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Mr. Jerald A Schiff, Mr. Axel Schimmelpfennig, Mr. Niko A Hobdari, and Mr. Roman Zytek

Abstract

In recent years, the issue of pension reform has been high on the agenda of many countries. To a large extent, this reflects common concerns regarding demographic trends of declining birthrates and increasing life expectancies that have shed serious doubt on the sustainability of current pension systems. Most countries have attempted to shore up their pay-as-you-go (PAYG) systems through some combination of reduced lifetime benefits and higher social taxes.

Mr. Jerald A Schiff, Mr. Axel Schimmelpfennig, Mr. Niko A Hobdari, and Mr. Roman Zytek

Abstract

The Baltic states inherited a PAYG pension system from the Soviet Union (Box 2.1). Economic developments of the early 1990s had a tremendous impact on the pension systems in ail transition economies, including the Baltic countries. Economic depression accompanied by growing unemployment (open and hidden) undercut the pension system’s financing while adding large numbers of new beneficiaries.1 At the same time, high inflation rates that were not immediately fully matched by nominal pension increases contributed to a sharp decline in the real value of pensions and flattening of benefits across different groups of beneficiaries.2

Mr. Jerald A Schiff, Mr. Axel Schimmelpfennig, Mr. Niko A Hobdari, and Mr. Roman Zytek

Abstract

While the early reforms of the Baltic PAYG systems were oriented at preserving the financial solvency of these systems, demographic trends led policymakers in the Baltics, as elsewhere, to look for alternatives to their pensions systems. A PAYG system remains solvent as long as the working generation is able and willing to share sufficient income with the retired generation. However, given expected population trends, it was viewed as unrealistic to expect future working generations, dwindling in absolute numbers, to continue to support an ever larger population of retirees to the same extent as at present. To ensure sustainability via a PAYG system would require further increases in the already high payroll tax rates—which would overburden the working generation, complicate social tax collection, and have an increasingly negative impact on work incentives 21—or reductions in lifetime retirement benefits. As indicated in Table 3.1, maintaining a 40 percent replacement rate and a retirement age of 60 in the Baltics would eventually require that a payroll tax collect about 40 percent of gross wages, which would imply a tax rate well in excess of 40 percent.

Mr. Jerald A Schiff, Mr. Axel Schimmelpfennig, Mr. Niko A Hobdari, and Mr. Roman Zytek

Abstract

A pension reform that introduces an FF pillar or increases the importance of an existing FF pillar will affect the macroeconomic savings-investment balance in three basic ways. First, a tax-financed pension reform strengthens savings by substituting an FF pillar based on capital accumulation for a PAYG pillar based on intergenerational redistribution. Second, a pension reform involves transition costs that need to be financed; other things equal, this reduces national savings. Third, a pension reform can affect private savings outside the pension system.

Mr. Jerald A Schiff, Mr. Axel Schimmelpfennig, Mr. Niko A Hobdari, and Mr. Roman Zytek

Abstract

This paper provides an overview of efforts in the Baltic countries to reform their pension systems, and examines the choices facing these countries in their continued reform efforts. Early reforms were aimed at correcting the flaws of the inherited Soviet system and, in particular, at shoring up the finances of the pension systems and reducing their distortionary impact. The Baltic countries have been in the forefront of transition economies in their pursuit of pension reform. They have taken important steps to shore up the long-run financial health of their existing pension funds and made preparations for the implementation of a three-pillar scheme. Although a move toward a fully funded pension system can potentially make an important contribution to the objectives of pension reform, such a change is neither necessary nor sufficient to meet these goals. The existing PAYG pension system can, at least in theory, be made sustainable by an appropriate adjustment of payroll tax rates and expected lifetime pension benefits, although the average replacement rate implied by such changes may well be fairly low, reflecting the expected demographic developments.

Mr. Jerald A Schiff, Mr. Axel Schimmelpfennig, Mr. Niko A Hobdari, and Mr. Roman Zytek

Abstract

The Baltic countries have made considerable effort during the course of the transition to ensure the long-term sustainability of their pension systems and the adequacy of retirement income. As described above, these efforts initially involved steps to shore up the pay-as-you-go system inherited from the Soviet period, including by reversing the early expansion of this system, increasing retirement ages to more sustainable levels, and linking more closely lifetime contributions and retirement benefits. While these steps met with some success in improving the financial health of the Baltic pension funds, gains were partially undone by subsequent ad hoc benefit increases. Further, the adverse demographic trends facing the Baltic countries led them to consider more fundamental pension reforms, in particular, the establishment of a three-pillar pension scheme, including a mandatory, fully funded, defined contribution second pillar.