers of pensioners. But they are adaptable and many reforms are already responding to these demographic changes. In principle, it would be possible to raise contribution rates so that the current benefit levels can be maintained. However, the trend of many reforms is to limit the required increase in contribution rates by lowering the level of benefits that is available at a given retirement age. If future pensioners want to reach the living standards of current pensioners, they will have to work longer or make additional provision for old age through private schemes.
It is very difficult to assess what adjustments to pension systems achieve the greatest fairness between successive age cohorts, between the Peters and Pauls, on the one hand, and the Jennifers and Kevins, on the other. Generational accounting has been used to try to provide an answer, but this methodology is not particularly robust. Moreover, we should try to take into account the fact that successive cohorts have experienced very different historic and economic situations; some experienced the deprivations of wars, others experienced economic prosperity - and raised fewer children, which should enable them to save more for their retirement.
To make things more complicated, the demographic ageing that is projected to take place over the coming decades is a combination of several developments: first there is the transition from cohorts with high fertility to cohorts with low fertility: the baby-boomers reaching retirement age. Then there is growing life expectancy: our demographic projections assume that life expectancy will rise by almost five years until the year 2050.
The baby-boom effect is of a transitional nature. Pension systems, whether funded or pay-as-you-go financed, will share the available GDP between the young and the old. Who bears most of the burden of this transitional demographic shift depends on whether contributions are raised or benefits lowered, either by cutting monthly pension amounts or by raising the age from which pensions can be received. In the case of pay-as-you-go schemes, the parameters are well known and are set by political decisions; in the case of funded schemes, there is an element of uncertainty about the rate of return of the assets held by the funds which is likely to be affected in some way by the demographic situation.
The other element of ageing, that is increasing life expectancy, raises a fundamental question about retirement. As we live longer in good health, we need to ask ourselves whether it makes sense to stick to the current retirement ages. How important is it to us to have a long period of leisure after the age of 60 or 65, knowing that we will be in good health and could be earning a living? Are we ready to pay much higher contributions to finance an ever longer period of leisure or would we rather postpone our retirement in line with increasing life expectancy and have more freedom to use our income during our working lives - or even take more leisure before retirement?
We do not need to have the same answer to these questions for all. There is now a trend towards more flexibility with regard to the retirement age. So people will be able to decide for themselves whether they want to retire early on a low pension or later on a higher pension. If they find that public pension schemes do not offer sufficient opportunities to build up enough pension entitlements for retirement at a relatively early age, then individuals can save through private, complementary schemes.
But we have yet a long way to go before we get pension systems that would give individuals more control over how they want to respond to the prospect of increased life expectancy. And of course, this also presupposes that individuals have opportunities to make the most out of the increased flexibility of pension systems: that their health status and qualifications allow them to remain on the labour market and that they are not discriminated against because of their age. And it presupposes that they can afford private pension provision.
For a majority of people, we can certainly create the conditions that would allow them to find the right response to the challenge of ageing. Solidarity in pension systems will, however, remain important for those who are unable to earn sufficient incomes and pension rights. But this solidarity is widely supported in our societies and would certainly not be regarded as robbery!
Thank you for your attention.