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Nicaragua: Selected Issues

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International Monetary Fund
Published Date:
September 2012
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V. Achieving Sustainability: Reforming The Nicaraguan Pension System1

The Nicaraguan social security system is unsustainable given its current parameters, and ongoing demographic and macroeconomic trends. Reforming the system is essential for long-term fiscal sustainability. A reform should be based on changing the benefits formula to make it actuarially fair and equitable, gradually raising the retirement age, and increasing the minimum number of years of contributions to qualify for a full pension to 30 years, while limiting increases in contribution rates.

A. Main Issues

1. The Nicaraguan social security system is unsustainable given its current parameters, and ongoing demographic and macroeconomic trends.2 Under the Nicaraguan pay-as-you-go pension system (defined-benefit), revenue and expenditures should be in balance over the long run to minimize fiscal pressures.3 The retirement age of 60 years; the number of years making contributions (approximately 15) to qualify for benefits; a minimum pension that is high relative to mean wages in the formal sector; and the level of total contributions (24.3 percent to finance pension, health insurance, job training, and occupation risk) constitute an explosive combination that will make the system to turn into deficit by 2015, and its trust funds to be depleted by 2021.4

2. At the request of the Nicaraguan government, an independent consultant carried out an actuarial assessment of the Disability, Old Age, and Survivor Program (IVM for its initials in Spanish) in 2009.5 The consultant’s proposals to balance the system include: (i) increasing the minimum retirement age; (ii) redesigning the benefit formula; (iii) calculating the contribution rate needed to balance the system; and (iv) reducing labor market informality.

B. The Current Pension System

3. Although the system’s coverage has increased in recent years, it is still limited. The number of participants in the system reached about 550 thousand workers by end-2010, equivalent to about 23 percent of the labor force (a 4 percentage-point increase from the 2005 figure). This implies that any proposal to balance the system in the medium term (in particular increasing payroll taxes), should take into consideration their effects on workers’ incentives to enter into a formal work relationship. In this regard, total payroll taxes (including health care and others) were more than 24 percent of wages in 2011 (Table 1)6–already a significant pressure on labor costs.7

Table 1.Nicaragua Payroll Taxes
WorkerEmployerTotal
Pensions 1/4.07.011.0
Occupational risks1.51.5
Health6.02.38.3
War victims1.51.5
Job training2.02.0
Total10.014.324.3
Source: Prepared by IMF staff based on Nicaraguan Legislation

Disability, Old Age, and Survivor Program (IVM)

Source: Prepared by IMF staff based on Nicaraguan Legislation

Disability, Old Age, and Survivor Program (IVM)

4. The main characteristics of the current pension system are:

  • To qualify for a pension, a worker needs to be both 60 years old, and to have contributed to the system for at least 750 weeks (15 years).8
  • The minimum pension cannot be lower than the minimum wage (more than 75 percent of pensioners receive the minimum pension). Pensions over this minimum are adjusted every year on November 30th according to the annual exchange rate crawl (5 percent). These two factors impact negatively the financial statement of the Instituto Nacional de Seguridad Social (INSS).9 In turn, the maximum benefit that a pensioner can receive is US$1,500 a month.
  • The dependency ratio is expected to increase: while in 2009 it was 0.17 (six workers financed one pensioner), under the government’s baseline scenario it will raise to 0.25 by 2020 (four workers will finance one pensioner).
  • Benefits have grown faster than wages in recent years: while the average reported wages grew at a nominal annual rate of about 9 percent, average pensions rose in excess of 12 percent a year over the last decade.
  • The formula used to determine the level of benefits includes two factors: a base (or fixed) factor and a factor of weeks worked in excess of 150 weeks (see Appendix A). The current system aims at being progressive by paying a minimum wage for all low income pensioners; however, it is also inequitable, particularly because the formula does not give adequate weight to the number of years of contribution by pensioners (Table 2). For instance, low-wage workers who have contributed for 17 years receive the same benefit as low-wage workers who have contributed for 32 years or more.
  • The INSS surplus of recent years was invested in its majority in government bonds, a way of financing the cost of current government consumption. As social security accounts turn into deficit, (and the trust fund begins to be depleted), the government will be forced to eventually raise taxes on citizens to pay the bonds.
Table 2:Ratio of Pension Benefit to Final Salary
Current formulaConsultant’s Proposal /1
Final Payment to Minimun WageNumber of years of participation in the programNumber of years of participation in the program
17321530
1100.0100.080.095.0
256.879.356.071.0
450.069.441.056.0
650.069.434.549.5
1050.069.421.536.5
10 to 10.500.690.270.38
Source: prepared by IMF staff with data from tables 4 and 6 of the actuarial report, Troncoso Group (2009)

Base multiplier = 0.65 and acrual factor = 0.01

Source: prepared by IMF staff with data from tables 4 and 6 of the actuarial report, Troncoso Group (2009)

Base multiplier = 0.65 and acrual factor = 0.01

C. The Baseline Scenario10

5. The baseline scenario main assumptions include:

  • The rate of growth of total contributions (separated between the rate of growth of the number of participants and of per capita contributions) and benefits are lower than that of the nominal GDP (Figure 1). The rate of growth in the number of participants is assumed to follow the projected growth in the labor force, which increases rapidly in the near future and moderately over the long term. The underlying demographic trends are closely aligned with those of the United Nations.
  • The average wage (in nominal terms) grows at a rate that oscillates between 0.75 and 11.5 percent across age brackets and gender in 2008. In turn, the minimum wage and nominal GDP are assumed to grow at higher rates than those of the average wage (about 10 and 11 percent a year, respectively).11 The final results under the baseline scenario are very sensitive to these assumptions, in particular the magnitude of minimum wage increases with respect to average wage growth, as the minimum pension is set equal to the minimum wage.
  • The nominal annual rate of return on trust fund assets is assumed to remain constant throughout the period of analysis at 6.5 percent a year.
  • The assumed operational cost is 1.2 percent of total contributions (4.2 percent of the INSS total administrative cost in 2010, including the health system). This cost is similar to that of private-pension administrators in Latin American countries.

Figure 1.Rate of Growth of Benefits and Contributions under the Baseline Scenario and of Nominal GDP

Source: prepared by IMF staff with data from basic actuarial assumptions of the actuarial report.

D. The Proposals under Consideration12

Changing the Benefit Formula

6. Changing the benefit formula contributes to achieve actuarial solvency. In this connection, TCG (2009) proposes a modification of the formula to incorporate three factors: a base multiplier (between 1 and 0.1); a general base factor; and, an accrual-based factor on years of service: 0.01 per each year of contribution (see Appendix A).

7. The proposed benefit formula would increase progressivity. While under the current system the ratio of benefits to final salaries between high-wage workers and low-wage workers with seventeen years of paid contributions is 0.50, under the proposed new formula the ratio would be 0.27 for workers with fifteen years of paid contributions (Table 2).

8. Moreover, the proposed formula would reduce benefits, in particular, for those with fewer years of contributions. Table 3 shows that the application of the proposed formula would reduce benefits, but that such reduction would be inversely related to the number of contribution years. This provides a stronger incentive for workers to join and remain in the system. Moreover, the requirement that the minimum benefit be equal to the minimum wage is eliminated.

Table 3.Percentage of Benefit Reduction under the TCG, 2009 Proposal
Final Payment to Minimum WageNumber of years of participation in the program
7173237
1−28.0−18.0−3.02.0
4−17.7−14.0−16.415.5
6−33.9−27.0−25.7−24.2
10−66.3−53.0−44.5−41.6
10 to 12.42.914.824.8
Source: prepared by IMF staff with data from table 8 of TCG (2009).TCG proposal includes base multiplier = 0.65 and acrual factor = 0.01.
Source: prepared by IMF staff with data from table 8 of TCG (2009).TCG proposal includes base multiplier = 0.65 and acrual factor = 0.01.

Changing other Parameters

9. Other, not mutually exclusive, alternatives could also contribute to balance the system in the long run. In this regard, TCG (2009) includes the following proposals: increasing retirement age to 65 years; limiting the annual increase of benefits to that of the minimum wage, and minimum wage increases to 5 percent a year; and increasing the number of participants.13

10. Table 4 shows the contribution rate needed to balance the system under different reform assumptions. These estimates assume that, the minimum and average wages will grow at similar rates; and, that there will not be any labor market response to higher payroll taxes. Increases in contribution rates are not too high only if the proposed new formula is implemented. Moreover, increasing the participation rate would only temporarily improve the financial situation of the INSS: once new entrants begin to receive benefits, the improvement is reduced until it disappears, as each new participant adds to the system’s liabilities.

Table 4:Government Options: Rate of Contributions to Balance the System
OptionRate
1Current law.24.7%
2Current law, 25% more new entrants.23.3%
3Current law, 25% more entrants, and increasing cap on taxable earnings.23.5%
4Current law, increasing retirement age to 65 and cap on taxable earnings17.5%
With the new formula
5New formula with 65 base, 1%/year accrual, retirement age at 65 and increasing cap on taxable earnings with 25 percent more new entrants.14.3%
6New formula with 65 base, 0.5%/year accrual, retirement age at 65 and increasing cap on taxable earnings.13.15%
7New formula with 65 base, 0.5%/year accrual, retirement age at 65 and increasing cap on taxable earnings with 25 percent more new entrants.12.15%
Source: prepared by IMF staff with data from table 11 of the actuarial report.
Source: prepared by IMF staff with data from table 11 of the actuarial report.

E. Policy Implications and Staff’s Views

11. Reforming the system is essential to limit the government exposure to contingent liabilities. Figure 2 shows how, under the baseline scenario described above, the pension system’s balance turns negative in 2015, and reaches a deficit of about 1.5 percent of GDP by 2022.

Figure 2:Current System: Fund Year’s End and Pension System Balance

Percent of GDP

Source: prepared by IMF staff with data from TCG (2009): basic actuarial assumptions.

12. The reform should consider using different instruments to address each of the causes of the system’s financial problem. However, as pointed out above, contribution rate increases should not jeopardize efforts to reduce labor market informality. A more balanced strategy could contemplate the following options:

  • Adopting a new benefit formula. A formula similar to that in TCG (2009) could be implemented with an accrual-based factor of 1 percent per year of contribution, but with somewhat less progressivity through a slighter reduction of the base multiplier when earnings increase (see Appendix A). The progressivity of the formula in TCG (2009) leads to some very low internal rates of return on contributions for higher-income workers, which could discourage their participation in the system.14
  • Gradually increasing the retirement age to 65 years. The average life expectancy at retirement grew in Nicaragua from 18.7 (1995-2000) to 21.1 years (2005-2010),15 therefore, it is reasonable that the retirement age also increase. By increasing labor earnings, raising retirement ages can also boost the growth of real consumption, even in the short run. Increasing the retirement age would also help avoiding even larger cuts in replacement rates than those already legislated.16 The gradual increases in retirement ages should not have substantial adverse effects on unemployment in the short-run. In addition, there is little evidence that increasing labor force participation of the elderly would increase the aggregate unemployment rates in the long run (IMF, 2011).
  • Increasing the minimum number of years of contributions to qualify for a full pension to 30 years. The current minimum contribution requirement of 15 years is too low compared with regional averages (one of the lowest among Latin American Countries, Table 5), considering the population’s average life expectancy at retirement (21.1, according to the United Nations – Population Division), and that survivors also receive benefits.
  • Workers who contributed less than 30 years would not receive a full pension, but a pension proportional to years of contribution. Allowing some pension proportional to years of contribution would benefit some temporary workers (such as in the agricultural sector) where contribution years are usually lower than that of workers in less seasonal or temporary occupations. It also helps women, who often drop out of the labor force or work part-time in childbearing years, thus facing obstacles to contributing fully for thirty years.
  • Delinking minimum pensions from the minimun wage. In particular, considering that nearly half of the workers report earnings less than two times the minimum wage (TCG, 2009), the current link makes the system financially unsustainable.
  • Redoubling efforts to reduce labor market informality. Participants into the system could increase at rates higher than those assumed. In this connection, TCG (2009) assumes the growth rate of contributors to the system to be 4 percent in 2012 (and declining through the medium term), while the actual rate during the last few years averaged about 7 percent yearly. Even though, a faster reduction in informality would not directly improve the financial situation of the system in the long run, it would improve it temporarily in the short-term, allowing more time to gradually implement needed reforms. Of course, lower informality would help the sustainability of the pension system in the long run by raising total factor productivity (Chapter 1 of this Selected Issues Paper).
  • Expanding and diversifying INSS portfolio of investment by considering other alternatives than that of government bonds, with the aim of increasing its financial income and deepening Nicaragua’s capital market. Under this scenario and taking into account the recent levels of investment income of INSS, staff assumes an 8.5 percent nominal annual rate of return on assets, instead of the 6.5 percent assumed in the actuarial report.
Table 5.Number of Months of Contributions to Qualify for Benefits
Nicaragua175
Venezuela175
Honduras180
Guatemala192
Panama216
Colombia280
Paraguay292
Mexico292
Costa Rica300
El Salvador300
Argentina360
Dominican Republic360
Ecuador360
Uruguay360
Average without Nicaragua282
Source: US Social Security Administration. Social Security Programs Throughout the World: The Americas, 2011.
Source: US Social Security Administration. Social Security Programs Throughout the World: The Americas, 2011.

Figure 3.Fund at Year’s End and Pension System Balance Under Staff Alternative Scenario

Percent of GDP

13. Last but not least, reforms should start by separating clearly the IVM system from the health care accounts. IVM contributions only represent about than half of the funds administered by the INSS. While each branch has a separate accounting of funds, there is no legal restriction to shifting reserves across branches. A reform of the IVM system should occur within a general INSS reform that legally and operationally splits pension and health care functions. This would allow creating separate trust funds and establishing rules that would guarantee the internal viability of each of the two branches.

Appendix: Current And Proposed Formulas To Determine Benefits

Current formula

A summary version of this formula can be written as:

B = [BF + (0.01591 * FWW)] * BMW

Where,

B=amount of pension.
BF=the base factor which is not significantly different for lower-paid workers (whose final average wages are less than two times the minimum wage), 0.45, and higher-paid workers, 0.40.
BMW=the basic monthly wage: the average wage of the last number of weeks worked (100; 200; or 250 weeks, depending of the number of weeks worked).
FWW=factor of weeks worked in excess of 150 weeks = (number of weeks worked – 150) / 50

Proposed formula in TCG (2009)

B = BM * GBF * AER + (0.01 * NY * AER)

Where,

B=amount of pension.
BM=base multiplier, between 1 and 0.1, inversely related to the level of earnings, which is reduced when the ratio of final payments to the minimum wage increases.
GBF=general base factor. For instance, if a worker’s final pay is twice the minimum wage and the general base factor is 0.5, she/he receives a benefit of 0.36 percent of his final pay or 0.72 percent of a minimum wage.
AER=average earnings at retirement
NY=number of year of contributions. For instance a worker who contributes 20 years will receive a 20 percent supplementary benefit.
References

    Da CostaR.J. R.de LaigleaisE.Martinez and A.Melguizo2011The Economy of the Possible: Pensions and Informality in Latin AmericaOECD Development Center Working Paper No. 295.

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    GillinghamR.2010Nicaragua: Review of Pension Reform Issuesmimeo.

    Instituto Nicaragüense de Seguridad Social (INSS)2010aAnuario Estadístico; Managua, Nicaragua.

    Instituto Nicaragüense de Seguridad Social (INSS)2010bPropuesta de Fortalecimiento del Sistema de Pensiones(www.inss.gob.ni).

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    International Monetary Fund (IMF)2007Propuesta de Fortalecimiento del Sistema de Pensiones by Instituto Nicaragüense de Seguridad SocialFiscal Affairs DepartmentWashington, D.C.

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    International Monetary Fund (IMF)2011The Challenge of Public Pension Reform in Advanced and Emerging EconomiesFiscal Affairs DepartmentWashington D.C.

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    Troncoso Consulting Group (TCG)2009Nicaragua: Different Options to Strengthen the Disability, Old and Survivor Program(mimeo), Washington, D.C.

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1Prepared by Ricardo Fenochietto; the author is grateful to Gabriel Di Bella, Mauricio Soto, and Javier Kapsoli for their comments and suggestions.
2During the last decade, there have been numerous attempts to reform the pension system, often at odds with each other. The attempts include: (i) Law 340 (April 2001), creating the framework for an individual account regime; (ii) creation of a National Advisory Commission (August 2004) that recommended a multi-pillar system with a pay-as-you-go first pillar to protect low-income workers, and simultaneous suspension of the Law 340; (iii) Law 539 (May, 2005) of Social Security, later declared unconstitutional by the Supreme Court, and never implemented. For more details see Gillingham (2010).
3Under a defined-benefits system, benefits usually depend on the number of years of contributions and the average covered earnings. Under a defined-contribution system, benefits depend on the contribution history and the returns to these contributions.
4This result is obtained under the baseline scenario described in section III.
6This level is somewhat lower than the international average, which shows high dispersion. For instance, Argentina, Brazil, Mexico, Russia, Colombia, and Venezuela have higher rates.
7The INSS administers all contributions except those for job training.
8Teachers and miners can retire when they reach 55 years of age if they contributed for at least 15 years. For disability pensions, workers must be certified as disabled, be younger than 60 years of age, and have at least 150 weeks of contributions.
9While the INSS manages Nicaragua’s social security system, there are two additional special social security programs, one for the armed forces (administered by the Instituto de Previsión Social Militar) and another one for the national police (administered by the Instituto de Seguridad Social y Desarrollo Humano).
10The baseline refers to that included in TCG (2009).
11Between 2000 and 2008, the average reported wages subject to social security contributions grew at an annual rate of 9.1 percent. Data suggest that reported wages decline as workers reach their late 50s and early 60s.
12The proposals described in this section refer to those included in TCG (2009).
13The increase in the number of contribution years to qualify for benefits is implicit in the consultants’ proposed formula, because it increases the minimum required contribution period for receiving full pension to 30 years.
14For instance, a male retiring at age 65 with 35 years of services and average earnings equal to 10 times the minimum wage might expect to get an internal rate of return of -0.7 percent per year with the supplemental replacement rate of 1 percent and a total contribution rate of 14.3 percent (IMF, 2011).
15Source: United Nations – Population Division. Average life expectancy at birth was in Nicaragua 73.0 in 2010 (71.4 for men and 77.5 for women).
16The most common measure to compare preretirement and postretirement income levels is the “replacement rate”: the result of dividing retirement income by working income.

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