Romas Lazutka Comments on THE CURRENT STATE OF LITHUANIAN PENSION SYSTEM AND DISCUSSIONS ON IT S REFORM Research Report P98-1023-R This research was undertaken with support from the European Union s Phare ACE Programme 1998. The content of the publication is the sole responsibility of the authors and it in no way represents the views of the Commission or its services.
Comments on THE CURRENT STATE OF LITHUANIAN PENSION SYSTEM AND DISCUSSIONS ON IT S REFORM by Romas Lazutka 1 Contents The starting point and rationale for pension reform 1 The future of the pension system 2 1 Associate professor, Vilnius University, Tel: +370 2 76 24 63, Mobile phone: +370 86 0 85 96, Fax: +370 2 76 18 90
THE STARTING POINT AND RATIONALE FOR PENSION REFORM The need for partial privatization of Social Insurance pensions is based on forecasts for the Social Insurance Budget. 2 The forecasts of MSSL indicate that excess funds will appear since 2004. This excess should peak (approximately 1,5% GDP) around the year 2015. Afterwards diminishing of excess funds will start and around the year 2040 the excess will disappear, and in 2055 the deficit of the Social Insurance Budget would reach the maximum limit of 1% GDP. After this the deficit will start reducing again. These calculations are based on the assumption that the Pension System is not reformed and that the retirement age is increased up to 65 years both for men and women. Changes of the Social Insurance Budget balance are based on variations of demographic indicators for the forecasted time period. The numerous generation born in 1960-1970 will be of the working age in 2004-2010, and the generation born during the War years, which is less numerous, is going to retire. The major argument for partial privatization of social insurance pensions, presented by A. Morkūnienė, is the risk that excess funds accumulated by the Social Insurance Fund may be used to increase pension benefits at the time such excess appears. To the author s opinion only individual private pension accounts could retain these amounts for pension benefits at time when both demographic situation would become worse and the Social Insurance Budget would experience deficit simultaneously. 3 Thus the need for and the time of the radical reform is based on the two following arguments: 1) the forecasted annual deficit of the Social Insurance Fund amounting to 1 % GDP, and 2) mistrust in the future Parliament Members, who may increase social insurance pensions around the year 2010-2015 without paying respect to the forecasted Social Insurance Budget deficit in the year 2050-2060. None of the above arguments seem to be sufficient to effect the radical Pension Reform, the results of which are less foreseeable compared either to the development of the existing system or to its parametrical reformation. Social insurance deficit up to 1 % GDP should not cause threat to Lithuanian economy. Only approximately 5,7 % GDP is spent for old age social insurance pensions. Even upon increasing these expenses by 1 % point, Lithuania would remain close to European countries having the lowest spending for pensions (see Annex 1). On the other hand, if there are intentions to accumulate funds in advance to cover the future deficit, it would be more reasonable to do this within the same Social Insurance Fund. Accumulation of temporary excess funds in it is cheaper than investment of these funds into individual accounts through private funds, as far as administrative costs for the latter would be much higher. Even under the current Social Insurance Law of the Republic of Lithuania, the Social Insurance Fund must have the money reserve. It has not been formed by now due to lack of revenue. 2 3 Morkuniene, A. The Political Economy of Pension Reform in Lithuania or Why Pension Reform in Lithuania has been Debated so Long? // Paper presented at the conference Practical Lessons in Pension Reform: Sharing the Experiences of transition and OECD Countries, Warsaw, 27-28 May 2002. P. 11. Morkuniene, A. 2002. P. 11.
2 In addition, there is another cheap possibility to leave the accumulating excess funds for covering future deficit. These funds would be just left with employers through reduction of social insurance contributions. In future, upon facing difficulties in financing pensions, they should be overcome through increase of social contributions, and even better through increase of either the VAT or (and) the corporate tax. Thus workforce would be made cheaper (in Lithuania it is burdened with relatively high income taxes and social contributions). Finally, it is hard to prove why the current Parliament Members, having to make a decision on partial privatization of pensions, would act more reasonably than the Parliament Members in 2010, who, as per initiators of the radical reform, would be more inclined to squander excess Social Insurance Budget without respect to the future deficit risk. The future Parliament will be closer to the forecasted change, will have more reliable forecasts and would be exposed to less uncertainty compared to 2002. Chart 1. mln.llt 0-200 -400-600 -800-1000 -1200-1400 The Balance of the Social Insurance Fund 1995 2000 2005 2010 2015 2020 2025 2030 Source: White Paper on Social insurance in Lithuania, Vilnius, 1995. The above-discussed argument for the partial pension privatization has an obvious ideological motivation. This statement could be judged from the fact that privatization was offered as a remedy when forecasting deficit of Social Insurance funds, and not only when forecasting excess funds. The Social Insurance White Book drafted with the World Bank s assistance in 1995 included Social Insurance Budget forecasts foreseeing only deficit of funds up to 2030. But such pessimistic forecast was also used as an argument for privatization of the public pension system. THE FUTURE OF THE PENSION SYSTEM Low social insurance old age pensions benefits and low spending for them opens an opportunity to prepare for society aging by limiting ourselves to moderate parametric pension reform in Lithuania. Its major direction should be defined by the two objectives usually raised for pension systems. The first one is avoiding poverty in old age. The second one is creating conditions for population to ensure compensation of income lost due to old age. The first objective in Lithuania may be implemented by strengthening the Social Insurance Pension System, and the second one by creating more favorable conditions for people to generate private old age savings. EU words similar targets in the pension area: ensure sustainability of public pensions and ensure wider diversity of private instruments.
3 The main problem of financial stability for Lithuanian social insurance pensions represents dramatic reduction in the number of active members of the system during the last decade. Old age was reached by the Lithuanian generation, who almost fully worked when being of the working age. Therefore, almost all the residents having reached the retirement age are entitled to pensions. While involvement of the working age generation into social insurance has reduced to a major extent. Of course, in order to finance pensions for a large number of pensioners by contributions of the decreased number of insured workers, the contribution rate is sufficiently high (25 % of wages). Therefore, under the Reform of 1995, the pension calculation formula was established with respect to these indicators, under which formula extremely modest pension values were set forth. If future pensions of the current working-age generation are also calculated under the existing formula, these pensions will be low, as well. Contributions paid even by average wage earners (1000 LTL) to finance pensions of the current pensioners generation will exceed income, which may be expected from the financed system by such person upon reaching the retirement age, by 1/3. The insured earning five average wages may not expect even half of the contributed amount. Redistribution to the benefit of the elder generation will not be effected only on the account of persons with very low income (earning the minimum wage and especially those with minimum insurance-covered time period). (See Table 1). Table 1. Redistribution among generations within Lithuanian Social Insurance Pension System* Salary (LTL) A 5 000 1 000 430 430** Contributed amount B 600 000 120 000 51 600 19 350 (LTL) Pension (LTL) C 1 138 338 224 101 Pension amount (LTL) D 273 120 81 120 53 760 24 240 D/B (LTL) 45,5 67,6 104,2 125,3 * The following were applied to calculate contribution amounts: the current contribution tariff for social insurance pensions - 25 % of the wages and 40 years of the insurance-covered time period was taken as the basis (except the ** marked case). The following were applied to calculate pension amounts: the existing pension formula and the presumption on the average pensioners living period 20 years - after reaching the retirement age. ** Contribution amount calculation was based on the assumption that contributions were paid for 15 years. The undue choice of financial sources and pension formula, rather than the very method of financing cause redistribution among generations. This problem should be solved through reduction of contribution rate and through covering the thus caused gap in funds by the general revenues (the State budget). Thus pension-funding burden would be spread to more numerous population. To the viewpoint of A. Morkūnienė, social insurance contributions and benefits need to be linked as closely as possible and, consequently, public pension systems financing opportunities depend upon such link. But experience of countries having national flat rate pension systems indicates that coping with non-payment of taxes is possible without any pension differentiation subject to amounts of taxes paid.
4 Due to population aging through increasing share of pensioners in the society, it may be hard to reduce poverty in the old age without a significantly increasing pension spending. Reduction of pension differentiation could represent a restrictive measure against the spending increase. The current old age pensions are not highly differentiated. Almost two thirds of pensioners receive pensions amounting from 200 LTL to 350 LTL. But this is caused by differentiation of wages received by the-then working current pensioners. Wages were not highly differentiated in the soviet period, and this is reflected on current pensions. Upon increase of differentiation in earnings, caused by transition to the market system, differentiation of wages has increased. This will have influence to pension differentiation of the currently working population. According to the pension formula in force, the potential highest and lowest pensions differ eleven times, or if calculated otherwise, the lowest pension represents only 8,7% of the highest pension (see Table 2). Income compensation ratio (pension vs. earnings ratio) for the highest and lowest pension beneficiaries is almost the same (22,8% and 23,5% respectively). Thus redistribution is almost non-existent in this case. It is true that redistribution exists between the highest pension beneficiaries and pension beneficiaries having earned average and minimum wages, but having a lengthy insurancecovered time period (40 years). For the minimum wage payees, the rate of income compensation is double compared to the income compensation rate for the highest pension (see Table 2). But even in this case the highest pension five times exceeds the pension calculated on the basis of the minimum wage. Table 2. State Social Insurance Pension Differentiation* Highest pension Pension for an average wage earner b/a Pension for the minimum wage earner c/a Lowest pension a b c e d f Pension A 1138 338,0 29,7 224 19,7 101 8,7 Salary B 5000 1000 20 430 8,6 430 8,6 A/B 22,8 33,8-52,1-23,5 - * The highest pension, the average pension and the minimum wage-generated pension were calculated for persons having 40 years of the socially insured time period and having respective income throughout the entire career the income amounting to five average wages, the average wage and the minimum wage. The lowest pension was calculated for persons having been insured only for 15 years and having earned the minimum wage all the time through. Therefore, even now the social insurance pension calculation formula applied in Lithuania opens considerable differentiation opportunities for old age pensions. Redistribution through the Social Insurance Pension system is not high. A person earning minimum wage, even having 40 years of the insured employment period may expect the pension only below the poverty line. 4 This means that increase of redistribution to the benefit of low pension beneficiaries would allow poverty reduction between pensioners without increase in spending. d/a 4 The relative poverty level for 2001, calculated as 50 % of the average consumption expenses in Lithuania amounted to 265 LTL.
5 Summing up: poverty reduction in the old age is possible through enlarging of social insurance pensions financing base (without limiting only to social insurance contributions) and through preventing future differentiation of social insurance pensions. Another objective of the pension system lost income compensation and retaining the living standard formed during the working age should be striven for through individual decisions to save. To this effect, the list of instruments suitable for old age saving should be enlarged. Pension saving in individual accounts of private funds (under Estonian, Polish models) is not the most suitable way. First, it provides for obligatory savings applicable even to minimum income payees, whose protection in the old age is ensured by the Social Insurance system. Second, individual participation in pension funds competing between them for customers requires high administrative costs. Individual accounts may be just an option for old age saving. A cheaper alternative could represent occupational pension schemes, popular in Western countries. They have several advantages. First, economy of scale is achieved due to collective participation. Second, such pension funds do not compete for customers, thus marketing expenses are avoided. Third, non-profit institutions are used, thus administrative costs are reduced. Therefore, with low and slightly differentiated social insurance pensions, higher income generating persons would have good incentives to take part in supplementary private pension schemes. This needs diversity of supplementary pension schemes.
6 Annex 1. Expenditure on pensions as a share of GDP in selected countries, 1999 (%) All pensions Old age pensions Belgium 11.6 7,4 Germany 13.0 10,3 Greece 12.7 8,5 Spain 9.9 7,4 France 13.5 10,7 Italy 15.1 11,3 Austria 14.0 8,1 Portugal 10.1 6,6 Finland 11.2 6,6 Sweden 12.2 9,2 United Kingdom 11.5 9,2 EU-15 12.7 9,5 Poland* 14.2 Slovakia 7.6 6,2 Slovenia 12.1 7,9 Latvia** 12.3 Estonia** 8,6 Lithuania 8.4 5,7 Source: Expenditure on pensions in Europe, http://europa.eu.int/comm/eurostat/ * Lindeman, D., Rutkowski M., Sluchynskyy O. The Evolution of Pension Sysytems is Eastern Europe and Central Asia: Opportunities, Constraints, Dilemmas and Emerging Practices. Room Document N 1, Session 1. 23-24 May, 2002. Sao Paulo, Brazil ** Katharina Müller. Old-Age Security in the Baltics: Legacy, Early Reforms and Recent Trends. No. 7/01.