Pensions under Ageing Populations and the EU Stability and Growth Pact

The Economic Policy Committee and European Commission (2006a,b) projects an average increase by 2050 in ageing-related expenditures of at least 5 percentage points of GDP in half of the EU Member States. , If these were to be financed from current tax revenues, statutory tax rates would have to increase by at least 8 to 10 percentage points. Moreover, the projected averages hide a wide range of variation across countries.

According to the EU Treaty countries should comply with the principle of sound public finances. In addition, the Treaty lays out an Excessive Deficit Procedure (EDP) with reference values for deficits (3% of GDP) and debt (60% of GDP). Even so, some countries believed that all this would still not be sufficient guarantee for the ECB to be able to operate independently and achieve price stability. This fear resulted in the Stability and Growth Pact (SGP). The “preventive arm” of the SGP aims at avoiding excessive deficits by requiring countries to strive for a medium run budget that is close to balance or in surplus. The other, “corrective arm” makes the Treaty-based EDP operational. The SGP was revised in March 2005 after failure to uphold it. As part of the revision, public debt and sustainability receive now more emphasis. This is also the case for structural reforms, including pension reforms.

We construct an (overlapping generations) model calibrated to the average EU projections to provide numerical illustrations of public debt, deficit and implicit pension liabilities under different pension and fiscal arrangements, with explicit attention to a transition towards (partial) funding that might be required for intergenerational equity. To this end, the model provides a benchmark that we term actuarial neutrality, under which each working generation pays, in present value terms, for its own future pensions. In other words, the balance of pension contributions and benefits of each generation is fully separated from the characteristics and pension policy choices of other generations. For example, if life expectancy increases, tax payments should increase, while the opposite is the case when the retirement age is raised. We highlight in particular the “Implicit Pension Debt” (IPD), defined as the accrued-to-date pension liabilities. The IPD distinguishes these from pension rights to be accrued in the future.

We calibrate our model and compare the budgetary outcomes to the restrictions imposed by the SGP. Some of the results are highlighted here. First, pay-as-you-go (PAYG) systems do not, in general, comply with actuarial neutrality but tend to shift an increasing burden to future generations.

Second, as long as a mono-pillar public pension system is maintained, our baseline with actuarial neutrality implies that the target should be a budget surplus of 2.5% of GDP for several decades, resulting in a long-run net public asset position of 60% of GDP – see Table 1.

Third, as Table 1 shows, a one-third privatisation of the pension system produces a 2.9% of GDP average deficit over the first 30 years, while combined with a one-and-a-half-year increase in working life over this period it produces an average yearly deficit of 3.5% (not shown in the table). With privatisation, tax payments of workers to the government fall, because their future pension will no longer be entirely financed from public assets but partly out of a private pension fund (the workers start paying premiums to the private fund). However, existing retirees still need to be paid their pension. With tax revenues falling relative to pension expenditure, the government will be running a deficit and public debt will increase.

Fourth, we also combine pension expenditures with other ageing-related expenditures, in particular health-care and long-term care expenditures. Also, these expenditures can be expected to rise substantially over the coming decades. Table 2 combines pensions under actuarial neutrality, a moderate retirement-age increase (by two years over the coming two generations), a net pension accrual rate reduction to 48% and a pro rata 4% increase in health- and long-term-care expenditures for both the younger and the elderly per period. This scenario combines a number of plausible changes in the benefit rules with projections made by the Economic Policy Committee and European Commission (2006a,b). The government deficit moves from the initial 1.9% of GDP deficit to a surplus of 1.6% over 60 years, while explicit debt declines by 100% of GDP over two generations. Clearly, this (plausible) scenario requires the government to take substantial measures to tighten its budget over a very long period.

Table 1: Public finances and pensions under PAYG and actuarial neutrality

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Notes: (1) Calibration is based on an assumed period length of 30 years (a generation). Initial debt is set at the SGP reference level of 60% of GDP. In period 1, fertility falls by 20%, while life expectancy of workers is assumed to increase by 3 years. In period 2, life expectancy of workers increases by another 3 years. (2) “net accrual rate” gives the pension benefit as a share of the net wage; IPD = implicit pension debt; total debt = explicit debt plus implicit pension debt. (3) The tax rate consists mainly of pension contributions and is expressed as a percentage of the total wage cost. (4) The final column “change” gives the %-point change from period 0 to the new steady state, except for the budget surplus/GDP ratio, where it gives the %-point change from period 0 to the lowest or highest level.

Table 2: Overall financial implications of ageing

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Notes: (1) ID = implicit debt, the sum of implicit pension debt and future health- and long-term care expenditures for current workers. (2) For further notes, see Table 1.

The paper discusses a number of implications of our numerical results for the SGP. First, after the revision of the SGP in 2005, the medium term objective (MTO) for budget balance at the end of the Stability and Converge programme period was made country-specific. For countries that have already adopted the euro or participate in ERM-II, the MTO ranges from a minimum of -1% of GDP for low debt and high potential growth countries to budget balance or surplus for high debt or low potential growth countries. In view of the projections just discussed, these MTOs do not seem ambitious enough.

Second, it is important that the targets for the public debt and the deficit be set such that the required surplus in the public pension system is fully integrated with the debt and deficit targets imposed on the entire government sector, as otherwise any pension system surplus is squandered with a deficit in other public policy areas.

Third, while the revised SGP now recognises the problem of the transitional cost of (partial) privatisation of the public pension system, it allows only a limited excess over the 3% of GDP deficit ceiling for a limited period of time. Therefore, a partial privatisation on a fully actuarially neutral basis of a mono-pillar pension system may not easily be accommodated under the current rules. Hence, a country that maintains the mono-pillar pension system can be much more comfortable with the SGP rules than a country that, for sound economic reasons, wants to implement a partial privatisation of the system. A remedy to this consequence of the current rules would require a change to the Protocol on the Excessive Deficit Procedure (EDP) annexed to the EU Treaty. One might consider a limited clause that the surplus in the private second pillar be included in the government budget balance for the purposes of this Procedure. However, this would require a unanimous decision of the EU Council.

Footnotes:

(1)  This contribution is based on Beetsma, R. and H. Oksanen, 2008, Pensions under Ageing Populations and the EU Stability and Growth Pact, http://www1.fee.uva.nl/toe/content/people/beetsma.shtm, which is a revision of Beetsma, R. and H. Oksanen, 2007, Pension Systems, Ageing and the Stability and Growth Pact, Economic Papers, No. 289, European Commission. (2) Economic Policy Committee and European Commission (2006a), The Impact of Ageing on Public Expenditure: Projections for the EU25 Member States of Pensions, Health-Care, Long-Term Care, Education and Unemployment Transfers (2004-2050), European Economy, Special Reports, No.1. (3)  Economic Policy Committee and European Commission (2006b), The Impact of Ageing on Public Expenditure: Projections for the EU25 Member States of Pensions, Health-Care, Long-Term Care, Education and Unemployment Transfers (2004-2050) – ANNEX, European Economy, Special Reports, No.1. (4) Under a PAYG system, current workers pay for the pensions of current retirees. (5) Public assets are accumulated and budget surpluses are run to cover future pension spending. (6) The ratio of elderly to net contributors is also assumed to increase moderately.


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