PART 1: International comparisons
In practice, there are three ways of providing pension coverage for the elderly: either through taxes, or through saving money (a funding scheme), or through insurance, which means buying a promise of a share in future production (an unfunded scheme, often in the form of a so-called pay-as-you-go system). Under a funding scheme (saving money), workers save part of their income and accumulate these savings in order to use them after retirement. The other two schemes – through taxes and insurance – are based on an intergenerational exchange, where current workers pay for current pensioners.
Different countries have various pension systems based on a tax scheme, a pay-as-you-go system, a funding scheme, or a combination of these schemes. Some countries rely on "flat-rate" systems that are mainly financed through taxes (for example, the United Kingdom, Switzerland, the Netherlands, Ireland and Denmark), which provides a basic income regardless of salary or contributions paid. Other countries prefer a pay-as-you-go system that is mainly financed through social security contributions (for example, Germany, Italy, France, Austria, Sweden), where pensions depend on previous earnings but at the same time a minimum pension is maintained. Moreover, countries with traditionally highly developed capital markets rely at least partly on a system of accumulating savings and subsequently investing them. Such countries, including the USA, the United Kingdom and the Netherlands, have developed a combination of a conventional "flat-rate" system and (mandatory or voluntary) funded plans, similar to the system recommended by the World Bank.
In 1981, the South American country of Chile allowed all contributions to be moved from the pay-as-you-go system to fully mandatory and voluntary investment systems. People's savings began to accumulate in personal accounts and be invested in securities on the capital market. Subsequently, first Chile's South American neighbours (for example, Peru – 1993, Argentina and Colombia – 1994, Uruguay – 1996, Bolivia and Mexico – 1997), and then many other countries carried out similar reforms and abolished or at least reduced the role of their pay-as-you-go systems. Facing the challenges of globalization, the problem of population ageing and high unemployment, which together create a financial burden on the pay-as-you-go system, many post-communist countries (for example, Kazakhstan, Hungary – 1998, Poland – 1999, Latvia – 2001, Croatia, Estonia, Russia – 2002) and some wealthy democracies (Denmark – 1983, Switzerland, the Netherlands – 1985, the United Kingdom – 1988, Australia – 1991, Sweden – 1996) introduced mandatory insurance systems. Most of them created a combined system based on a pay-as-you-go system and funding/investment tiers.
However, not all countries are satisfied with the idea of replacing the pay-as-you-go system with mandatory funding/investment. Undoubtedly, an effective pay-as-you-go system has considerable advantages, which may explain its strong position in continental Europe and countries with mixed systems. Even population ageing is not a killer of the pay-as-you-go system – an effective but not very popular solution may be raising the retirement age. Moreover, the transition from a pay-as-you-go system to a funding/investment system requires enormous costs that become a financial burden on the state budget. Because of this, many countries (for example, Germany, Italy, France, Austria, Spain, the Czech Republic and Slovenia) concentrate on improving their pay-as-you-go systems and supporting voluntary funding/investment schemes, rather than developing a mandatory funding/investment system.
When reforming pay-as-you-go systems, some countries, for example, Sweden, Germany, Italy or Poland, introduced a "notional defined contribution" system. The principle of operation of this system – when current workers pay for current pensioners – remains the same. However, the notional defined contribution has two new features: 1) each person has their own notional account, where inflows and outflows of money are recorded throughout their life, 2) the pension is calculated as the sum of the balance on the account at the time chosen for retirement, divided by an estimate of average life expectancy for a person of that age, which means that the pension mainly depends on the contributions paid throughout the entire working career.
Reform in Central European countries. Hungary (in 1998), Poland (in 1999) and Slovakia (in 2004) carried out major pension reforms involving the privatization of their national pension systems, partly replacing them with funding/investment systems of personal savings accounts managed by commercial entities. In Hungary, the pension reform left the state pay-as-you-go system almost unchanged – with excessive redistribution of money and no accounting of personal contributions. On the other hand, Poland introduced a system of notional accounts, where pension payments will reflect personal contributions in an almost linear manner. Slovakia chose a similar approach, although without introducing notional accounts. It also developed a combined system, but compared to some other post-communist countries it is moving more progressively towards a mandatory funding/investment system (Table 1). Conversely, in the Czech Republic and Slovenia, governments decided to reform their current state pay-as-you-go systems without privatization. At the same time, they encouraged citizens to voluntarily save money for retirement in private pension funds.
PART 2: Reform in Slovakia
Slovakia introduced a major pension reform in 2004. Its main factor was widespread dissatisfaction with the standard of living of pensioners. The state pension fund had experienced a constant shortage of money since 1997, which caused a steady decline in real pensions. The average old-age pension was 157 euros in 2003 – approximately 45% of the average wage in the country's economy compared to 54% in 1991. The old system had a high level of redistribution of funds. The difference between the lowest and highest pensions was minimal. This system was good only for low-income workers and speculators who worked in the shadow sector of the economy and paid minimum contributions. This trend was further strengthened by the process of globalization, which gave opportunities to those with high salaries to avoid paying contributions to this system altogether. The sharp increase in unemployment in the late 1990s, together with the expected demographic crisis, created the need to reform the system. Taking into account the recommendations of the World Bank and studying the experience of reform in Hungary and Poland, the new government decided to build a pension system based on three tiers and a "safety net" for citizens with very low pensions. The old pay-as-you-go system was divided into mandatory social insurance (first tier) and mandatory saving (second tier), supplemented by a smaller-scale system of voluntary savings (third tier). Solidarity was clearly separated and reduced to guaranteeing a minimum subsistence level financed through taxes.
Reform of the pay-as-you-go system – first tier
The reform of the first tier led to the introduction of the following main innovations:
1. A gradual increase in the statutory retirement age on average from 55 years for women (depending on the number of children) and 60 years for men to a final 62 years for both sexes. All men will retire at the age of 62 from 2006, and all women will retire at 62 starting from 2015.
2. A new pension calculation formula. Compared to the old one, the new pension calculation formula provides higher pensions to those who earned more and paid higher contributions throughout their entire working career, and vice versa. The redistribution of money will decrease over a three-year transition period. The new calculation scheme should increase the motivation to pay contributions and eliminate contribution avoidance. Accordingly, such a system puts at risk low-income citizens who will receive very low pensions. It is envisaged that they will also receive assistance from the state budget. Thus, solidarity was clearly separated from the payment of mandatory contributions.
3. A new indexation of granted pensions: this is the so-called "Swiss method", which means automatic annual indexation of pensions to the weighted average of the consumer price index (inflation) and the growth of average nominal wages in the economy. The weight of each parameter will be 0.5. Overall, the changes in indexation principles weaken the influence of politics on pension calculation but link it to the growth of economic indicators. This is a good sign, because indexation was often the subject of political struggle on the eve of reforms.
4. Early and late retirement. Unlike the former system, the reformed pay-as-you-go system allows early and late retirement. For each month of retirement before the statutory age, the pension is reduced by 0.5%, and for each month of retirement after the statutory age, the pension increases by 0.5%.
Potential problems. Although the new pay-as-you-go system strengthens motivation, it does not automatically change the level of employment. The latter has a significant impact on the volume of pension contributions and is the main constraint on the size of pensions. However, neither the new pension calculation formula nor the new indexation rules reflect these changes, and the system continues to provide unguaranteed promises. Given demographic expectations, this problem may reappear as early as 2015. This will require another reform of the pay-as-you-go system, including several options, among which are a further increase in the retirement age, an increase in contributions, changes to the pension calculation formula and/or changes to the pension indexation rules (for example, inflation only, which is expected to be lower than wage growth).
Also subject to criticism is the futile attempt of Slovak reformers who wanted to build a universal system with the same rules for everyone. The resistance of the security forces (for example, the military and police) was too strong, and therefore the privileges remained unchanged. However, the good news is the fact that at least a political agreement has been reached to abolish these privileges.
Introduction of a mandatory funding/investment system – second tier
The new mandatory "second" tier will take effect on 1 January 2005. All citizens younger than a specified age (approximately up to 52 years) will be allowed to make a choice by June 2006: whether to join the funding/investment system or not. After joining the system, there will be no way back. Young people entering the labour market for the first time will be required to start with the second tier. Their assets will be managed by private pension companies competing on the market, and an independent financial supervision authority will monitor their activities. The founders of pension companies must be reliable financial institutions that will have at least three years of experience in such activity. The minimum basic capital must be 300 million Slovak korunas (7.1 million euros). Each pension company will manage three funds with different investment restrictions and different risk-return ratios (Table 2). The money paid into the second tier will be the private inheritable property of the citizens who save the money. The interest earned on such funds will not be subject to taxation.
Investment portfolio. Equities are too volatile an instrument for providing income after retirement, although they can be a valuable component of an investment portfolio during the period of accumulating money. Bonds provide a more stable income at the expense of lower returns. Because of this, clients of pension funds invest money mainly in equities in order to take advantage of higher but volatile returns, and then gradually, as the time of retirement approaches, move the money into bonds. To allow such an investment strategy, Slovak reformers needed three different funds. Each saver can simultaneously have assets in only one fund. Fifteen years before retirement, savers cannot hold assets in an investment fund, and seven years before retirement they must fully move their assets to a conservative fund.
Guarantees. The state does not directly guarantee either particular performance results of pension funds or the nominal value of contributions paid. However, indirectly, the law establishes strict investment restrictions for pension companies and provides strict regulation of their activities. The law also requires pension companies to achieve a certain minimum level of performance commensurate with the performance of their competitors. Moreover, the state guarantees one hundred percent payment of pensions in the event of fraud or misconduct.
Investment restrictions. According to the law, securities issued by Slovak issuers must constitute at least 30% of the investment portfolio's funds. Supporters of this restriction argue that it should "make the outflow of domestic capital impossible..., accumulate sources for investment in the Slovak economy... and help develop Slovakia's securities market." However, most economists warn about the negative impact of this restriction. Overall, it limits the choice of the best investment opportunities and also has a negative impact on the rate of return and the size of pensions. Moreover, this restriction not only fails to comply with European Union rules on the free movement of capital but also limits the ability of the funding/investment system to withstand the demographic crisis.
Transitional costs. The introduction of the second tier causes high transitional costs that will appear over the coming decades. These costs are a significant obstacle for many countries that have strong pay-as-you-go systems and are considering a transition to a mandatory funding/investment system. Transitional costs are a consequence of moving contributions from the pay-as-you-go system to the second tier – as a result, the state receives less money but still has to pay the same pensions. Thus, transitional costs actually depend on the size of contributions to the funding/investment system and on the number of people who transition to this system. In Slovakia, these costs should amount to approximately 1% of Slovakia's annual GDP (in 2005 approximately 15 billion Slovak korunas, or 360 million euros). This is also a political commitment that the country assumes in accordance with the Maastricht criteria for the transition to the common European currency. There are also several options for how to finance the transitional costs: a large part of the costs can be covered by: 1) the reformed pay-as-you-go system, which will bring higher revenues after the retirement age increase – here the connection between the introduction of the funding/investment system and the need to raise the retirement age is obvious – and this should generate resources in the state reserve fund (4.75% of the monthly gross payroll, preferably to cover the pay-as-you-go system's deficit). Other sources are: 2) privatization revenues (the Slovak government saved 65 billion Slovak korunas, or 1.55 billion euros specifically for this purpose), 3) the state budget, 4) loans. The reserves of the pay-as-you-go system and privatization revenues should cover all transitional costs until 2011. However, a shortage of money may appear earlier in the event of a mass transition to this system. Later, other sources can be attracted, including revenues from further privatization, contributions to the state budget and loans. In the long term, even after raising the retirement age to 65 for both sexes (which is very likely), after 2030 a deficit will appear in the financial balance of the pay-as-you-go system. However, after 2054 the pay-as-you-go system will have a surplus, because most people will receive a combined pension from the funding/investment tier and from the pay-as-you-go system.
PART 3: Lessons of the reform and recommendations
Motivation. In the era of globalization, avoiding paying social security contributions is becoming even easier. Thus, the motivation to work legally and pay contributions is crucial for maintaining the pension system and the entire economy. To achieve this goal, the size of the pension must reflect the size of contributions paid.
Solidarity. Systems that focus on motivation pose a threat of poverty in old age for low-income groups of the population. This threat needs to be minimized through direct support provided by the pay-as-you-go system financed through taxes. The volume of transfers can be easily adjusted by policymakers.
Transparency. Solidarity should be financed through taxes and be clearly separated from the mandatory insurance system and savings contributions. This provides the possibility of providing support to the poorest pensioners and creates a prospect for mandatory funding/investment systems to become voluntary and private.
Pensions and stability. Both the pay-as-you-go system and the system of funded/investment plans offer higher pensions under different conditions. While the labour market (changes in the workforce and productivity) determines the size of pensions in the pay-as-you-go system, the securities market (the real rate of return on capital) is decisive in the funding/investment system. The combination of both systems provides an opportunity to diversify the sources of financing for future pensions between the labour market and the securities market and to increase the stability of the system as a whole.
Transitional costs. The introduction of the second tier carries considerable transformation costs. If Slovakia had not retained a large part of privatization revenues, the introduction of Europe's largest second tier would have been impossible. A large part of the transitional costs can also be financed through savings in the pay-as-you-go system, which can be created by limiting their generosity (for example, by raising the retirement age or introducing less generous pension indexation).
Demographic crises. Population ageing is not a killer of the pay-as-you-go system – an effective but not very popular solution may be raising the retirement age. However, negative demographic expectations have a direct impact on reducing pensions in the pay-as-you-go system, all other things being equal. On the other hand, the funding/investment system makes it possible to "export" capital to an economy with stable or positive demographic changes and avoid negative consequences.
Automatic adjustments. It should not be extraordinary intervention by politicians, but ordinary changes in the system that should influence the dynamics of key economic indicators. For example, the indexation of pensions should correspond to inflation or wage growth or both of these indicators at the same time, rather than waiting for decisions by politicians who have a tendency to make unrealistic promises. In the optimal variant, indexation should reflect only changes in the size of increased contributions.
Administrative costs. Administrative costs are higher everywhere for private than for public pension plans. They are particularly high in the case of private personal pension accounts.
Popularity of the second tier. The number of people transitioning to the second tier exceeded expectations in both Hungary and Poland. The reason is widespread distrust of the state pension system and the desire to save in a personal pension account. This argument makes the introduction of the second tier much easier. However, a larger number of people transitioning to this system increases the transitional costs. Thus, the issue of regulating the process of transition to this system needs to be considered.