THE URBAN INSTITUTE GERMAN EMBASSY. Social Security and Pension Reform in the United States: Lessons from Europe Friday, July 27, 2001

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1 THE URBAN INSTITUTE GERMAN EMBASSY Social Security and Pension Reform in the United States: Lessons from Europe Friday, July 27, 2001 Experts from nine European Union Member States and the European Commission discussed social security and pension reform in an Urban Institute workshop hosted by the German Embassy. Ambassador Wolfgang Ischinger of the Federal Republic of Germany and Urban Institute president Robert Reischauer introduced the event. Senior Urban Institute Fellows Rudolph Penner, Eugene Steuerle, and Lawrence Thompson moderated the sessions and addressed implications for U.S. Social Security reform. After a brief overview of demographic conditions in European Union member states with comparisons to the United States, experts discussed details behind member states' current and considered reforms. The presentations were followed by a roundtable discussion among all speakers, and questions from the audience, on issues including benefit growth indices, demographic drivers of long-term financing, political challenges, and social costs. Presentations were given by: Declan Costello, economist, Directorate-General for Economic and Financial Affairs, European Commission Ole Settergren, economist, National Social Insurance Board, Sweden Henk Becquart, Advisor to the Minister of Social Affairs and Pensions, Belgium Salvatore Giovannuzzi, statistician and actuary, Social Security Institute, Italy Christoph Schumacher-Hildebrand, director, Federal Ministry of Labor and Social Affairs, Germany José M. Marco, managing director of budget control, Social Security, Spain Mark Heholt, pensions policy expert, Department for Work and Pensions, United Kingdom Pedro Marques, Adviser to the Minister of Labor and Solidarity, Portugal Jens-Christian Stougaard, senior economist, Confederation of Trade Unions, Denmark Hubert Martin, counselor for labor and social affairs, French Embassy DEMOGRAPHIC CHALLENGES AND BEYOND IN EUROPE

2 Population projections for the EU indicate that the ratio of persons of working age (15 to 64) to those aged over 65 will decline from 4.1 in 2000 to 2.1 in While the total population is not expected to increase, the elderly population will increase from 61 to 103 million and the number of persons older than 80 will almost triple from 14 to 38 million. Failure to prepare for the budgetary impact of ageing could complicate the conduct of the monetary policies in the euro zone, and is one reason for enhanced co-operation on pension at EU level. National projections indicate that spending by EU member states on public pensions would increase to between 3% and 5% of GDP in most countries, and that ageing could lead to average increase in public spending of 5%-8% of GDP. In addition, simulations show that the demographic changes could lead to a fall in the annual growth rate by 0.5% due to a decline in the size of the labour force. Maintaining EMU budgetary rules (Stability and Growth Pact), will help countries meet the budgetary costs of ageing, and at the same time help keep tax burdens at reasonable levels. Regular exchange of information on national pension reforms- as agreed in June 2001 at the EU summit in Göteborg-, and policies to increase employment rates (especially of older workers) will also be key factors. A comprehensive report on the quality and sustainability of pension systems will be sent to the European Council by December A LOOK AT EUROPEAN SYSTEMS The Swedish Pension Reform Faced by largely the same demographic challenges as other OECD countries, Sweden opted in 1992/1994 for a radical reform of its national old-age pension system, a process supported by five parties and some 85% of members of Parliament. In effect, Sweden moved from a traditional income related defined-benefit system, to two types of defined-contribution systems. The old system was financed more or less on a pay-as you-go basis. In the new system, about 14% of contributions will go into individual financial accounts under the financial defined-contribution system (FDC), while the remaining 86% will be channelled into the new pay-as-you-go system. Financial accounts are managed by a variety of private funds chosen by the individual. The equivalent of 16% of each individual s annual pensionable income will be credited yearly to his or her notional account under the Notional Defined Contribution System (NIC). The corresponding amount is transferred on monthly instalments to the system s Buffer Fund, similar to the Trust Fund of the United States federal pension system, which finances pension payments. Recently significant liberalisation has been introduced in the investment rules for the funds, 70% of which can now be invested in equities. The new system has no formal age of retirement. Pension credits will always be earned and added to the notional (as well as financial) accounts if the individual has pensionable income, regardless of age. Pension credits are given for all social insurance benefits in the nature of income replacement, such as sickness, unemployment, disability, and maternity/paternity benefits. In addition pension credits will also be given for some activities such as childcare years, university studies and compulsory national service. Pensions from the pay-as-you gosystem are calculated at the time of retirement by dividing the notional-account balance by a life expectancy at retirement. Those with insufficient contributions throughout their careers will be entitled to a minimum guaranteed pension, paid for by general taxes. The guaranteedpension is indexed by the change in the Consumer Price Index.

3 Because of the commitment to keep the contribution rate fixed, the new system will accommodate demographic and economic developments by adjusting the value of the pensions. The automatic balance mechanism legislation, the final piece of pension reform legislation adopted in May 2001, ensures this. The mechanism provides for a switch in indexation basis for pensions from growth in the average income to the internal rate of return of the NDC system if liabilities in the system should exceed assets. The pension level is automatically re-established, as is the growth in average income as the basis of indexation, as soon as this is possible without undermining the financial balance of the system. Social Security and Pension Reform: the Belgian Pension System The objectives of the pension reforms in Belgium are: securing the first pillar of the pension system, making participation in the second pillar a right for everyone, and banning poverty. The first pillar, a pay-as-you-go system, has benefits for everyone within minimum and maximum limits and takes into account periods of unemployment and sickness. Reform objectives include higher minimum pensions that follow salaries, and regular adaptations of the oldest pensions. The reduction of public debt in Belgium and the favourable budgetary situation between 2000 and 2010 have created budgetary margins above the increased cost of an ageing population. Between 2010 and 2030 however, the retirement of the baby boom generation leads to increased pension and health care costs and budgetary constraints. As a result, a rise in the effective age of pensions (a difficult issue) and the creation of a demographic reserve fund (Silver Fund)-an accelerated debt reduction mechanism- are envisioned. The second pillar should become a real complement to the first pillar for everyone. A law to this effect has been accepted by the government, and has been submitted to parliament. The goal of the new legislation is to make adequate supplementary protection via social pension funds available for the many, not the few because at the moment the second pillar has only a penetration rate of 33% in the work force. Pension plans will have to be offered to all workers in the sector or company, and will have to meet a number of social criteria if they are to benefit from a supportive tax regime. The creation of sectoral funds (branch-wide) is anticipated, entrenched in the existing system of sectoral collective bargaining. More information will be provided to the employees, in the form of annual reports. Since the system is meant to facilitate early retirement, the retirement age will be a topic of discussion. Because the eradication of poverty is not an explicit goal of the first two pillars, a new law modernizes the guaranteed income for the elderly, one of two means-tested type of benefits for the elderly. The benefits were augmented, and the amounts exempt in the calculation of the other means of the elderly were raised with increased equality between man and women and married and unmarried couples. Pension Reform in Italy In 1969, a full pay-as-you pension system was introduced, but expenditures in the 70s and 80s soared as a result of a reduction in the retirement age and of legislative measures, which increased benefits in real terms for more people. In the 1990s reforms were enacted which, among other things, raised the retirement age and the number years required for pension entitlement, and also made it possible to postpone retirement until after the maximum retirement age. Contribution rates for employees were lowered, and different contribution rates were introduced for the self-employed and informal

4 workers. At the same time, indexation of existing pensions was partially frozen, the minimum pension levels were raised and pensions benefits were extended to people who were not covered by any benefit before the law. The reforms have led to a reduction in average pension benefits under the first pillar of the Italian pension system, and a reduction of 1.5% in the pension expenditure/gdp ratio. The Italian welfare system still has a bias towards pensions as compared to expenditures in areas like unemployment. Yet the reforms have lead to a system oriented towards a threepillar structure, with the first pay-as-you-go pillar progressively providing less coverage, and the second pillar (the occupational provision of pensions) and the third pillar (personal policy subscriptions) gaining in significance. Pension Reform in Germany The profound modernisation of the old-age security system was adopted by the German parliament on May 11, 2001 in response to demographic and social developments. By taking all these measures, the contribution rate to the pension insurance of 20.3% still applicable in early 1999 is forecasted to remain below 20% until At the same time, by 2030 the net income replacement ratio will fall to between 67 and 68 per cent, as compared to 70 per cent today. Hence, the pension reform includes the further development of the second pension pillar : the introduction of a voluntary, capital-funded provision for old age, which complements the statutory old-age pension insurance. This provision will be intensely promoted by governmental subsidies and is particularly designed to support those with a lower income and families with children. It will take effect on January 1, Investments qualifying for promotion include occupational pension schemes, such as direct insurance and pension funds as well as pension insurances, funds and bank savings plans as private, capital-funded provision for old-age. The insured will only pay his/her own contributions; the state subsidy will be paid directly into the promoted contract at the request of the insured. The new promotional scheme also seriously improved the conditions for an increase in occupational pension schemes on the basis of collective agreements between the social partners. Other characteristic features of the German pension reform include: return to wage-oriented pension adjustment improvement of old-age security for women (including incentives to enter and remain in the labour market) closing pension gaps in the beginning of an insurance history improvement of information by pension insurance funds pensions will offer basic protection for everyone, according to need reform of pensions for reduced earning capacity The Pension System in Spain The pension system in Spain is built on three pillars. The general contributory scheme, financed on a contribution basis of 28.3 % by employers (23.6%) and employees (4.7%), is currently financially stable as a result of recent increases in activity rates in the labour market. The system covers general retirement, disability and survivors pensions. The non-contributory scheme, financed through taxes, provides for minimum pensions and retirement benefits for those who have been unable to contribute sufficiently to the system. Finally, since 1987,

5 complementary pensions out of the social security framework have been introduced, with success thus far limited to occasional individual users. Increased economic growth and employment levels in Spain, combined with the retirement of the civil war generation and the net effects of immigration, have improved the dependency ratio and mitigated the challenge of the demographic evolution in the short term. Still, the Toledo Pact of 1995 initialled a permanent and broad social dialogue on reform efforts, leading most recently to the April 2001 Agreement for improvements and development of the system of social protection. Central to the reform process undertaken thus far is the establishment of the Reserve Fund in The Fund is scheduled to accumulate up to 1% of GDP by Policy measures linked to the employment policy, include stricter limits on contributions in the contributory scheme and incentives for the over 65 population and women to increase participation in the workforce. Other policy measures include more flexible early retirement schemes, revaluation of pensions in accordance with the Consumer Price Index, and clearer links between real contributions throughout the career and pension benefits. The UK State Pensions System The UK has four tiers to its pension systems: state social security benefits for pensioners, which consist of a basic flat rate state retirement pension and a state earnings related pension scheme (SERPS) occupational pension schemes, offered by employers third pillar pension schemes established by private insurance companies underpinning all the above, a state minimum guarantee, which any pensioner will be topped up to by the state if his or her pension income falls below the minimum The challenge for the pension systems in the UK is not their cost, but the growth in income inequality among pensioners. Too many people have difficulty adding on to their flat-rate basic state old age pension. SERPS by its nature results in low wage earners ending up with small pensions, and also people such as carers who have periods out of the labour market are poorly catered for. And, occupational and private pensions have tended to benefit the better off most. The strategy of the current government is therefore to making savings during the career more desirable and possible, and to protect those who cannot save because of low earnings or other circumstances with a State Second Pension (S2P) from The S2P will provide more generous additional pensions for low and moderate earners, certain careers and people with a long-term illness or disability. In addition, in 2003 the existing Minimum Income Guarantee (MIG) for pensioners, available to those whose total income falls below a level set each year by Parliament, will be replaced by the pension credit which should provide extra help to the poorest pensioners and reward those with low or modest incomes (for example from occupational pension schemes). The cost associated with the new measures will increase spending on pensions to 1% above the rise in GDP by 2050, a moderate increase in spending. Pension Reform in Portugal In the overview of pension reform in Portugal, the distinction was made between the contributory scheme of the private sector workers system, which covers the invalidity

6 pension, the survivors and the general old-age pension and the non-contributory scheme, which offers a social pension to those not covered by the general contributory scheme. The value of the means-tested social pension is always under the minimum amount of the general scheme. The need for reform of the system stems from the substantial increase of the elderly dependency ratio from 19.5% in 1990 to 33.5% in Despite the fact that the ratio is projected to be the second lowest in 2030 among the EU countries, the USA, and Japan, the system would become financially unsustainable. To improve the level of social protection and assure financial sustainability at the same time, reform measures are aimed at providing a boost in economic growth by an increase in labour productivity, as well as in immigration and in women participation in the labour market. Further steps include better pensions for low-salary earners, a revised pension calculation formula (based on the entire career), and the creation of a Reserve Fund with mandatory annual inflows from part of contributions and surpluses. According to the new Basic Law, future plans should include support for the development of the 3 rd pillar, an adaptation of the Civil Servants Scheme, and a future study of new sources of funding. The Danish Pension System The Danish pension system went through a reform process for the better part of the last decade. In total, the movement towards more weight on a funded system with less weight on pay-as you-go- financing of pensions has continued. The special element of individual savings in the first pillar of the pension system, the state retirement and statutory schemes were described. One of the main changes has been the introduction of labour market pension schemes for privately employed blue- and white-collar workers, which were established in and established the second pillar the pension system even more firmly. Similar schemes already existed earlier for public servants and academics, or on a company basis. The new schemes are based primarily on collective agreements between employers and employees and are typically sector-specific. The targeted contribution rate in the private sector is 9% of wages and salaries by 2003, 2/3 financed by employers and 1/3 by employees. The agreement-based schemes cover those who receive a salary from an employer. Pension contributions are not made for people receiving unemployment benefits, sickness benefits etc. The new agreement-based labour market pensions are typically placed with life-insurance companies that are owned by both the employer organizations and the unions. That means that in reality every financial investment decision is the result of a collaborative process. In the long term 85 to 90% of future pensioners are expected to receive a labour-market pension. Also highlighted was the increase in pension savings under schemes taken out by individuals themselves, with a bank or life insurance company. The development of this third pillar has been strongly influenced by particularly favourable tax rules. Retirement Pensions in France The French retirement pension consists of a wide variety of individual programs. Most programs, however, consist of a basic pension and a supplementary pension. The Basic Plan (Régime Général) covers most private sector employees. The programs are managed by executive boards with representatives from employers and employees.

7 While the system has been successful with an average replacement rate of 80% and the average retiree household income approaching that of the average worker household income, financial problems loom on the horizon. The declining birth rate and the increase in the number of retirees has a negative impact on the dependency ratio. Without reform, pension expenditures as part of GDP could rise from 12.6% (2000) to 16.7% in Reforms have been enacted since 1993 in the basic pension plan, with changes in the number of contribution years required to enjoy pension rights and in the calculation of the reference wage for the pension amount. Pensions will also be adjusted to the price index instead of the wage index. The supplementary pension plans have been reformed as well. Recently a Reserve Fund was created which should accumulate around $ 150 billion by The reserve will be funded in part by the present surplus of the basic program, a special tax and the interests of the sums left in the fund. Additional measures include the creation of a Council for Pension Orientation, and steps to increase the comparatively low participation on the labour market for those over 54. COMPARISONS OF REFORM STRATEGIES Roundtable Discussion The roundtable discussion between experts and the audience questions, which followed the main presentations, raised a wide variety of issues. 1. Public Finances and Labour Market Reforms A majority of experts hold the opinion that the pension reforms in Europe are not so much the result of concerns over the demographic evolution, but rather instigated by the catastrophic state of public finances in the EU in the early 1990s and the need for labour market reform. Both are key factors in the success of any pension reform, together with the need to base the reforms on the broadest possible social consensus considering that sometimes the adjustments put a financial burden on the system in the short term. 2. Use of Pension Reserve Funds in Europe The establishment and management of the funds is not subject to much political controversy in most countries. The Funds are mostly seen as buffer, sometimes temporary, against worst-case scenarios rather than a central component of the new systems. Financial investment rules vary from country to country. 3. Adjustment of pension benefits after retirement Different rules exist, but every system has an automatic adjustment provision linked to the consumer price index or the wage index. The remaining life expectancy sometimes plays a role as well. 4. Political sustainability of the reforms Experts agree that this is a sensitive issue given the impact of demographics on voting patterns. Information on what the situation would have been if no reforms had been enacted was a key tactic in many European countries. 5. Self-employed Opinions differ on the issue of whether the desire to include the self-employed in the new systems under a higher contribution rate might conflict with the need for more start-up businesses in Europe. In Spain and Denmark, the contribution rates and the rules for the self-employed are not all that different, whereas in the UK the self-

8 employed continue to pay less but also get lower benefits. Reform discussions with this diverse group are not easy. 6. Health care cost Experts agree on the lower cost of health care as an important factor in the absence of debate on increasing health care costs for the ageing European population. France spends 9% of GDP on health care, one of the highest rates in the EU, while the US spends 14% of GDP. In addition, health care in most EU countries is financed through taxes so the link between contribution and benefit is less visible. In the UK, for example, there is a striking difference in public opinion between health care, seen as the responsibility of the state, and pensions where individual responsibility is allowed to play a greater role. 7. Labour force participation rate Only in Sweden did the need for increased participation in the labour force as a vital complement to pension reform not seem to be an issue. In most European countries, more working hours, the need to harmonize labour supply and demand, an improvement of the marginal tax rates, better child care facilities and labour policies targeted towards women were on the agenda. In this context, the integration of partial retirement into reform plans is not a priority in Europe. In Sweden, few people seem to take advantage of the new flexible rules in this area, whereas France wants incentives for employees to stay active after 60 rather than the other way around. Given the stable youth dependency ratios in Europe, and the relatively low education budgets in comparison to pensions, savings on education or lowering the below productivity age are not seen as politically viable options. European forecasters also do not have much evidence that increased labour productivity or immigration significantly affects the financial sustainability of pension reforms. A more important factor is the unknown evolution of the ageing process itself over the next decades. 8. Planning The planning horizon in Europe for forecasting the financial sustainability of pension systems in Europe is generally not as long as in the USA. Most European experts set the limit at 2050, because by that time the effects of the baby boom will have been included in most countries. In addition, after 2030, models become more unpredictable as even small changes in assumptions point to serious budgetary repercussions. 9. Individual accounts in retirement systems The role of these accounts varies from country to country. Spain, for example, has no tradition in this area. In Belgium and the UK the use of individual accounts is voluntary, whereas in Sweden and Portugal the accounts are mandatory. In Sweden, for example, those who do not choose a mutual fund are assigned the default fund, run by a government agency. Should this number of non-choosers increase, a legitimacy problem could arise. The management of mandatory individual accounts systems did not seem to present insurmountable problems in Europe. One of the reasons is that, unlike in the USA, governments generally already possess the information they need from pensioners. In Sweden, the switch to individual accounts took longer than expected because of legal, administrative and IT problems, but now the system works fine. Generally these accounts are add-ons to existing pension systems, but not always entirely separate from them. On average, they are more widespread among higher income earners. 10. Influence of disability on pension right. European countries have a variety of provisions in place, which guarantee the pension

9 rights of the disabled. Often, like in Denmark, the disabled enjoy a higher pension. In the UK, disability is treated as if you had an income from labour. In Sweden the government pays the contributions for the disabled, and disability schemes are entirely financed by taxes, separately from the pension system. 11. Attitude of the younger generation toward pension reform In general, younger people tended to be largely indifferent to this issue. European opinion polls register some scepticism that the forecasted future benefits will actually materialize, as well as increasing support for capital funded pillars of the system. For the EU Presidency, Bart Deelen Tel bart.deelen@diplobel.org