The economic and financial crisis that began in 2008 has raised the need to review the economic feasibility of what we know as the welfare state, as the State now has difficulty assuming the economic cost of keeping the services running, together with the fact that over many years of social struggle the citizens have gained what society considers as rights, which should not be terminated by any governments, independent of their political ideology. As a result of the crisis, one of the aspects with most impact has involved pensions and their viability. Pension policy has suffered phenomena such as falling birth rates, increased life expectancy, and labor markets modified by the decline in employment.
a) The pensions system should consider the following items (Barr and Diamond, 2010):
- Mechanisms to distribute consumption throughout life to prevent the lowering of income and ensure adequate resources for older people, and
- Redistribution of income to alleviate poverty.
b) In order to achieve these objectives it must also consider the costs of achieving them. As a useful guide:
- The main objective of a pension is economic protection in old age, achieved through the distribution of consumption, insurance, poverty relief and redistribution.
- The main objective of a pension design is to optimize protection during old age, including the cost of providing this protection
c) The purpose of pensions is to maintain well-being throughout life and provide shelter when income decreases. Therefore the pension’s objective is distribution of consumption during an individual’s life, so that people transfer some of their income from maturity to retirement, enabling a reasonable rate of substitution when the individual leaves work and it becomes retires. The objectives of pensions are based on 3 fundamental points: the first is to prevent poverty and achieve a minimum standard of living, in other words it is redistributive; the second is allows consumption to be distributed between the working stage and active or passive retirement; and the last is to increase pension revenue through the existence of private plans. Redistribution is when pension systems can redistribute income over a lifetime, complementing the role of progressive taxes on annual income. Lifetime redistribution can be achieved by paying pensions to low earners that are a higher percentage of their previous earnings (i.e., a higher replacement rate), thus subsidizing the consumption smoothing of lower earners.
Since life-long earnings are uncertain from the perspective of an individual, such a system provides some insurance against low earnings. There can also be redistribution towards families, for example paying a higher pension to a married couple than to a single person, even though both families have paid the same contributions. On the other hand, consumption allows people to try to maximize their well-being, not at a single point in time, but over time. Someone who saves does so not because extra consumption today has no value, but because he values that extra consumption in the future more highly than extra consumption today. A teenager who saves for an aero plane ticket is making a judgment that they will get more enjoyment from the trip than from spending the money now. Similarly, most people hope to live long enough to be able to retire. Thus a central purpose of retirement pensions is consumption smoothing – a process which enables a person to transfer consumption from their productive middle years to their retirement, allowing them to choose their preferred consumption trajectory over their working and retired life.
And finally, poverty relief targets resources at people who are poor over their lifetime, and who are therefore unable to save enough. On a practical note, poverty relief must also address transient poverty. Such programs may target all the elderly or concentrate on those who have contributed to the pension system. Nowadays, in the OECD many countries use the PAYG (Pay-As-You-Go) system, where (Navarro, 2010) today’s workers finance the pensions of those who no longer work. However, in the capitalization system, used in the USA, there is no such transfer between generations. Therefore, the question that we should ask is who pays the pensions of those who are retiring now, and who will be retiring for the next few years. The answers are the state. This means enormous expense, very high transition costs, both from the purely economic point of view as well as administrative one.
In addition, any process towards pension privatization is seen socially as a loss of profits, forcing the government to give sufficient coverage to this issue to ensure conviction legitimacy and acceptance. However, experiences in countries like Chile show that it is a very difficult process because the social costs are very evident, and the number of people who do not have a pension or who have lost their rights is very high. For this reason, the main target of compulsory pensions programs has been, and still is (Hotzmann 1999), to provide income support during retirement, focused on individuals, not people, with a general uncertainty about the future evolution of mortality, volatile income and prices, a lack of instruments in the appropriate financial market, and political reference to poverty alleviation and income redistribution.
Traditionally it has been considered that public intervention was important the welfare state compared to the result of individual decisions in a world of asymmetrical and distorted information. Historically, the pensions system in Europe has not been homogeneous (Rubio 2013). In the case of the liberal regime, pensions were intended to alleviate poverty through lump-sum benefits (flat-rate), i.e., consisting of a determined-amount. In the first states, access to pensions depended on the applicant. Later on, some countries established a universal pension financed by general taxation of wage, but their amount was not generous, because of the main goal driving these systems. This is the reason private schemes developed, and why so often the basic pension is topped up with individual and professional pensions.
On the other hand the Bismarck model sought to ensure a similar level to working life income. Consequently, the idea is not only to maintain living standards but also ensure a good level of income. The financing depends on the contributions made by employers and employees, so that the pension is conditional on the quantities made by each. Its connection with wages meant the exclusion not only of social groups not integrated into the labor market, but also of employees with high wages and self-employed workers.
3. Types of pensions (Barr and Diamond, 2006):
Fully-Funded Schemes are based on savings – contributions are invested in financial (or possibly physical) assets, the return on which is credited to the scheme’s fund. Funding is thus a method of accumulating financial assets, which are exchanged for goods at some later date. While fully-funded schemes can take many forms, in principle they always have sufficient reserves to pay all outstanding financial liabilities (or equivalently, liabilities are defined by available funds). If there is no redistribution across generations, a generation is constrained by its own past savings and a representative individual gets out of a funded scheme no more than he has put in.
If, in addition, there is no direct redistribution across individuals, when an individual retires, the pension fund will be holding his past contributions, together with the interest and dividends earned on them. This accumulation finances the person’s consumption in retirement, through an annuity or in some other way.
Defined-Benefit Schemes: In a defined-benefit (DB) scheme, a worker’s pension is based not on his accumulation, but on his wage history, possibly including length of service. A key design feature is the way wages enter the benefit formula. In a final-salary scheme, pensions are based on a person’s wage in his or her final year, or few years. Alternatively, the pension can be based on a person’s real or relative wages over an extended period, including an entire career. In either case, a person’s annuity can be, in effect, wage indexed until retirement. The worker’s contribution is generally a fraction of his or her wage; thus the sponsor’s contribution is conceptually the endogenous variable in ensuring the scheme’s financial balance. DB schemes can have assets held in a central pool.
Defined-Contribution Schemes: In a defined-contribution (DC) scheme, also called funded individual accounts, each member pays into an account a fixed fraction of his or her earnings. These contributions are used to purchase assets, which are accumulated in the account, as are the returns earned by those assets. When the pension starts, the assets in the account finance post-retirement consumption through an annuity or in some other way. In a pure DC scheme (i.e., one with no redistribution across individual accumulations), a person’s consumption in retirement, given life expectancy and the rate of interest, is determined by the size of his or her lifetime pension accumulation, preserving the individual character of a person’s lifetime budget constraint.
4. European pensions in recent years
Following the debate that has taken place in recent years about the necessary pensions reforms in order to assure pension financing in the coming years in Europe, an analysis has been undertaken of the future of pensions in the upcoming decades. Governments and social partners disagree on possible future solutions, but the magnitude of the problem requires the implementation of appropriate initiatives for the future.
The basic pension scheme is based on the three keystones of Leuven (European Parliament Committee, 2014)
- The first keystone serves as a means for avoiding old-age poverty; the second focuses on adequate pensions in terms of the replacement rate, whereas the third is meant to provide an opportunity for individuals to save towards increasing their retirement income.
- The first aspect is mostly defined by the progressivity of its distribution and its social security and poverty-prevention aspects. Defined benefits and a minimalistic approach to adequacy therefore prevail, with pay-as-you go (PAYG) schemes being the rule. The level implies the necessity to cover all the population’s basic and essential needs. It is financed by State Budget, its management is public and basic services include healthcare, family support, disability, orphan hood, unemployment and basic retirement.
- Second-keystone schemes, whether PAYG or funded occupational pensions, are designed to ensure a greater proportionality to income and ensure a higher replacement rate for middle- and high-income individuals; these have been subject to reform in recent years.
- Voluntary funded schemes (third keystone) present a set of challenges to policy- makers even in terms of their mere definition. Voluntary occupational schemes form part of these under the classical denomination, the distinction from semi-mandatory occupational schemes is narrow and often presents no conceptual differences, and the overlap with other financial products and policies is strong. Due to the pressure on PAYG and increasingly also on second-keystone schemes, these have gained in relative importance, but their development remains low.
The following European geographical areas can be distinguished:
Northern Europe: countries such as Denmark, Finland. Great Britain, Holland. Ireland and Sweden have a basic level, but the system is orientated towards greater capacity for free choice by the people, and there is a universal benefit system, which is covered by State Budget and a widespread mandatory professional system but with private management based on capitalization.
Eastern Europe: the pensions system has move from PAYG to capitalization. Southern Europe: Spain. Greece, Italy and Portugal have a system based on public funding through the PAYG system, but private supplementary schemes are developing rapidly.
Central Europe: These countries are in the middle ground between a capitalization and distribution system.
Germany has developed reserve accounting systems in companies for pension commitments, and in France there is a public system together with the private system, in recent years, the problem of pension has not ceased to be serious problems in the most European countries, since their populations are among the longest-lived in the word. In 2008, the first year of crisis, this problem exacerbated short-term viability and long term sustainability. With this in mind, in the European Union’s 97th plenary session, from 8 to 10 October, 2012, the Committee of the Regions wrote the White Book; Agenda for Adequate Safe and Sustainable Pensions, which gave a series of recommendations to secure pensions in the future. It also establishes the necessity to balance increasing life expectancy and rise in retirement age.
The average effective age of labor market exit was 64.6 for men and 63.1 for women across all countries in 2014. Across all OECD countries, the average effective age of labor market exit for men is six months higher than the average normal retirement age, while for women it is the same as the average normal retirement age for women. The lowest effective exits are found in France for men and in the Slovak Republic for women at 59.4 and 58.2 years old, respectively On the other hand there is a notable distortion in both legal and effective retirement ages in countries such as Portugal and Iceland, which have the highest effective retirement ages, and Belgium and France, which have the lowest. Also the difference between the legal and effective ages is wide in countries like Spain, Greece, Italy and Finland. This has led to the need to restrict early retirement more in most European countries, resulting in reforms to reduce the gap between the legal retirement age and the actual one.
This encourages private pensions for the coming decades because, as discussed, public pension replacement rates are dwindling. In this sense, we can see whether private pension systems are really becoming important to ensure an adequate pension support in the future. We should analyze the behavior of pension replacement rates, both from public point of view and a private one, and compare these with % Public Pension Expenditure 2015.
% Public pension expenses in GDP 2015 versus replacement rate pensions
The replacement rate, which is the ratio of dividing the average pension and the average salary, shows significant variation from 76.6 in Austria to 29.5 in the Netherlands this shows that countries in Europe have very different ways of organizing their pensions. For example Spain lets the greatest burden fall on the State and the amount is determined by historical employment contributions. Pensions in Great Britain and the Netherlands are independent of a worker’s contribution history and are designed to support only basic welfare, with workers voluntarily contributing to private pensions.
Figure 1: Correlation between Public Pension Expenditure in GDP with replacement rate of Public Pensions
Source: Proprietary work, 2016
5. European Pensions: Future Viability
One of the greatest challenges facing the welfare state and pensions in particular in developed countries is demographics. Economic growth is possibly one of the main causes of reduced birth rates. This phenomenon is known as the demographic-economic paradox and points to the existence of an inverse correlation between improved living conditions and the number of children born per woman, in other words, the birth rate. This demographic challenge over the coming decades can be seen in the evolution of the population distribution from 2010 to 2050. The following table shows the average percentages of the population for age groups.
Averages percentages of the population by age groups 2010-2050
Source: United Nations. World Population Prospects- The 2015 Revision
The 2015 United Nations review expects the population of Europe to grow from 738 million in 2015 to 734 M in 2030 and 707 M in 2050. Some countries are expected to experience a population decrease of more than 15% and the birth rate is currently below a level sufficient to maintain a stable population in the long term (about 2.1 children per woman on average); in most cases, for decades the birth rate has been below the level of replacement. As can be seen in Figure 3, the percentage increase in population aged 60 and above by 2050 will be very important, although not all countries will see the same increases.
In countries like Italy, Portugal and Spain the increase will be higher than in the northern countries, such as Denmark and Norway, as these countries are already suffering the effects of an aging population and the percentage of people aged more than 60 year is quite significant. This makes it likely that asymmetries in pension’s expenditure in the various European countries will continue, and the convergence requested by the European Commission does not take into consideration the demographic asymmetry in the different countries. In addition, all these elements should be correlated with the labor market, as in European countries labor reforms have allowed contracts labor with reduction in the social security contributions causing the fall in income that as a result they have impact on expenditure and one of their games is spending on pensions.
To this effect it can be seen that in none of the cases can the increase of GDP offset the percentage rise in retirement age, so the conclusion is clear: in the long-term European countries need to find public or private mechanisms to ensure a minimum level of spending on pensions.
An expanding welfare state and maintenance of the pension levels wanted by the citizens of European countries requires a full-capacity, growing economy, something that has been endangered by the demographic dynamics of the last decades. Birth rates in most European countries are very low and their populations are rapidly aging. The average age in the European Union in 2030 is expected to be 45, with the proportion of young people between 15 and 24 years of age declining. The generation of baby boomers, i.e., those that were born approximately between 1945 and 1970 will account for more than 25 per cent of the total population.
In the next few decades, as the bulk of the population transforms from young cohorts to mature ones, major demographic changes will be produced, and the economic crisis will increase the pressure for pension reforms in many countries of the European Union. The reforms have so far focused on the public pensions system with modifications retirement age, increasing this in order to have more years to compute the amount of pensions, restriction of early retirement and the implementation of measures to reconcile work and retirement, and mitigate the possibility of a decline in the rate of public pension’s replenishment. Although many countries had already initiated reforms before the financial crisis, the reforms have gained momentum in recent years. Around 20 countries have increased the age of retirement since 2010.
There has also been legislative support, encouraging private pension plans, as well as the freedom to choose the type of investment and manage the risk associated with the pension that enables different forms of pensions, as financial income, lifetime or single repayment at the beginning of the age of retirement. The basic concept of pensions, the first keystone, is as a means to avoid poverty in retirement, and many countries have considered this entirely the responsibility of state pensions. This concept has evolved due to the financial crisis. The second keystone is important for compensating for the reduction or freezing of public pensions and ensuring an adequate replenishment rate that allows retirees to live a dignified life. The last keystone allows people who save to have a series of extra revenues once retirement age is reached.