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Hungary: Selected Issues

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International Monetary Fund
Published Date:
November 1997
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III. Structural Pension Reform in Hungary34

A. Introduction

41. This chapter updates the analysis contained in a background paper to the 1996 Article IV consultation, which described the Hungarian pension system, the new retirement age regulations, and the pension reform—as outlined in the draft laws of July 1996 (SM/96/207). The first section reviews some aspects of the approved reform that differ from those of the reform proposal discussed in SM/96/207. The second section updates the fiscal impact of the reform, also discussed in SM/96/207.

B. An Update on the Hungarian Pension Reform

42. The overall structure of the reformed pension system is in line with that described in SM/96/207. The pension system will comprise both a reformed mandatory PAYG public pension system (heretofore, modernized PAYG) and a new three-pillar pension system.35 The latter will include a mandatory PAYG pillar, a mandatory pension fund, and a voluntary pension fund. Appendix I summarizes the main regulations of both the reformed and the new PAYG schemes regarding eligibility conditions, benefit formula, indexation, contribution rates, and tax treatment, and compares the new regulations with those of the current PAYG system.

43. This section focuses on the principal reform parameters that are referred to in the principal report: the indexation mechanism, the noncontributory pension periods, and the penalties for early retirement. Other important, albeit more technical, changes (for example, the taxation regime and benefit formula) are discussed in the next section, insofar as they are related to the financial projections.

44. Overall, the new regulations are an improvement on the existing ones. Pension benefits are currently indexed to the change in net average wages in the previous year. This system will be gradually replaced by a combination of price and wage indexation, the so-called Swiss indexation (50 percent wages and 50 percent CPI). This indexation mechanism will result into a low rate of growth for pension expenditures with respect to the old indexation scheme, under the reasonable assumption that in the long run, real wages will rise.36 Not much improvement can be reported with regard to noncontributory pension periods. The only new restrictions will apply to university education and the period of child care support. University years attended after January 1998 will not be counted toward retirement, while the period of child care support will continue to be counted, provided that the insured worker pays the required employee contributions. In fact, more liberal regulations have been introduced in this area. The credit for the periods of maternity and child care benefits have been replaced by a credit of two years for each child (three if disabled), with no limit to the accumulation of credit years, as long as the mother has at least 10 years of contribution history. Overall, the new regulations on early retirement, both with and without penalty, are more restrictive than the transitional regulations approved in July 1996. Eligibility for early retirement with no penalty is conditional on having reached age 59 and at least 40 years of contributions. This is an improvement with respect to the previous regulations, as the minimum age (57 for women and 60 for men) and years of contribution (38) for early retirement with no penalty were, on average, lower. In addition, eligibility conditions for early retirement with penalty tend to be stricter in the new system, although penalty rates are essentially the same (see Box 1).

C. Simulation of the Fiscal Impact of the Multipillar Reform

45. The simulation of the reform is presented in two steps. First, the impact of the various measures designed to improve the balance of the PAYG system is compared with the no-reform scenario and progressively assessed (Figures 5-7). Second, the effect of the introduction of the second pillar is examined.37

Figure 5.Hungary: PAYG Deficits After New Pension Formula and New Tax Treatment, 1996–2050

(In percent of GDP)

Source: Palacios and Rocha, 1997.

1/ Changes in the pension benefit include: (1) shift from net to gross wage base; (2) phasing-out of the regressivity factor; and (3) changes in accrual rates. The new tax treatment includes: (1) exemption of employee contributions from the income tax; and (2) taxing of benefits.

Figure 6.Hungary: PAYG Deficits with New Pension Formula, New Tax Treatment and with Changes in Retirement Age and Indexation, 1996–2050

(In percent of GDP)

Source: Palacios and Rocha, 1997.

Figure 7.Hungary: PAYG Deficits with All the Reforms Before and After Compromises, 1996–2050

(In percent of GDP)

Source: Palacios and Rocha, 1997.

46. The impact of the changes in the pension formula and the related changes in tax regimes are shown in Figure 5.38 These include: (i) the shift from a net to a gross wage base in the benefit formula; (ii) the phasing out of the regressivity factor in the benefit formula;39 (iii) changes in the accrual rates designed to compensate for the elimination of the regressivity and the shift to a gross wage-based formula; (iv) the exemption of employee contributions from the base of the income tax; and (v) the taxation of pension benefits.

Box 1Regulations on Early Retirement with Penalty

In the previous system, early retirement (with penalty) could be claimed with a contribution history as much as 5 years shorter than the years of contribution needed to qualify without penalty (38 years). In the new system, early retirement (with penalty) can be claimed with a contribution history as much as 3 years shorter than the years of contribution needed to qualify without penalty (40 years).* The mechanism for determining penalty rates for early retirement is the same for both systems. Penalty rates are a function of the shortfall in the number of contribution years required to qualify for early retirement with full pension (38 in the previous system and 40 in the new). If only one year is missing, then the monthly penalty is 0.1 percent per month. If two years are missing, then the penalty rate is 0.2 percent per month, and so on. Therefore, the maximum penalty in the new system is lower (0.3 percent per month) than in the previous regulation (0.5 percent per month).

* Therefore, in the previous system, the minimum years of contribution for early retirement (with penalty) were 33 (38–5). In the new system, the minimum years of contribution for early retirement (with penalty) are 37 (40–3).

47. The exemption of the employee contribution from the income tax would produce an immediate loss in revenue and a commensurate increase in the central government deficit.40 This is shown by the difference between line 1 and line 2 in the early years. The combination of the other factors (moving to gross wage base, applying new linear accrual rates, and taxing benefits) would start producing lower net entry pensions and smaller deficits after 2009—when these changes start having an effect. These expenditure savings and higher tax revenue will balance the losses due to the initial reduction in tax revenue around the year 2025, and result in lower deficits after that.

48. Figure 6 reproduces line 2 and introduces both the increase in the retirement age (line 3) and the Working Group’s original proposal for moving to a combined wage/price indexation in 1998 (line 4). The retirement age increase is expected to have an important impact on deficits because of the improvement that occurs in the system dependency ratio relative to the no-reform case. Taking into account the new indexation method, the balance of the PAYG moves into a surplus. This is shown by line 4, which takes into account the combined impact of both reforms. Note that the surplus peaks in 2009, when the first demographic shock hits the pension system. The surplus disappears by 2037, when a second demographic shock hits the pension system, increasing the system dependency ratio further.

49. Line 4 in Figure 6 can be interpreted as the surplus that would have been originated by the original reform package prepared by the Working Group. However, the bill submitted to parliament included several compromises that increased the system’s expenditures and reduced the projected surplus. Figure 7 shows the effect of the two most costly compromises, namely, the improved conditions for widows’/widowers’ pensions (see Appendix II) and the delay to 2001 of the indexation change. The impact of those two measures amounts to more than 0.5 percent of GDP during the first years of the transition.

50. This scenario is the starting point for assessing the introduction of the second pillar. This requires an assessment of the impact of the opt-out on the PAYG balance. As shown in Figure 8, the opt-out implies immediate deficits. The loss of revenues during each of the first five years of the reform is approximately 1.1 percent of GDP, taking into account that the switching process would take place gradually throughout 1998.41 The PAYG deficit would tend to increase in the years immediately following the establishment of the second pillar, as the revenue loss caused by the gradual expansion of coverage in the new system would increase. However, the measures designed to adjust the PAYG would more than offset the revenue losses caused by the opt out, resulting in a decline in the deficit until the onset of the first demographic shock in 2009.

Figure 8.Hungary: Deficits Before and After Introduction of Multipillar Systems, 1996–2050

(In percent of GDP)

Source: Palacios and Rocha, 1997.

51. This deficit would start to increase again after 2009, peaking in 2020, and falling significantly after that year, which is when the first cohort in the new system retires (i.e., those aged 39 in 1998). Note also that the difference between the PAYG balances with and without the opt-out increases until 2020 and narrows thereafter. By 2043, the PAYG deficit with the opt-out is actually smaller than the PAYG deficit without the opt-out. These results are driven by two factors. First, the replacement ratio in the first pillar of the new system is about two-thirds of the replacement ratio in the reformed PAYG. Thus, the imbalance between replacement ratios and contributions created by the opt-out starts to taper off in 2020. Second, the reform involves a certain reduction in the accrued rights of workers who opt for the new system. As a result, the “compensatory pensions” given to those who have switched to the new system for the years of contribution under the old system are lower than what they would have received under the old benefit formula.

52. A comparison between line 6 (Figure 8) and line 1 (Figure 5) shows the impact of all the reform measures, including the establishment of the multipillar system. Although the opt-out leads to a worsening of the deficit of around 1.5 percent of GDP in 1998, the full reform scenario closes the gap with the no-reform scenario already in 2004. From then on, the positive difference between the full and the no reform scenarios increases gradually, reaching 2 percent in 2018, and some 5 percent by the end of the projection period.

53. Although the opt-out would generate deficits in the PAYG, these would be accompanied by an increase in flows to private pension fund accounts.42 The increase in total savings generated within the pension system is obtained by combining the public and private pension savings flows, as shown in Figure 9.43

Figure 9.Hungary: Pension System in the Multipillar Reform, 1996–2050

(In percent of GDP)

Source: Palacios and Rocha, 1997.

APPENDIX I Hungary: Main Parameters of the New PAYG System
OLD-AGE PENSIONBeforeTransitionSteady State
1Structure
Mandatory PAYG scheme.None. New system takes effect in January 1998.Reform of the existing Mandatory PAYG scheme + Introduction of a three-pillar pension system:

  • (i) A mandatory PAYG scheme.

  • (ii) A mandatory fiilfy funded pension fund

  • (iii) A voluntary pension insurance plan.

2Eligibility
* Statutory Retirement Age (SRA)
Male60 yearsGradually raised to 62 by 2001 (See SM/96/207)62 years
Female55 yearsGradually raised to 62 by 2009 (See SM/96/207)62 years
* Early Retirement with NO penaltyNot allowed apart firom:

Hazardous occupations:up to 5 years earlier than SRA
Unemployed:up to 3 years earlier
Employed in firm in financial difficulty:up to 5 years earlier
No change in regulations on special occupations.No change in regulations on special occupations.
Early retirement with no penalty is allowed provided new conditions on minimum years of contributions are met. See SM/96/207 for schedule of phased implementation.Eligibility for early retirement with full pension: as early as 59 years, but with minimum 40 years of service.
* Noncontributory pension periods counted toward retirementEnd of Transition Period

Women2009
Men2001
UnemploymentRegarded as service timeNoneRegarded as service time only if the required contribution is paid by both the unemployed and the Unemployment Fund.
University yearsRegarded as service timeNoneOnly years of full-time study prior to January 1, 1998 are considered as service time.
Period of maternity and child care benefitsRegarded as service timeNoneIt has been made more liberal. Two years for each child (3 years if disabled). No limit to credit years, provided mother has at least 10 years of contribution.
Period of child care support.Regarded as service timeNoneRegarded as service time only if tlie required contribution is paid.
Child care benefitsRegarded as service timeNoneRegarded as service time
Period spent as a clergymanRegarded as service timeNoneRegarded as service time
Military serviceRegarded as service timeNoneRegarded as service time
Sick leaveRegarded as service timeNoneRegarded as service time
Prison timeRegarded as service timeNoneRegarded as service time, provided the person is cleared of the charges or the criminal proceeding is terminated.
3Benefit FormulaEnd of transition period:December 31, 2012
* Covered earningsNet Earnings:Earnings net of 6 per cent payroll taxNet earnings:Earnings net of personal income taxGross earnings:Earnings including the personal income tax.
* Years included in earnings historyAll years starting from 1988All years starting from 1988All years starting from 1998
* Indexing of earnings historyIndexed to changes in net national average wage up until two years before retirement.Indexed to net average national wage up until three years before retirement.Indexed to the increase in the gross personal earnings in each year up until three years before retirement
* Regressivity factorAverage monthly

Earnings bracket
Replacement

Factor
Average monthly

Earnings bracket
Replacement

Factor
Brackets will be increased with the growth of theannual average national net wage (Three quarters of precedingyear and fourth quarter of the year prior to that).
-16000100%-35000100%
16001–1800090%35000–4000090%
18001–3000090%40001–4500080%
30001–4000070%45001–5000070%
40001–5000060%50001–5500060%
55001–6000050%55001–6000050%
60001–7000040%60001–7000040%
70001–8000030%70001–8000030%
80001-over10%80001-over10%
For 1998 only. From 1999, the brackets will be increased with the growth of the annual average national net wage (Three quarters of preceding year and fourth quarter of the year prior to that).
* Benefit accrual rateNon linear:

Years

Up to 10th year 1/

At 15 years

At 20 years

Up to 25th year

Up to 32th year

Thereafter
Accrual Rate

33%

43%

53

Plus 2% per year

Plus 1% per year

Plus 0.5% per year
Non linear:

Years

Up to 10th year 1/

At 15 years

At 20 years

At 25 years

At 40 years

Thereafter
Accrual Rate

33%

43%

53

63%

80%

Plus 1.5% per year
Linear:Accrual Rate
YearsModernizedNew First Pillar
Up to 20th year 1/33%24.4%
At 25 years41.25%30.5%
At 30 years49.5%36.6%
At 40 years66%48.8%
ThereafterPlus 1.65% per yearPlus 1.22% per year
* Reduction factor for early retirementNone. Because retirement before statutory age is not permitted.See SM/96/207 for penalty rate schedule.0.1% per month with 39 years of service period

0.2% per month with 38 years of service period

0.3% per month with 37 years of service period
* Minimum/Maximum benefitsYes/YesYes/YesNone/Yes 2/
4Indexation of benefitsEnd of transition period:December 31, 2012
Change in net average wages in the previous year1998 Expected Nominal Net Wage Growth in 97 minus 2.5% 3/

1999 Planned CPI 99 + Exp. Real Net Wage Growth in 98 3/

2000 30% planned CPI 2000 + 70% Exp. Norn NetWage Growth 2000

2001–2012 50% planned CPI + 50% Exp. Nom Net Wage Growth
Swiss Indexation: 50% CPI + 50% Nominal Gross wage growth. (Both based on first three quarters previous year and last quarter of two years before)
5ContributionEnd of transition period:December 31, 1999
* Base
EmployerNo ceiling. Minimum contribution equal to one minimum wage.No change.No change.
EmployeeCeiling of 99,000 forints per month.Twice gross wage, as of 1998.No change.
* Rates (Pension only)Employee6%
Year
Employee19981999
In mixed system
PAYG (I Pillar)1%1%
Pension Fund (II Pillar)6%7%
In Modernized PAYG7%8%
Employer
PAYG24%23%
EmployeeYear

2000
In mixed system
PAYG (I Pillar)1%
Pension Fund (II Pillar)8%
In Modernized PAYG9%
Employer
PAYG22%
6Tax treatment
* PensionersPension is not taxed but is taken into consideration for deteminin income tax bracket.Current legislation in effect until December 31, 2012.Pension benefit is taxed.
* ContributorsFor employers the contribution increases their total wage cost For employees the contribution paid is taxable.Current legislation in effect until December 31, 2012.

Starting in 1998, a PIT credit will be given to employees. The percentage of contribution to be granted as credit will be decided at the time of the budget.
Contributions are not taxable.

Minimum years of contribution for eligibility to old age pension.

Shortfalls with respect to social minimum will be addressed by the social assistance system through income tested allowance.

Benefits are adjusted in November for divergence between expected and actual wages and CPIs.

Minimum years of contribution for eligibility to old age pension.

Shortfalls with respect to social minimum will be addressed by the social assistance system through income tested allowance.

Benefits are adjusted in November for divergence between expected and actual wages and CPIs.

APPENDIX II Hungary: Changes in Widows’ and Widowers’ Pensions
Before ReformNew Regulations
1Eligibility
For a temporary pension: (This is paid for 1 year, if surviving spouse does not qualify for permanent pension.)If the deceased person was a pensioner or he/she had accumulated the minimum required service period for an old-age or disability pension.No change, apart from: the disbursement can last up to 3 years if the widow is supporting a child younger than 18 months, handicapped, or permanently sick.
For permanent pensionPaid to a widow if she:

has reached 55 years, or

is incapable of working, or

is supporting at least two children.



Paid to a widower if he:

is incapable of working and his wife had supported him for at least 1 year prior to her death.
Paid to a widow/er if she/he:

(i) is above the relevant retirement age for old age pension; or

is disabled; or

is supporting at least two children; or

(ii) if any of the eligibility requirements above are met within ten years from the time of the spouse’s death.

For widow/er pensions granted before Jan 1, 1997, the relevant retirement age is 55 for women and 60 for men.

Entitlement of partners, divorcees, and separated couples is subject to additional conditions.
Revival of widow/er’s pension:Revival is allowed provided:

(i) eligibility ended for reasons other than a new marriage, and

(ii) any of the eligibility requirements for permanent pension are met within 10 years from:

* the termination of widow/er pension, if person becomes a widow/er after February 28, 1993; or

* March 1, 1993, if person became widow/er before this date and if the pension was interrupted for no more than fifteen years.
2.Benefit Level
Temporary50% of the pension (or accumulated rights) at time of death.No change. Until December 31, 2008, a minimum temporary pension is guaranteed, provided widow/er is above the relevant retirement age or is disabled.
Permanent50% of the pension (or accumulated rights) at time of death.20% of the pension (or accumulated rights) at time of death.
In combination with own pensionSurvivor with own pension may choose whichever pension is most favorable. A low own pension may be supplemented from the widow’s pension up to a ceiling.Combination is allowed if the entitlement was acquired before Jan. 1, 1998. The widow/er can choose either:

(i) own right pension plus old-regime widow/er’s pension up to a ceiling, or

(ii) own right pension plus new-regime widow/er’s pension
APPENDIX III The Opt-Out or Switching Decision

1. The original draft reform discussed in SM/96/207 considered introducing a mandatory cut off age of 40 years. A voluntary opt-out was eventually proposed to Parliament, as the new arrangement would entail a lower transitional deficit and a lower implicit pension debt. The impact of the opt-out decision on the transitional deficit and pension debt is explained below.

A. General Switching Analysis

2. International experience has shown that age is a very important variable in switching decisions. The age factor seems to be more important than other ones, including assumptions regarding the rate of return and administrative costs of the fully funded system:

  • younger workers tend to gain from switching from a defined benefit (DB) to a defined contribution (DC) scheme, because: (i) the present value of the marginal benefit of a unit contribution in a DB scheme is much smaller for a younger worker; and (ii) a unit contribution in a DC scheme will yield a much higher return, due to compounding, for a younger worker than for an older worker.

  • the incentive to switch will increase the greater the expected net rate of return is on the investment fund when compared with the growth of the wage bill, and the lower the perceived administrative costs are for a fully funded scheme.

3. Other factors at work in determining how many people will actually switch include: (i) the credibility level of the existing PAYG scheme; (ii) the overselling of new schemes (UK); and (iii) the guarantees on the DC scheme.

B. Opt-Out in Hungary

4. A model was developed by the Hungarian authorities to simulate the replacement rates (first pension payment as a percentage of last salary) of the modernized PAYG, the new first pillar, and the second pillar, as a function of a worker’s age in 1998. This model will be available to workers to make their opt-out decision.44Figure 5 shows the results of this model for an average Hungarian worker. Under a reasonably conservative set of assumptions,45 the reform variables chosen by the government would lead only younger workers to switch. The compound interest rate effect in the second pillar makes the mixed system a progressively less attractive proposition the higher a worker’s age is in 1998. This way, a high early transition deficit may be avoided.

5. The top line shows the projected replacement rate in the modernized PAYG. It decreases for younger workers to reflect the shift to the gross wage based formula and the extension of the assessment period to a lifetime wage history (Appendix I). The same factors affect the replacement rate in the new first pillar (bottom of stacked figure). The second pillar’s replacement rate decreases with the age of the worker (top of stacked figure). The replacement rate in the multipillar system is equal to the sum of the stacked figures. In this scenario, the multipillar system becomes attractive for workers in their low 30s.46

6. The calculation of the replacement rate for the new first pillar is based on the new linear accrual rate of 1.22 percent per year multiplied by the average gross wage and subject to PIT (Appendix I). In terms of net wage, this roughly corresponds to an accrual rate of 1 percent per year. This applies also for workers who are already working in 1998, despite the fact that the accrual rate in the PAYG scheme to which they were already contributing was higher, at approximately 1.8 percent. The offer of lower statutory retirement rates for the new first pillar was made possible by the attractiveness of the second pillar and by the voluntary nature of the switching decision. A compulsory switch would have demanded the promise of higher statutory replacement rates.

7. The use of a voluntary opt-out arrangement allows savings on the order of 40 percent of the accrued rights of workers under age 40, a significant reduction in the implicit pension debt. These savings would be higher if more workers decided to switch. This would happen if workers were more optimistic with regard to the expected rate of return of the second pillar. In terms of Figure 10, if the workers’ perceived real rate of return on the second pillar increases by 0.5 percent, the switching age would increase to some 37 years. If the workers perceived the real rate of return to be zero, the switching age would be about 27.47

Figure 10.Hungary: Switching Decision for Average Hungarian Worker by Age in 1998

Source: Palacios and Rocha, 1997.

Prepared by Edgardo Ruggiero.

Workers under the age of 47 can choose to stay in the reformed PAYG or to switch to the new multipillar system. All workers above 47 years have to remain in the modernized PAYG, while all new entrants are automatically enrolled in the three-pillar system. At the time of writing SM/96/207, the switch was compulsory for all workers under 40 years.

During the transition period, various combinations of prospective prices and wages will be used, with a top-up in 1998–99, in case inflation is higher than expected. From 2001 to 2012, a Swiss indexation based on expected net wages and CPI will be used. The steady state Swiss indexation will be in force in 2013 when actual gross wages and CPI will be used (Appendix I).

This section is based on preliminary estimates in Palacios, Robert, and Roberto Rocha, 1997, “The Hungarian Pension System in Transition,” draft, (July), World Bank.

The simulations in Figures 5 and 6 are based on the original reform package of December 1996-January 1997 prepared by the Working Group on Pension Reform. The simulations from Figure 7 onward reflect the government’s proposal to Parliament of May 1997, see ¶49. The latter approved the law with some modifications. These are not taken into account in the projections. The main modifications during parliamentary discussion were the lengthening of the transition period for the new benefit formula and tax treatment from 1998 to 2013 and the concession of a PIT credit for employee contributions to the modernized PAYG, and to the I and II pillars. It will be decided within the 1998 budget law what percentage of contribution will be granted as PIT credit. These modifications would result in a lower deficit during the transition. In terms of Figure 5, line 2 would then define the maximum deficit implied by the new tax regulations.

The regressivity factor is the schedular percentage of wage that is taken into account into the formula for calculation of the pension level. The factor is called regressive because, in the current formula, the percentage falls as the wage brackets increase (see Appendix I, point 3).

The loss in tax revenue is included in the projections because the model attempts to assess the reform package’s actual cost to the public sector.

The switching decision, and its impact on the transitional deficit, is discussed in Appendix III.

The accumulated pool of long-term savings would grow very rapidly during the first twenty years of the system, given that few participants would become eligible for second pillar pensions and the balances would be compounding over time. After 2019, however, the rate of growth of the second pillar would be tempered by the gradual outflow of annuity payments. Nevertheless, the accumulation of assets reaches 50 percent of GDP by 2030, a figure comparable to Chile and the United States today and somewhat lower than the United Kingdom and Switzerland. The new private pension system is likely to play an important role in developing financial markets and facilitating investment finance, with positive effects on growth. These effects are not considered in the simulations presented in this chapter.

The real rate of return on the second pillar account is assumed to be 1.5 percent above real wage growth in the long run, an assumption consistent with the performance of private pension funds with balanced portfolios in OECD countries (Davis, E.P., 1995, Pension Funds, Retirement-Income Security, and Capital Markets—An International Perspective (Oxford:

A worker will have to specify his/her starting/ending wage as percent of average wage, the rate of return of the second pillar, and his/her expected age at retirement. Other variables that are given in the model are the administrative costs of the second pillar, the taxation regulations, mortality tables, and so on.

Among these are administrative costs of 15 percent of contributions, an interest rate used for annuity calculation equivalent to wage growth, a real second pillar return equivalent to wage growth plus 1.5 percent, and an age at retirement of 61 years.

The simulations in Figure 9 are based on the conservative assumption that all workers below 40 opt-to switch, notwithstanding the 3–4 percentage point advantage, in terms of replacement rate, that the modified PAYG seems to offer with respect to the multipillar scheme for workers below 40 (Figure 10). A number of factors may induce workers to switch, notwithstanding the apparent financial advantage of remaining in the modified PAYG: (i) low credibility level of the modified PAYG; (ii) perception that administrative costs in the II pillar will be lower; (iii) high guarantees offered in the multipillar scheme; and (iv) overselling.

In this model, a real rate of return of zero is equivalent to a nominal rate of return equal to nominal wage growth

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