THE POTENTIAL OF NON-FINANCIAL DEFINED CONTRIBUTION SCHEMES

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1 PART IV THE POTENTIAL OF NON-FINANCIAL DEFINED CONTRIBUTION SCHEMES IN OTHER COUNTRIES REFORMS 517

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3 Chapter 20 Investigating the Introduction of NDCs in Austria Bernhard Felderer, Reinhard Koman, and Ulrich Schuh* AUSTRIA, LIKE A NUMBER OF OTHER ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT (OECD) MEMBER STATES, faces the challenge of ensuring the long-term financial stability of the public pension system. In recent years the reform of the Austrian pension system has become a dominant issue in the political and public debate. Despite the fact that the Austrian government has implemented a number of far-reaching modifications of the pension system in the last decade, a comprehensive and persuasive reform is still out. This chapter addresses the issue of the long-term financial stability of the Austrian pension system by demonstrating the impact of different scenarios on expenditures, revenues, and replacement rates of the public pay-as-you-go (PAYG) pension system for the period 2000 to In addition, we describe the effects of the introduction of a multipillar system with a notional defined contribution (NDC) pillar. 1 We proceed as follows: the next section gives an overview on the provisions of the Austrian pension system prior to the most recent 2003/04 pension reform, provides some indications for the need to reform, and summarizes the most recent debate on pension reform in Austria. The following section describes the effects of a multipillar reform with notional accounts. We undertake projections for the Austrian pension insurance system and simulations of pension reform using the World Bank s Pension Reform Options Simulation Toolkit (PROST). We explain the required inputs and the assumptions underlying the different scenarios, and present the results that were obtained from the simulations with PROST. For the different labor force scenarios, the key results for a multipillar system with notional accounts are confronted with the results for the current monopillar system. The final section concludes. Retirement Income Provision and Pension Reform in Austria The Austrian public PAYG pension system consists of different schemes for employees; farmers; self-employed persons in commerce, trade, and industry; and some groups of * Bernhard Felderer is professor of economics in Cologne, Germany, and director of the Institute for Advanced Studies in Vienna; he may be reached at felderer@ihs.ac.at. Reinhard Koman holds a Ph.D. in economics and is currently working as an economist at the Institute for Advanced Studies in Vienna; he may be reached at koman@ihs.ac.at. Ulrich Schuh is the head of the Department of Economics and Finance at the Institute for Advanced Studies; he may be reached at schuh@ihs.ac.at. Helpful comments by Robert Holzmann, Yvonne Sin, Asta Zviniene, Hans Stefanits, Michaela Mayer-Schulz, Karl Grillitsch, and Reinhard Haydn are gratefully acknowledged. 519

4 520 PENSION REFORM: ISSUES AND PROSPECTS FOR NDC SCHEMES freelance professionals. Civil servants have their own retirement schemes, which are funded by their contributions and their respective public employers. The Austrian Pension System Prior to the Recent Reform Process The Austrian public pension system is mandatory for every worker except a small group of self-employed persons and those with very low earnings. Hence, coverage by the public pension system is very high: approximately 93 percent of the labor force is covered by the public pension system. The public pension schemes also provide disability and survivor benefits. 2 The Austrian pension system is financed mainly by the contributions of the insured, supplemented by transfers from other systems (for example, unemployment insurance and the family burden equalization fund) and a federal contribution that essentially covers the gap between revenues and expenditures. The pension insurance contribution for employees is 22.8 percent of the contributory wage, which is the part of the pay below the upper earnings threshold, of which percent is paid by the employee and by the employer. The contribution rate has more than doubled since 1956, when it was 10 percent. The contribution rates for self-employed persons in commerce, industry, and trade and for farmers are currently 15 and 14.5 percent, respectively. When the public pension system was extended to farmers and other self-employed workers, contributions were fixed at a rate similar to the employees contribution rate, with the government taking over a fictitious employer share. Some groups of freelance professionals pay 20 percent. The statutory retirement age for a standard old-age pension is 60 for women and 65 for men. Persons are entitled to an old-age pension if they have accumulated at least 15 years of contribution. In 1992, it was decided to raise women s statutory retirement age gradually until it is the same as it is for men. This adaptation will start in 2024 and finally be implemented by Five years earlier, between 2019 and 2028, the age limits for early retirement will be similarly harmonized. The age limits for early retirement due to long insurance coverage have been increased in recent years from 55 and 60 to 56.5 and 61.5 for women and men, respectively. The current basis of pension assessment is derived from the average salary during the highest-paying 15 years of contribution. Earnings in each year are revalued to the year in which the individual retires by a series of revaluation factors. The actual pension level is derived from the assessment basis by applying a replacement rate, which is calculated from increments credited for each year of contribution to the system. Currently, for each year of contribution, 2 percentage points, so-called increment points, are credited. The maximum replacement rate at the statutory retirement age is 80 percent of the assessment base, which is consequently achieved after 40 years of contribution. There does exist a bonus for later retirement and a penalty for retirement before the statutory retirement age. The deduction for retiring earlier is currently set at 3 percentage points per year, with 10.5 percentage points and 15 percent of the replacement rate as upper limits. The bonus per year is now 4 percent of the assessment basis. This bonus, however, is subject to the maximum replacement rate, 80 percent plus 2 percentage points per year after the statutory retirement age, with 90 percent as upper limit. The Austrian pension system has no provision for a minimum pension. However, a means-tested support for low-income persons is incorporated in the system by way of equalization supplements awarded to all those who have a general claim for pension payments and fall below the minimum income level. The means test takes into account the family income. The minimum income for nonmarried pensioners is approximately equal to half the median net income from active work earned by dependent employees.

5 INVESTIGATING THE INTRODUCTION OF NDCS INAUSTRIA 521 The annual adjustment of existing pension claims is based on the principle that the average pension and the average wage, both net of social contributions, should increase at the same rate. This makes sure that an increase in pension contributions would not only increase the burden on wage incomes but would also reduce net pensions. The adjustment formula also takes into account structural changes in pensions due to relatively high firsttime pensions and relatively low benefits for persons leaving the pension schemes, leading to an automatic increase of the average pension: the annual adjustment factor and this structural effect, approximately 1.5 percent per year, should add up to a net pension increase equal to the net wage increase. This principle of net indexation of pension increases curbs the growth of pension expenditures. This concept, however, makes any reductions in pension benefits for new pensioners ineffective with respect to overall pension expenditures: any reductions in average expenditures per new pensioner are automatically compensated for by increased benefits for existing pensioners. In addition to old-age pensions, the Austrian pension insurance provides benefits to survivors and disability pensions to invalids. A disability pension may be claimed on the condition that a certain amount of insurance years has been accumulated, always provided that the claimant is an invalid. The required number of insurance years depends on the claimant s age. Persons are in any case entitled to a disability pension if they have accumulated 15 years of contribution. The definition of invalidity varies depending on the type of work. If invalidity is due to an accident at work or an occupational disease, no minimum number of insurance years is required. The pension of a widow or a widower is 60 percent of the deceased spouse s (actual or hypothetical) pension entitlement in all cases where the survivor receives only this benefit and has no other income. In all other cases, the percentage depends on the income gap between spouses during their active working lives; the minimum was 40 percent until the recent reform and is now 0 percent. Orphans are entitled to an orphans pension until they have completed their eighteenth year of age, provided that the deceased parent has accumulated sufficient insurance years for a disability pension. The age limit is extended when the orphan is still in school, at university, in occupational training or incapacitated for work. Overall public expenditures for all kinds of pension benefits are relatively high in Austria. In 2000, public pension expenditures amounted to 14.5 percent of GDP, which was the highest value for all OECD countries. This figure has to be seen alongside the practically nonexistent funded pillar of the Austrian pension system. Nonpublic forms of social protection continue to be less important than they are in other Western countries, and funded schemes are quantitatively insignificant. 3 The Need for Reform Like any PAYG pension system, the Austrian public pension scheme is strongly affected by demographic trends. For decades, the Austrian pension system took advantage of the favorable relationship between contributors and retired persons. Since the middle of the 1980s, the constraints for the fiscal balance of the system became apparent, leading to a sequence of reform attempts. The official demographic projections of the Austrian Statistical Office, Statistics Austria, for the period , used in the calculations below, point to a rather uncomfortable development. 4 The main variant of the projections assumes an increase in the fertility rate from 1.34 per women to 1.5, and assumes that this stays constant thereafter. It is projected that life expectancy will rise during the projection period by about 6 years to 82 and 87 years for men and women, respectively. Net immigration is assumed to follow the recent trends and is projected to increase from about 17,000 persons to 24,000 persons in the year 2050.

6 522 PENSION REFORM: ISSUES AND PROSPECTS FOR NDC SCHEMES The assumptions described above imply that total population is projected to increase slightly until 2030, showing some decline afterward. It is expected that, until the year 2050, total population will increase by 100,000 persons to 8.1 million people. According to this projection, the period 2000 to 2050 will be characterized by a rather dramatic change in the age structure of the Austrian population. In the year 2000, the share of persons aged less than 15 years amounted to 16.7 percent of total population. The corresponding share of people with age above 60 was 20.7 percent. Until 2050, the share of young persons will decline to 13.2 percent, whereas the share of people aged above 60 will increase to 35 percent. The ratio of persons aged 60 and above with respect to persons aged 15 to 60 will climb from 33 percent in the year 2000 to 67 percent in The average age increases from 39.6 to The demographic trends imply a considerable deterioration of the conditions for the fiscal stability of the Austrian pension system. With a view to permanently monitoring the statutory pension insurance system, a committee was established the Committee on Long-Term Pension Sustainability which has the task of preparing long-term scenarios on the development of the statutory pension insurance system in three-year intervals. The first report was presented in the year The committee presented different scenarios resulting from different assumptions on the demographic development (that is, using different variants of the official projections of Statistics Austria described above) as well as the development of labor participation and productivity. All scenarios were developed on the basis of the legislation in force in the year In addition to the demographic development, the fiscal balance of the pension system is determined primarily by labor force participation. In this respect, the labor force participation of the age group is of crucial importance. Higher labor force participation of this age group implies both higher contributions and a reduction of expenditures because of later retirement. Three different scenarios for labor force participation have been used in the projections. The initial reference value for the labor force participation rate is 67 percent in the year All three scenarios assume an increase of labor force participation on the basis of the main demographic variant of Statistics Austria. The increase in the labor force participation rate is assumed to be driven mainly by higher participation of women and persons aged above 55. Until 2050, it is assumed that the participation rate increases to 72 percent (low scenario), 76 percent (medium scenario), and 84 percent (high scenario), respectively. Labor force participation of persons aged between 55 and 65 increases from 26 percent in 2000 to 43 percent, 53 percent, and 74 percent for the different scenarios in In the year 2000, the total expenditure of the general private sector pension scheme expressed as a share of GDP was about 10.5 percent. 5 In all scenarios this ratio increases steadily but slowly until the year 2015, with an acceleration of the increase in the period , and a slight decline afterward. Under the main demographic variant, the expenditure-to-gdp ratio increases to 15.6 percent (low participation scenario), 13.4 percent (medium scenario) and 11.5 percent (high scenario) in the year Another figure that reveals the fiscal burden of the pension system is the implicit contribution rate. This is the contribution rate that would be necessary to finance the pension insurance completely from contributions of insured persons, so that no additional transfers from the general government budget would be required. At present, the implicit contribution rate is 31.3 percent. According to the projections of the committee, this rate would rise to maximum values of 44.4 percent (low scenario), 40.7 percent (medium scenario), and 36.7 percent (high scenario). Based on a generational accounting exercise, Keuschnigg et al. (2000a, b, 2002), Koman et al. (2000), and Koman, Keuschnigg, and Lüth (2002) provide data about the intergener-

7 INVESTIGATING THE INTRODUCTION OF NDCS INAUSTRIA 523 ational incidence of recent fiscal and pension reforms and their effect on long-term fiscal sustainability. The authors calculated the actuarial implicit debt 6 of the isolated general private pension scheme for the year 2000 that is, the present value of the excess of projected pension expenditures, including means-tested equalization supplement over projected pension insurance contributions. According to the legal situation in 2000, the implicit debt of the general private pension scheme amounted to approximately 200 percent of GDP. In their analysis the authors also demonstrated the measures needed to dispose of the debt of the pension system. The drastic consolidation requirements following from this idea illustrate the still alarming dimensions of the sustainability gap in the pension system: a consolidation exclusively financed by an increase of pension contributions would have to more than triple contributions (an increase of percent) if it were to be limited to future generations that is, to cohorts born after Even if the increase in contributions were to be extended to all (current and future) generations, it would have to amount to an increase of approximately 70 percent. If, on the other hand, the consolidation were to be financed exclusively by spending cuts, it would mean an immediate reduction of pension expenditure by around 40 percent. It should be noted in this context, however, that a not-too-small part of the sustainability gap of the Austrian pension system is due to non-insurance-related benefit entitlements, particularly because insurance periods during which insured persons pay no contributions such as periods of unemployment, sickness, maternity leave, or military service increase pension claim. The results described above reveal the existence of a huge fiscal imbalance in the Austrian pension system. This is caused not only by demographics trends, but also by low labor force participation rates of the elderly, particularly after the early retirement age a rather distinctive feature of the Austrian pension system is the large share of early retirement pensions. To eliminate fiscal imbalance and to restore long-run solvency, it seems inevitable that the labor force participation of the elderly and the effective retirement age will have to be raised considerably. A key question is to what extent can the very low participation rates of the elderly be attributed to current incentive effects of the public pension system. Based on the method portrayed in Gruber and Wise (1999), Hofer and Koman (2001) provide an overview of the interaction between social security and retirement behavior in Austria and present the results of a series of simulations aimed at assessing the retirement incentives generated by the pension system. Austria has labor force participation rates at older ages that are among the lowest in similarly developed countries; participation rates have been falling dramatically in the postwar period and this process has even accelerated since the 1970s, particularly among men over age 55. Between the ages of 60 and 65, only about 10 percent of the population is in the labor force. To some extent, the sharp drop in labor force participation among the elderly must be attributed to major disincentives of the Austrian pension system; on closer examination, this system turns out to provide significant incentives to retire early. Hofer and Koman quantify these incentives by computing measures of social security wealth and of the implicit tax rates on continued work generated by the current system. The tax on continued work becomes quite large after the early retirement age; the implicit tax on additional work is particularly high, even before the early retirement age, for workers who are entitled to claim disability pensions or equalization supplements. Figure 20.1 summarizes labor force participation data and retirement incentives for Austria and the 11 countries covered by Gruber and Wise, presenting a scatter plot of the unused labor capacity and the tax force to retire. The unused labor capacity is defined as the unweighted average of the proportion of men not working in the age groups between 55

8 524 PENSION REFORM: ISSUES AND PROSPECTS FOR NDC SCHEMES Figure Unused Capacity versus Tax Force to Retire unused labor capacity Spain Canada Germany United States Sweden Japan United Kingdom Austria France Belgium Italy Netherlands tax force to retire 10 Source: Gruber and Wise 1999, Hofer and Koman (2001). and 65; the tax force to retire, an indicator intended to summarize the country-specific incentives for early retirement, is calculated as the sum of the implicit tax rates on continued work beginning with the earliest possible retirement age. 7 The measures for the tax force to retire range from values close to 10 (Italy, Belgium) to values only slightly higher than 1.5 (the United States, Japan). The tax force to retire calculated for Austria amounts to 5.88, which is close to the top rates in the sample, although it is still below the very top. As already documented by Gruber and Wise, the international comparison of labor market and retirement behavior shows a strong correlation between the tax on continued work and labor force participation; the solid line in the figure is a regression curve based on the regression of unused capacity on the logarithm of the tax force. About 80 percent of the variation in unused capacity can be explained by the tax force to retire. Austria has the second highest unused capacity in the sample, 65 percent (according to 1997/98 micro-census data), which is exceeded only by the Belgian value (67 percent). Pension Reform in Austria: Recent Reforms, Current Debate, and Reform Perspectives As mentioned above, since the mid-1980s the Austrian pension system has been the object of a sequence of reform attempts aiming at financial sustainability. However, the results presented in the previous section indicate that the fundamental underlying problems of the system have not been addressed adequately. In the year 2000, the new Austrian government emphasized the will to reform the Austrian pension system in its working program. A pension reform commission was appointed to discuss the long-run perspectives of the Austrian pension system. The reform commission has initiated a lively discussion on the direction of future reforms of the system and a number of proposals have been submitted. Another significant step in the reform process marked the most recent pension reform enacted in 2003 and 2004, which was to a considerable extent influenced by the discussions of the pension reform commission.

9 INVESTIGATING THE INTRODUCTION OF NDCS INAUSTRIA 525 Following Holzmann and Heitzmann (2002), proposals for reforming pension systems may be classified into two categories: parametric reforms adhere to the existing provisions of the PAYG pension system and tend to adjust the main parameters of the system (that is, contribution rates, retirement age, and replacement rates). Historical and most recent reforms of the Austrian pension system belong to this type of reform approach. The pension reform of the year 2000 raised the early retirement age by 1.5 years to 56.5 for women and 61.5 years for men, raised the deductions and bonuses for retiring before and after the statutory retirement age, and abolished the early retirement scheme that allowed retirement because of reduced working capacity. The most recent 2003 pension reform, which became effective with the beginning of the year 2004, will lead to a gradual abolition of early retirement due to long insurance periods until the year There will remain, however, some exemptions from this reform for blue-collar workers, depending on their age. The increments awarded for each year of contribution, which determine the replacement rate, are gradually lowered from 2 to 1.78 in This implies that the maximum replacement rate of 80 percent will be attained only with 45 years of contribution. The number of years included in the assessment basis will be gradually extended from currently 15 years to 40 years in the year In order to cushion the immediate effects of the reform, an upper limit of benefit reductions vis-à-vis the 2003 legal situation of 10 percent was introduced. A significant number of Austrian pension experts still advocate the parametric approach to reform the pension system. Proponents of this approach argue that the main factors determining the financial sustainability of the system are beyond the domain of the provisions of the pension system. Consequently, efforts to safeguard the long-term solvency of the system should concentrate on the main exogenous factors, which are, according to this view, economic growth and labor market performance. This view does not, of course, imply that this group of experts regards reforms of the pension system as unnecessary. An overwhelming majority of Austrian experts is in favor of harmonizing the currently rather diverse provisions of the pension schemes for different occupational groups, a situation that is considered not only to be in conflict with intragenerational fairness, but also to hamper labor market flexibility. There is also a broad consensus that there is a need to develop a consistent and transparent scheme for the currently very complex and unsystematic way in which the financing of the pension system is organized. This applies in particular for the current financing of fictitious insurance periods (such as child care, unemployment, sickness, and military service). Finally, the majority of Austrian pension experts endorses the extension of the assessment period to the whole working career. Parametric reforms, however, are unlikely to put pension systems on a long-run, stable financial footing. For politicians facing the option of setting the parameters of a PAYG pension system at a level that safeguards long-term fiscal stability, a problem of time inconsistency arises. 6 Following this argument, it seems more promising to undertake a comprehensive reform effort with clear and transparent rules. Whereas most effects of fundamental reforms could also be generated through parametric reforms, such a fundamental reform approach would have the advantage that politicians are able to convince the public of the necessity and fairness of the reform. A fundamental reform approach has been advocated by an increasing number of Austrian experts, particularly by Prinz and Marin (1999), Holzmann (2000b), Gauss (2000), and the Institute for Advanced Studies (Buczolich et al. 2001). What these proposals have in common is that they are based on a notionally defined contribution (NDC) approach, as it has already been implemented in a number of countries. 9 It is argued by all experts that a complete switch to a fully funded

10 526 PENSION REFORM: ISSUES AND PROSPECTS FOR NDC SCHEMES system is not realistic for Austria, as it would require immediate financing of the accruedto-date liabilities of the current PAYG system. It is proposed, however, that the current PAYG system is reorganized by introducing individual pension accounts where all contributions to the pension system are recorded, and pension benefits would be calculated on the basis of the contributions accumulated during the whole working career. These proposals imply the harmonization of the currently diverse occupational pension schemes. Central to these proposals is the idea that individuals will become convinced through this introduction of individual accounts that they will acquire tangible claims on future benefits by contributing to the system. This group of reform approaches explicitly aims to build a pension system that is equipped to sustain long-term changes in external conditions such as changes in fertility, mortality, productivity, or employment. Individual accounts would provide an exact description of the sources and the level of individual benefit claims. One of the most attractive aspects of these proposals is that they are able to contribute to a solution of the problems associated with the low actual retirement age: individuals can choose their optimal retirement age on the basis of their benefit levels, which depend strictly on contributions. Thus any adverse effects on labor markets are avoided. Financial stability of the system under this reform is basically introduced by using the growth rate of the contribution base as the relevant effective internal interest rate. A buffer fund shall help to smooth the expected long-term changes of fertility. Another important issue is the development of a funded pillar of the Austrian pension system. As mentioned above, funded pension schemes are practically nonexistent in Austria. In June 2002, the Austrian parliament adopted a government bill reforming the Austrian severance pay system. The reform aimed at improving the efficiency of the severance payment scheme. Among other goals, it was the intention of the Austrian government that the new scheme should form the basis of the underdeveloped second pillar of the Austrian pension system. However, the contribution rate to this scheme is set only to 1.53 percent of gross wages, and contributors may withdraw assets before retirement. 10 Another school of thought 11 has emerged that intends to mirror the benefit levels of the old system in the new pension accounts system by adapting the internal interest rates so as to reproduce, approximately, the current replacement rates. Such a benefit-defined pension accounts system, however, would not yet solve the problem of fiscal imbalance. An important issue in these reform proposals is also the time horizon for the transition into the new system. Most experts are in favor of a rather slow and smooth transition to the new system of pension accounts. The proposal of the Institute for Advanced Studies, however, explicitly proposed to switch to the new system immediately and to refrain from any transition periods. Long transition periods would make the overall pension system even more opaque and would only be fostering distrust in the system. In 2004, the Austrian government finally decided to introduce a harmonized system of benefit-defined pension accounts beginning January 1, This new pension system basically extends the 2003 reform for private sector employees to all other occupational schemes, including the civil servants scheme. The new pension law applies to all persons aged 50 years and less. A Multipillar Reform Model with Notional Accounts The following section presents, for a time horizon up to 2050, projections for the current Austrian pension insurance system and simulations of a multipillar pension reform with notional accounts, using the World Bank s Pension Reform Options Simulation Toolkit (PROST).

11 INVESTIGATING THE INTRODUCTION OF NDCS INAUSTRIA 527 The underlying demographic trends are based on the main variant population projection of Statistics Austria as described above. We consider five labor force participation scenarios, one based on the status-quo participation rates, one on the legal situation in 2000 taking into account the 2000 reform legislation and also including, between 2019 and 2033, the implementation of the already enacted increase in the female statutory and early retirement age up to the age limits applicable to men and the low, medium, and high labor force participation scenarios specified by the Committee on Long-Term Pension Sustainability appointed by the Austrian government (see above). 12 The main exercise here is to link the five labor force participation scenarios with four policy scenarios one scenario assuming that the current system remains in force and three reform scenarios. The initial reform measure is the move from the current notional defined benefit (NDB) scheme to a unified NDC scheme at the beginning of 2005, involving a complete switch of all active contributors, the harmonization of contribution rates, a full recognition of accrued rights, and a full protection of pensions already in payment. We compare the replacement rates of the newly retired and the financial flows contributions, expenditure, and current balance under those two regimes. As the switch to a defined contribution scheme implies the reduction of the internal PAYG rate of return to a sustainable level and thereby leads to a reduction in the replacement rate (at a given retirement age), we also investigate the effects of a second, mandated fully funded pillar on the total replacement rate, evaluated under two additional policy scenarios: contribution rates to the funded pillar of 5 percent and 10 percent, respectively. The civil servants pension schemes (for which sufficient data are often not available) are not included in the simulations. We also assume that the current size of the civil servant force, measured by the age- and gender-specific shares in total population, remains at its current level. Thus, employment effects of any labor force expansion will affect only the private sector. Objectives and structure of the next subsections are as follows: the next subsection introduces the input data determining the demographic structure of the pension system, age, and gender-specific information on contributors, beneficiaries, and length of service at retirement. It then describes how these data were generated and checked for consistency. The next subsections give a short overview of the underlying macroeconomic trends, the benefit calculation in PROST, and the trend in non-pensions-related expenditure. The fifth subsection deals in more detail with the multipillar reform specifications and the final subsection presents the results of the simulations. Additional details about the simulations can be found in the annex. Contributors, Beneficiaries, and Length of Service The labor force scenario determines the age- and gender-specific numbers of contributors. Nominal contributors account for all those to whom pension rights are accruing in a particular year. Not all of those people are actually employed and do actually contribute to the pension system. Some are, as described above, exempt and receive contribution credit for periods of nonemployment, as when they are recipients of unemployment benefits, sickness benefits, or maternity allowance, or are military servants or persons serving in alternative civilian service. Finally, up to four years per child are credited as periods of child-raising. To get the number of effective contributors, who actually pay pension contributions, PROST simulations require input of age- and gender-specific exemption rates. We apply the age- and gender-specific exemption rates of 2000 for the whole time period until Data on contributors have to be consistent with age- and gender-specific input data on old-age pensioners and disabled persons that is, with the number of eventual retirees in

12 528 PENSION REFORM: ISSUES AND PROSPECTS FOR NDC SCHEMES the cohort and the length of service they claim at retirement. Data on length of service at retirement are used, in the case of old-age benefits, in the PROST benefit formula, as described below. PROST adjusts input data on the number of old-age pensioners in order to ensure that the total length of service accrued by a cohort is equal to the total length of service claimed by the cohort at retirement. To avoid an adjustment of retirees beyond what would be consistent with the underlying scenario, input data for the length of service were derived from given data on contributors and retirees for each cohort by a separate procedure. Further details can be found in the annex. The starting point of the simulations and the base case is the status-quo scenario, in which the age- and gender-specific shares of nominal contributors in the population remain constant at the year 2000 level. Flows of old-age pensioners and disabled persons over the simulation horizon are principally based on the flows, as a percentage of the age- and gender-specific population, observed at the beginning of the simulation horizon. These flows were then adapted in such a way that, over the whole simulation horizon, the stock of pensioners and disabled persons has, as a share of the age- and gender-specific population, a peak that is consistent with the peak in the nominal contributors. Finally, the age and gender profile of the average length of service at retirement was derived from the data on contributors and retirees. Input data on length of service by age and gender in 2000 are based on a random sample provided by the Austrian ministry of social affairs and generations. The scenario 2000 legal situation takes into account the increase of the early retirement age from 60 to 61.5 for men and from 55 to 56.5 for women between 2000 and 2003 and, between 2019 and 2033, the increase in the female statutory and early retirement age up to the age limits applicable to men (65 and 61.5, respectively). People who would have retired under the base case and are now denied that possibility were to some extent assumed to claim disability; we used the available pension entry data, as far as the 2000 reform is concerned, and assumed, as far as the harmonization of retirement ages is concerned, a share of 10 percent in the case of men and a share of 30 percent in the case of women. This leads, after the harmonization process, to a gender convergence in the age-specific population shares of disabled persons. The rest of those prevented from retiring were not completely assumed to enter the labor force and become nominal contributors: a significant number of new retirees at the early retirement age are moving from out of the labor force into retirement and are therefore not likely to enter the labor force simply because this age limit is raised. Finally, again the age-and-gender profile of the average length of service at retirement was derived from the data on contributors and retirees. In the remaining scenarios the low, the medium, and the high participation scenario specified by the Committee on Long-Term Pension Sustainability the labor force increases are translated into additional numbers of nominal contributors. We take into account, however, that these additional contributors will not necessarily imply a one-to-one reduction in the stock of pension recipients; some of them will be mobilized from out of the labor force. Furthermore, the substantial increases of female participation rates will also lead to additional pension claims of women who would not have satisfied the minimum contribution requirement and would not have qualified for a pension in the base case. Again, length-of-service data were derived from the data on contributors and retirees. The number of recipients of survivor and orphan benefits is taken from the recent longterm report of the committee. They do not depend on the labor force participation scenario. Macroeconomic Trends The annual rate of labor productivity growth is set at 1.8 percent, the average value in recent years. Real wage growth is linked to productivity growth, which implies that the

13 INVESTIGATING THE INTRODUCTION OF NDCS INAUSTRIA 529 wage income share in GDP remains at its level at the beginning of the simulation horizon and GDP growth equals wage sum growth. We also maintain current age and income profiles and current income differentials between men and women. Finally, we maintain the age- and gender-specific unemployment rates of 2000 for the whole time period until The real interest rate is set at 3 percent, and the long-term inflation forecast at 1.7 percent. Pension Benefits PROST offers the opportunity to provide input for the average survivor and the average orphan replacement rates, which are defined as the average survivor benefit and the average orphan benefit as ratios of the average covered earnings, for the base year, the end year, and any year in between. We take into account the 2000 pension reform. In Austria, survivor benefits depend on the relative lifetime incomes of spouses. Until 2000, the pension of a widow or a widower was, depending on the income gap between spouses during their active working lives, 40 to 60 percent of the deceased spouse s (actual or hypothetical) pension entitlement. The 2000 reform abolished the 40 percent floor. If the assessment basis of the surviving spouse is more than 2.5 times higher than that of the deceased, that spouse s pension is now 0. We take account of the reduction of the average survivor replacement rate in 2001 due to this reform. Furthermore, because increasing participation rates of women lead to additional and higher pension claims on their own behalf and reduce income gaps between spouses, we adjust the average survivor replacement rate according to the increase in women s own pension claims. For new old-age pensioners and new disabled persons, replacement rates in the base year, the end year, and any year in between, again in terms of the average covered earnings, can even be specified by age and gender. Data on the average new old-age pension and the average disability benefit in 2000 by age and gender are available from a sample provided by the Austrian ministry of social affairs and generations. We use these data for the simulation of disability benefits and take into account the fact that the average disabled person s replacement rate will also be determined by people who would have been old-age pensioners under the base case, but who claim disability in one of the other scenarios. For old-age benefits, PROST offers also the use of a benefit formula that automatically, year by year, calculates old-age pension benefits, based on given input data on required years of service, length of service at retirement, the incremental replacement rate, the maximum replacement rate, actuarial deductions for early retirement, the assessment period, indexation of earnings included in the assessment base, and minimum benefits. 13 Finally, the Austrian system of pension indexation had to be implemented into the simulation by iteration. Other Expenditures Non-pensions-related expenditures are assumed to grow in line with GDP that is, other pension fund expenses as a percent of GDP remain at the level observed at the beginning of the simulation horizon, which is 0.9 percent. Multipillar Reform Specifications The multipillar reform specifications required for the simulation comprise important assumptions about the NDC and the fully funded pillar. As mentioned above, all contributors, without any exemption, are assumed to be transferred to the new system at the beginning of 2005, the assumed time of reform. Pensions already in payment are 100 percent protected and pension rights accumulated by those not yet retired are fully recognized and translated into notional initial capital. The pension entrants of the reform year receive the replacement rate promised under the old law, and accrued rights of still-active

14 530 PENSION REFORM: ISSUES AND PROSPECTS FOR NDC SCHEMES contributors are calculated as a pro rata proportion of the pension that could have been expected under the old law, depending on the number of working years spent in the old system. The PAYG contribution rates are harmonized at the current level in the blue- and white-collar workers scheme, 22.8 percent of gross wage income, which yields a harmonized rate of about percent if the contribution base is grossed up by the part of the contribution paid by the employer (12.55 percent). Furthermore, we introduce a pensioner contribution rate of 2.3 percent on pension payments. 14 As the notional interest rate we choose the growth rate of the covered wage bill, which incorporates changes in the number of contributors and most closely corresponds to changes in revenue. For annuitization we use unisex mortality tables. Pension benefits (also pensions from the old system) are indexed for inflation, and the inflation rate is also the annuitization interest rate that is, the only interest being paid on the balance postretirement is what has been specified as indexation. The reform is assumed to decrease or increase PAYG benefits to disabled persons, survivors, and orphans by the same proportion as PAYG old-age benefits. Finally, as in the NDB simulation, non-pensions-related expenditures grow in line with GDP. The long-term nominal rate of return in the funded pillar is 4.75 percent (based on the interest and inflation forecast), which is a relatively modest assumption. For annuitization we use again unisex mortality tables, and annuities are indexed to inflation. Results Tables 20.1 through 20.5 present the main results of the simulations. The projected numbers of contributors and beneficiaries in the status quo labor force participation scenario show the crucial effect of the expected aging process on the demographic structure of the population. At the beginning of the simulation horizon, about 49.1 percent of men and about 39 percent of women are nominal contributors. Under the current participation rates, population aging would translate into a decline in the population share of contributors down to 40.5 percent and 31.9 percent, respectively. Pension recipients, on the other hand, rise considerably, from 17.2 to 30 percent of the population in the case of men and from 18.0 to 31 in the case of women. The increase of survivor benefits is less remarkable; orphan benefit recipients will be slightly reduced. An increasing labor force participation, however, can have a powerful impact on the demographic structure of the pension system. Under the most optimistic participation scenario, the ratio of contributors in the male population could almost be held at the current level and the ratio of female contributors could even be raised close to the same level. Accordingly, the ratio of old-age and disability pensioners in the population would be at about 24 percent for both men and women, which is considerably lower than they would be in the worst case. This would imply, however, a substantial increase of the average retirement age, even above 65, the current statutory retirement age for men. The tables also present, in terms of the economywide average contribution base, projected average replacement rates of new old-age pensioners in the current pension system and in a multipillar system over the simulation horizon to 2050, based on the different labor force participation scenarios. According to the base-case projection, replacement rates of new old-age pensioners in 2005 would be about 79 percent in the case of men and 47 percent in the case of women. Until 2050, the average replacement rate of newly retired men would remain roughly at the current level and female replacement rates would go slightly up, to 50.5 percent. In the 2000 legal situation scenario, the average replacement rate of male retirees would grow slightly above the current level and female replacement rates would increase to approximately 57 percent. Under the same labor force participation scenario, a multipillar reform as described above would, until 2050, reduce replacement rates in the first pillar to about 41 percent of

15 INVESTIGATING THE INTRODUCTION OF NDCS INAUSTRIA 531 Figure 20.2a. Replacement Rate, NDC Pillar Men rate (percent) Women rate (percent) status quo scenario 2000 legal situation scenario low scenario medium scenario high scenario Source: Authors calculations. Note: 0 = status quo scenario; 2 = 2000 legal situation scenario; L = low scenario; M = medium scenario; H = high scenario.

16 Table Status Quo Scenario Men Nominal contributors 49.1% 48.5% 47.9% 47.0% 45.2% 43.2% 41.7% 41.1% 40.9% 40.7% 40.5% Old age pensioners and disabled 17.2% 18.9% 20.5% 22.0% 23.9% 26.1% 28.0% 29.1% 29.6% 29.9% 30.0% Survivors 1.0% 1.0% 1.1% 1.2% 1.3% 1.3% 1.4% 1.5% 1.5% 1.5% 1.5% Average retirement age Average length of service Women Nominal contributors 39.0% 38.8% 38.6% 37.8% 36.2% 34.3% 33.1% 32.7% 32.4% 32.2% 31.9% Old age pensioners and disabled 18.0% 19.8% 21.3% 23.0% 25.1% 27.3% 29.0% 29.8% 30.4% 30.8% 31.0% Survivors 10.6% 10.7% 10.9% 11.1% 11.4% 11.9% 12.4% 12.8% 13.0% 13.1% 12.9% Average retirement age Average length of service Orphans 0.6% 0.6% 0.6% 0.6% 0.6% 0.6% 0.6% 0.6% 0.6% 0.6% 0.6% Average replacement rate of new male old age pensioners NDB (current scheme) 79.1% 79.4% 78.7% 78.6% 77.8% 77.5% 78.0% 78.8% 78.8% 78.4% NDC 79.1% 75.6% 71.1% 66.7% 61.7% 56.8% 52.3% 47.6% 41.8% 35.4% NDC + FF 5% 79.1% 77.2% 74.1% 71.3% 67.8% 64.5% 61.3% 58.0% 53.2% 47.5% NDC + FF 10% 79.1% 78.7% 77.2% 75.9% 74.0% 72.1% 70.3% 68.4% 64.7% 59.6%

17 Average replacement rate of new female old age pensioners NDB (current scheme) 46.8% 47.2% 48.2% 48.6% 48.0% 47.0% 47.8% 49.1% 49.8% 50.4% NDC 46.8% 44.6% 42.8% 40.1% 36.5% 32.9% 30.5% 27.9% 23.9% 21.3% NDC + FF 5% 46.8% 45.6% 44.7% 43.0% 40.4% 37.8% 36.4% 34.9% 31.6% 29.2% NDC + FF 10% 46.8% 46.5% 46.6% 46.0% 44.3% 42.6% 42.4% 42.0% 39.3% 37.1% NDB (current scheme) financial flows Employer and employee contributions 7.4% 7.5% 7.5% 7.5% 7.5% 7.5% 7.5% 7.5% 7.4% 7.4% 7.4% Total contributions 7.4% 7.5% 7.5% 7.5% 7.5% 7.5% 7.5% 7.5% 7.4% 7.4% 7.4% Old age and disability pensions 8.2% 8.8% 9.6% 10.5% 12.0% 13.7% 15.2% 15.9% 16.2% 16.5% 16.7% Survivor and orphan pensions 1.7% 1.6% 1.7% 1.7% 1.8% 2.0% 2.1% 2.1% 2.2% 2.2% 2.1% Total expenditure 10.8% 11.4% 12.2% 13.2% 14.7% 16.6% 18.2% 19.0% 19.3% 19.6% 19.7% Current balance 3.4% 3.9% 4.7% 5.7% 7.3% 9.1% 10.7% 11.5% 11.9% 12.2% 12.3% NDC financial flows Employer and employee contributions 7.7% 7.7% 7.7% 7.7% 7.7% 7.7% 7.7% 7.6% 7.6% 7.6% Total contributions 7.9% 7.9% 7.9% 8.0% 8.0% 8.0% 8.0% 8.0% 7.9% 7.9% Old age and disability pensions 8.8% 9.4% 10.0% 11.0% 12.1% 12.7% 12.4% 11.8% 11.0% 10.1% Survivor and orphan pensions 1.6% 1.6% 1.6% 1.7% 1.7% 1.7% 1.7% 1.6% 1.5% 1.3% Total expenditure 11.4% 12.0% 12.6% 13.6% 14.8% 15.4% 15.1% 14.3% 13.4% 12.3% Current balance 3.5% 4.0% 4.7% 5.6% 6.8% 7.4% 7.1% 6.4% 5.5% 4.4% Source: Authors calculations. Note: Contributors and beneficiaries in percent of population; contributions and benefits as percent of GDP.