Pension Reform Igor Guardiancich European University Institute R. - - PowerPoint PPT Presentation

The Political Economy of Pension Reform

Igor Guardiancich European University Institute

• R. Kent Weaver

Georgetown University & The Brookings institution

Outline:

• Challenges and Options in Pension

Reform

• Comparing Patterns of Pension

Reform in West and Central/East Europe

• Explaining Patterns of Change
• Lessons on the Political Limits of

Reform

The Five Challenges of Pension Reform:

1. Demography 2. The welfare of seniors 3. Financing 4. Behavioral change 5. Politics– Can a reform be:

– Adopted (without harmful design flaws) – Implemented effectively (and meet performance

• bjectives)

– Sustained politically (rather than eroded or reversed)

Patterns of Pension Reform in EU15 (and other OECD) Countries

• 1. Refinancing

– Increase payroll tax base and rates – Add dedicated revenue sources or increase general revenue subsidies

Followed by:

Pension Reforms have:

• Become Aggressive in the Past 20 years
• Transferred increased market risk from

government to current and future pensioners

• Followed a general sequence--

• 2. “Stealth” retrenchment to

benefits and eligibility (easier to hide) e.g.,

–Changes in years of work required for full benefit –Changes in indexation formulas Followed by:

Followed by:

• Increased penalties for early

retirement

• Increasing standard retirement

ages, especially for women—and widespread breaking of the 65 “upper limit” Initially with long lead times to make them more politically acceptable

• 3. More visible retrenchment, e.g.:

• 4. Modest structural reforms in

some EU15 countries, e.g.:

• Automatic Stabilizing Mechanisms

(ASMs) provide “clean hands” cuts, e.g., – Notional Defined Contribution – “Sustainability factors” in benefits – Automatic increases in retirement ages

• Individual Defined Contribution (DC)

Accounts—largely as a modest supplement to rather than replacement for existing pension tiers (e.g., Sweden, Germany, Italy)

1950 1974 1985 1995 2012 NDC Bismarckian Universal Mixed Residual Asterisk indicates that a country has added a small mandatory or

quasi-mandatory defined contribution individual account tier. Italy * Sweden * Germany * Austria France Denmark Ireland Neth. Switz. U.K.

• 5. No pattern of convergence toward a

single type of “pension regime” in EU15

• 6. Post-2007 financial crisis leads to

renewed rounds of retrenchment in EU15 rather than structural reform, e.g.:

• Increases in standard retirement

age

• Further restrictions on early

retirement

• Further limitations on special

provisions for specific

• ccupational groups
• With some use of ASMs (e.g.,

Spain, Greece) rather than full NDC

• 7. Automatic Stabilizing Mechanisms

in OECD countries have a mixed record on sustainability:

• Sweden- Sustained but:

– partially evaded through tax mechanism – Effects made less visible by shift in formula

• Germany 1- Repealed
• Germany 2- Partially and temporarily

suspended

• Italy- Suspended, strengthened and

supplemented

Patterns of Pension Reform in Central and Eastern Europe

1.Reform phases in CEE countries followed similar modal sequence to OECD

• Refinancing

– rapid increase in social security contributions (e.g., PL 25% in 1981; 38% in 1987-9; 45% in 1990), discontinued due to declining international competitiveness

• Retrenchment

– arbitrary freezing of indexation of all but minimum benefits

1989 1995 2000 2005 2013 NDC Bismarckian Bismarckian Lite Universal Mixed Residual Asterisk indicates that a country has added a small mandatory or

quasi-mandatory defined contribution individual account tier. Poland * Latvia * Slovenia Czech Estonia* Lithuania* Kosovo* Hungary Slovakia Croatia*

• 2. Compressed and Higher level of

Pension Restructuring in CEE

including move to multi-pillar systems, but with substantial cross-national variation

15

• Different types of privatization

– Substitutive (KO) – Parallel (LT) – Mixed (BG, HR, EE – not only carved out, HU – reversed, LV, MC, PL, RO – stalled, SK – partly reversed) – Voluntary (AL, CZ, SI – quasi-mandatory, SR)

• Coverage

– Mandatory for young workers (HU only new workers) – Voluntary for intermediate cohorts (PL 30-50; HR 40-50) – Not available to older employees (HU rare exception, active errors)

• Size

– Substantial (HU 68/33.5; LV 210/20; PL 7.3/19.52; SK 9/18) – Medium (BG 25/23; HR 5/20; EE 4+2/20; LT 2.55.5/18.5; RO 2.56/28) – Small (SW 2.5/18.5)

16

• Temporary measures

– many CEE countries froze the indexation

• f pensions (wages of public employees,

social transfers) during 2010-12

• Various CEE countries introduced a

number of “overdue” incremental reforms—e.g.,:

– higher retirement age – fewer early retirement venues – lower regular indexation

• 3. The financial crisis led to additional

incremental retrenchment in CEE…

Bulgaria Contributions: frozen at 5% during 2007-14, rising to 7% in 2017 Switching back: early retirees brought back to PAYG system Estonia Contributions: suspended temporarily (employees can pay in 2%) Hungary Contributions: diverted back to public pillar Switching back: strong incentives to all pension fund members Latvia Contributions: reduced from 10% to 2% temporarily Lithuania Contributions: reduced from 5.5% to 2% temporarily Poland Contributions: reduced from 7.3% to 2.3%, rising to 3.5% by 2017 Switching back: allowed in 2006 for early retirees Romania Contributions: frozen at 2% Slovakia Switching back: allowed to all pension fund members, no mandatory entry for new workers

• 4. …and to some reversals of

privatization and reallocations of contributions

…as governments prefer to spend for Keynesian measures than for transition costs

Summary comparison:

Some parallel trends between EU15 and CEE countries, but reforms in CEE countries were:

• Compressed in time,
• more likely to be structural, and
• more prone to move to and retreat from
• f multi-pillar reforms

than in EU15 countries

Why? And what lessons does it suggest for the future?

Explaining Patterns of Reform

20

• 1. The problem stream—what are

perceived to be the key problems needing a response

• 2. The policy stream—what responses

are perceived to be viable

• 3. The policy stream—what interests

have influence, and how decisions are made

Three “clusters” of explanatory variables:

A Politically-mediated Model of Pension Policy Change

Demographic change Institutional Carriers of reform Ideas (e.g., WB, EU, OECD) Political- partisan environment Perceived need for policy change (problem stream) Direction And Extent

• f Policy

Change:

• Retrenchment
• Refinancing
• Modified or

new policy regime (restructuring) Economic Status of The Elderly Labor Market Partici- pation of Older Workers Afforda- bility of Pension Regime New social risks Policy feedbacks:

• Policy regime
• Micro-rules
• Age of policy

regime Incentives for politicians, mediated by: Fiscal pressures Competitiveness pressures Available incremental and regime transition options (policy stream) Domestic political institutions Strategic Decisions by politicians Group environment (politics stream and decision procedures)

Cluster 1: Economic- Demographic variables Cluster 3: Political/ Institutional variables Cluster 2: Policy Feedbacks and Ideas

• In EU15 countries, both low rates of

economic growth and high public pension spending lower the interval between rounds of pension retrenchment

• But the relationship between

demographic aging and retrenchment actions is weak

Source: Juan J. Fernandez, “Economic Crises, High Public Pension Spending and Blame Avoidance Strategies: Pension Policy Retrenchments in 14 Social-Insurance Countries, 1981-2005”, Max Planck Institute Discussion Paper 10/9, 2010

Cluster 1-Economic/Demographic Constraints

Reform pressures in CEE countries exacerbated by extreme compression

• f economic-demographic changes,

including:

Source: U.S. Department of Health and Human Services and Department of Commerce, An Aging World, 2008, p. 22.

Total Fertility Rate, 2008

(Births per woman)

• declines in

fertility rates

• a boom in the number of retirees

and soaring unemployment rates as a result of economic restructuring a fiscal crisis exacerbated by weak GDP growth in most countries

Diversion of contributions back into first pillar pensions in CEE countries spurred by:

Source: Social Security

Administration, International Update, March 2012, p. 1

• post- 2007 financial

crisis, which exacerbated the “double payment problem

• Stability and

Growth Pact criteria, and failure to win exemption

Cluster 2- The Policy Stream: Policy Feedbacks and Institutional Carriers of Ideas

• 1. “Positive policy feedbacks” limit the

pension reform options of policymakers:

– Constrain choice sets – Create constituencies who resist any change that would make them worse off

• 2. Age and maturity of pension regime

makes change more difficult (e.g., “double payment problem”)

• 3. Negative feedbacks can undercut

support for a pension regime—e.g.,

– Perception that pension regime (or changes in it) impose losses on important groups, or – Fiscal unsustainability But: – Negative feedbacks lead to pension regime change only when

• Incremental reforms have been

exhausted

• Alternative policy regimes are

politically and fiscally attainable

Negative feedbacks differ across pension regime types, e.g.,

• Bismarckian regimes have serious

fiscal sustainability problems as populations age

• Mixed regimes may transfer a lot of

risk to workers

• Universal flat-rate regimes target

inefficiently and pose severe adequacy-sustainability trade-offs Which structural reform options are attainable depends on where countries are starting from, e.g.,

1950 1974 1985 1995 2009 NDC Bismarckian Universal Mixed Residual Asterisk indicates that a country has added a small mandatory or

quasi-mandatory defined contribution individual account tier. Sweden * Denmark Ireland Switz. U.K.

Universal Pension Regime Transitions: Early exits and multiple destinations

1950 1974 1985 1995 2009 NDC Bismarckian Universal Mixed Residual Asterisk indicates that a country has added a small mandatory or

quasi-mandatory defined contribution individual account tier. Italy * Sweden * Germany * Denmark Australia Neth. Switz. U.K.

Mixed Pension Regime Transitions: Multiple Precursors, and No Exits

1950 1974 1985 1995 2009 NDC Bismarckian Bismarckian Lite Universal Mixed Residual Asterisk indicates that a country has added a small mandatory or

quasi-mandatory defined contribution individual account tier. Italy * Sweden * Germany * Austria France

The double payment problem inhibits transitions from Bismarckian Pension Regime Transitions to Mixed regimes in OECD countries…

Multiple negative feedbacks helped to generate exodus from “Socialist Bismarkian” pension regimes in CEE countries:

• Perceived financial unsustainability
• Strong inequities between groups of

workers

• 4. CEE Countries were more susceptible to

influence from external ‘institutional carriers” of reform pressure and ideas, notably: – World Bank and IMF – European Union, through Maastricht criteria and Stability and Growth Pact (SGP) which: – Facilitated privatization initiatives during transition from socialism, but: – reduced domestic buy-in, making privatization reforms vulnerable when external actors changed priorities

1989 1995 2000 2005 2013 NDC Bismarckian Bismarckian Lite Universal Mixed Residual Asterisk indicates that a country has added a small mandatory or

quasi-mandatory defined contribution individual account tier. Poland * Latvia * Slovenia Czech Estonia* Lithuania* Kosovo*

…and transition financing threatens the

sustainability of CEE shifts to mixed regimes

Hungary Slovakia Croatia*

Cluster 3-The Political Stream and Decision Mechanisms

Any reforms that impose losses on pensioners or taxpayers create strong blame-avoiding pressures on politicians And blame- generating

• pportunities

for their

• pponents…

with a few opportunities to claim credit for offsetting improvements, e.g.:

• Introduction or expansion of DC

individual accounts

• Introduction or expansion of

dependent care credits

• 1. the general sequence of reforms

(refinancing to retrenchment to restructuring)

• 2. Timing of retrenchment: “Hazard” of

pension retrenchment is higher in post- election years in OECD countries

• 3. But connection between partisan

composition of government and retrenchment is tenuous

Source: Juan J. Fernandez, “Economic Crises, High Public Pension Spending and Blame Avoidance Strategies: Pension Policy Retrenchments in 14 Social-Insurance Countries, 1981-2005”, Max Planck Institute Discussion Paper 10/9, 2010

Blame-avoiding pressures help to explain:

Lessons on the Political Limits

• f Reform

• 1. Multiple reform options exist but

all are politically constrained

• 1. The menu of incremental and

structural reform options for pension systems is substantial

• 2. Some “good practices” are

emerging on how to structure specific reforms—e.g.,

– managing individual account systems – providing information on expecting retirement income

but

• 1. Politically easy “stealth”

incremental reforms have mostly been exhausted

• 2. In EU 15, most structural pension

reforms are neither politically nor fiscally feasible given countries’ starting points,

• 2. Reform processes rarely

generate broad, durable support

• Broad coalitions can be built for

reform through mechanisms such as:

– Expert commissions – All-party or multi-party politician-led mechanisms – Pacts with social partners

but

• Consensus can rarely be generated

for major reform of retirement income systems; the best that can be hoped for is elite agreement followed by social “acquiescence”

• Reforms imposed without broad

party support are vulnerable to reversal

• Electoral cycles pose an ongoing

risk of reform erosion

• 3. Pension reform initiatives should be

evaluated by multiple criteria—including:

• Poverty Prevention
• Income replacement
• Long-Term Affordability
• Clarity on Total Expected Income in

Retirement

• Encouraging Longer Work Life
• Promoting Gender Equity
• Exposure to Market Risk
• Exposure to Political Risk
• Administrative Effectiveness and Cost

…and concentrate on those where a specific country’s performance is worst

• 4. Automatic stabilizing mechanisms

confront a fundamental trade-off:

• Clarity– for workers to adapt successfully

to new pension policies, they must be given clear, early signals about changing their savings and retirement behavior

versus

• Obfuscation/stealth– sending clear signals

about future cutbacks in eligibility and benefits – Is frightening to politicians – Makes it less likely that a reform will be adopted

• 5. Lessons on Automatic Stabilizing

Mechanisms:

• 1. Don’t expect ASMs to do the “heavy

lifting” of pension retrenchment over time

• 2. ASMs are subject to reversal (Kohl

reform in Germany) after party change when enacted without opposition party support--Changing the default position alone is not enough

• 3. Worry more about erosion and evasion
• f ASMs than repeal

• 4. Avoid using highly volatile measures in

ASMs (e.g., AP Fund in Sweden, employment changes in Germany)

• 5. Avoid long periods between adjustments

(e.g., increases in retirement ages with life expectancy) that create large disparities between adjacent cohorts of retirees

• 6. Aggressive ASMs will put pressure on

minimum (“zero pillar”) pension tiers— which in turn puts pressure on general government deficit

• 6. Lessons on Multi-Pillar Reforms:
• 1. Second-pillar pensions are more

vulnerable to political risk of erosion and “confiscation” than originally thought, especially when:

– countries face a severe fiscal crisis – Strong external pressure to reduce budget deficits – public confidence in the second pillar as investment vehicle is low

• 2. Erosion through “temporary” payroll tax

diversion is more serious threat than

• utright abolition of second pillar in CEE

countries—but how temporary?

• 7. Second Pillar pensions can create

new sources of political conflict, e.g.:

• Number of providers and how they

are selected

• Investment practices of funds
• Regulation of fund management

fees that can seriously erode investment returns

• Design of default options and

engagement of young workers

• Limitations on very risky options

• 8. Increasing retirement ages poses

multiple challenges, e.g.:

Fiscal and senior welfare challenges:

• Increased pressure on disability program

financing and implementation

• Fiscal pressure on zero-pillar pensions

Political challenges:

• Equity issues, since low wage workers

have shorter life expectancies

• Framing problems, given high youth

unemployment

• Potential growth of pensioner/older

worker parties

The Bottom Line:

1. Policy designers need to focus on the political challenges of: – Implementation as well as adoption – Both political and financial sustainability 2. Don’t look for the “best” system—all reforms involve trade-offs 3. Build on the system you have rather than starting fresh in order to:

– avoid uncertainty – reduce highly visible loss-imposition – Reduce the risk of policy reversal

The End