Heikki Oksanen European Commission Directorate-General for Economic and Financial Affairs

1. Heikki OksanenEuropean CommissionDirectorate-General for Economic and Financial Affairs Pension Reforms in the European Union: An Assessment of the Present Situation and the Challenges Ahead Conference “Pension Reform in the European Union: Comparing the Different National Approaches”, Cicero Foundation, Paris,10-11June, 2004 Views expressed are exclusively those of the author and should not be attributed to the European Commission. (Version 9.6.2004)

2. The challenges stem mainly from demographic factors (low fertility and increasing longevity). Nothing much can be done about them, thus, the pension systems have to be adjusted. There are also other important issues (changing work patterns etc.). Main reference for analytical issues: Heikki Oksanen: “Pension reforms: illustrated basic analysis”, DG ECFIN Economic Paper 201, April 2004, and CESifo Economic Studies 3/2004

3. Wide variety of pension systems in the EU However, the main concerns relate to the relatively generous pure PAYG public pension systems in Continental Europe These systems have their understandable and acceptable historical reasons: • pension funds lost in the 1930s • suffering from WWII • after WWII generation worked hard and accumulated wealth (collectively and privately)

4. Conceptually: A pure PAYG emerges only if some generations receive benefits having contributed less than actuarial value of their pensions (which can have been justified) Once established and matured, a pure PAYG can be fair if the age structure of population is stable However, this is exactly what is now NOT the case !

5. People are aware that there is a problem, but they do not know how serious it is and how drastic reforms are necessary. It is also not easy to know as to how fairness across generations should be interpreted. – The time span is, say, 60 years, thus it is easy to get confused by many unknown and uncertain factors.

6. The root of the problem is population ageing, illustrated by the increase in the old age dependency ratio (OADR) which increases from 40% to 70% …. … mainly due to declined fertility and increasing longevity.

7. Figure 1. Old age dependency ratio* in EU-15, 2000-2050 * ratio of population aged over 60 years to those aged 20-59 years. Source: Eurostat projection

8. Figure 2. EU15: Total fertility and completed fertility Total fertility: number of births in a given year per number of women, weighted by age-specific fertility rates of the respective calendar year, 1970-2002. Completed fertility: number of children by birth year of the mother, 1940-1966. The two times scales overlap by 30 years reflecting the average childbearing age.

9. Stylised data example: At work at age 20-59, initial longevity 78, replacement rate 60%. If population is stationary, contribution rate in a pure PAYG is 27% of wages. Fertility declines from 2.1 to 1.7, longevity increases gradually to 83, retirement age constant >>> expenditure increases to 45% of the wage bill.

10. Figure. Old age dependency ratio* in EU-15, 1995-2050, and the stylised model projection

11. Stylised data example (2): In a pure PAYG, with constant benefits and retirement age, contribution rate would increase to 45%. The same principle of fairness which prevails in a pure PAYG under stable population requires that contribution rate be increased for the first generation with low fertility and increasing longevity. Result: a rate of 38%, together with proceeds from the fund, will cover the expenditure (indefinitely).

12. Stylised data example (3): Or, if contribution rate is not increased, the replacement rate need to be reduced from 60% to 36% ! Or, retirement age needs to be increased to 66.3. Thus: for fairness, the required combination includes • increased contributions (now !) • reduced pension rights • later retirement Under plausible assumptions funds to be accumulated 100-150 % of GDP in 60 years, of which 2/3 in 30 years

13. Two main blueprints: 1. A reformed and partially funded Defined Benefit system, possibly partially privatised. 2. A transition to a Notional Defined Contribution system, possibly accompanied by a fully funded second pillar

14. In either option: 1. Incentives for later retirement should be strengthened. 2. The ratio between accumulation of pension rights and contributions paid by prime age workers must be reduced.

15. The accumulating funds need to be managed, either in public or in private sector entities: • Reducing public debt, • Creating a specialised public/private pension fund investing various assets (Finland), • A mandatory second pillar, funds managed by privately managed pension funds, • Non-mandatory occupational pension funds, • Voluntary pension saving (tax incentives?) In all cases big effects on financial markets and institutions !

16. Notional Defined Benefit system: • Fixed contribution rate • Notional individual accounts • Rate of return (roughly) equal to the rate of increase of the wage bill • Capital at retirement transformed to an annuity

17. Transition to NDC (1) Main effect: decrease of replacement rates to comply with the fixed contribution rate in the long run If retirement age remains at 60, replacement rate decreases from 60% to 36%. Two ways out: Retirement age increase (incentives strengthened) Parallel 2nd pillar (4% contr. give an additional replacement rate of 8.5%-17% depending on ret. age and int. rate).

18. Transition to NDC (2) Transition problems are not trivial !!! • How to transform the accrued DB rights to initial entries to the NDC accounts? • Fixing contributions and respecting the accrued DB rights leads under ageing to a deficit • Retirement age increase will significantly ease the transition.

19. Migration • Projections for EU-15 assume net migration of 0.15% of total population per year • This corresponds to ¼ of the effect of decline of fertility from 2.1 to 1.7 • Should migrants pay for the old debt? • The outcome depends on the pension system rules.

20. Comments on some countries (1) Sweden: comprehensive NDC reform. But: • took a long time to prepare • fertility higher than in EU average • Inherited funds 27% of GDP from the old system for financing transition • A moderate second pillar (contrib. 2.5% of wages) • Finland: reforming DB system • Partially funded from the beginning (now 25%) • A factor to take account of longevity increase introduced recently • Incentives to postpone retirement strengthened • Germany: reforming DB system • Longevity factor introduced, but without incentives to postpone later retirement • Taxes on pensions to be increased

21. Comments on some countries (2) Italy: “notional NDC”: • After an initial increase, pension expenditure projected to decrease to current level (as % of GDP) • Transparency of rules ? • Politically sustainable ? • Spain: reliance on migration • United Kingdom: public pensions low • Private pillar strained – companies with DB systems under financial struggle • Adequacy has become a problem • Indexation to prices: relative pension decreases: 82 year old receives 33% less than 60 year old (if real wage increases by 1.75% p.a.)

22. Comments on some countries (3) New EU Members States • Some are more advanced than the old MSs • Latvia, Poland, Hungary,… • Atypical careers … structural changes … questions of justice and fairness … • Yet, a pension system with stable rules should be put in place.

23. Should European systems be harmonised? (1) Harmonisation using EU legislation is excluded ! Yet, harmonisation of national systems could take place by national decisions. Needs and purposes: • creating a level playing field for companies • making life easier for people moving from one country to another • portability is an issue also within countries – both for efficiency and fairness

24. Should European systems be harmonised? (2) R. Holzmann’s paper: “Toward a reformed and coordinated pension system in Europe: rationale and potential structure”: Three (new) pillars: • Basic social pension • NDC • Supplementary pensions (fully funded)

25. Should European systems be harmonised? (3) Current rules on portability and the Directive on Institutions for Occupational Retirement Provision (IORP) guarantee some harmonisation Open Method of Co-ordination etc. help in finding good practises.

26. Should European systems be harmonised? (4) NDC has clear merits • Replacement rates adjusted downwards to comply with population ageing • Incentives for later retirement • Financial market risks absent (internal rate of return = wage bill growth • More transparent rules than under DB • Provides stability • Facilitates portability Trade-off between more coordination and urgency of reforms NDC a useful benchmark for other reforms

27. Final remark Increasing the retirement age is the overarching important complex issue to be tackled under any system ! Presenting scenarios where r-age is varied by assumption highlights its importance, but does not tell what is required to be done. Peoples’ perceptions of a fair r-age need to be put into question ! Financial incentives need to be put in place. Employers’ incentives to move their older workers to retirement should be abolished ! Employers incentives to provide training to older workers need to be strengthened !

28. Thank you for your attention !