Can Eastern Europe’s Old-Age Crisis Be Fixed?

International Monetary Fund. External Relations Dept.
Published Date:
January 1995
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The transition from central planning to a market orientation in the former centrally planned economies of Eastern and Central Europe (ECE) has not been easy. Since the Berlin Wall fell, these countries have faced declining incomes, inflation, and unemployment. One of the biggest obstacles to restoring stable growth and increasing saving and investment has been persistent fiscal deficits, caused in part by rapidly growing expenditures on pension benefits.

Eastern and Central Europeans spend much more on pensions than their incomes or demographics would predict (see chart). These expenditures have been rising rapidly since the transition began, with an increasing share of these countries’ falling GDPs being captured by pensioners. In many countries, pension expenditures are the largest single item in the government budget, accounting for about 15 percent of GDP in Poland and Slovenia, and 10 percent in Bulgaria,

Hungary, Latvia, and the Slovak Republic. Unlike in Organization for Economic Cooperation and Development (OECD) countries and middle-income developing countries—where funded, privately managed programs cover a growing share of the work force—ECE countries have only public, pay-as-you-go (PAYG) pension systems financed entirely by payroll taxes from their working populations (see Estelle James, “Averting the Old-Age Crisis,” Finance & Development, June 1995; two related articles on pension reform that appear in the same issue; and Kathie Krumm and others, “Transfers and the Transition from Central Planning,” Finance & Development, September 1995). Under central planning, the state was able to finance these expenditures through high tax rates. In market economies, however, these high tax rates are dysfunctional and increasingly inequitable. How did this crisis come about?

LOUISE FOXa US national, is a Senior Economist in the Municipal and Social Service Division, Country Department IV of the World Bank’s Europe & Central Asia Regional Office.

Pension spending in selected transition, OECD, and middle-income economies

Sources: Louise Fox. “Old Age Security in Transition Economies.” World Bank. Policy Research Department Working Paper No 1257. February 1994; World Bank. Averting the Old Age Crisis: Policies to Protect the Old and Promote Growth. Oxford University Press New York. 1994.

1 1991

Under central planning, the command economy promised cradle-to-grave income security, including pensions replacing roughly 80 percent of wages upon retirement. This has been viewed as compensation for relatively modest wages during the working years. Retirement ages were set very low, with lots of exemptions and special privileges. As a result, the average effective retirement age in the ECE countries is currently about 57 for men and 53 for women, compared with 65 and 67 for most OECD countries. Despite recent declines in health indicators, the average post- retirement life span in most Eastern and Central European countries is still longer than in most OECD countries. In other words, these countries, with much lower incomes and tax- collection capabilities, have promised pension benefits whose accumulated value after the retirement period is higher than some of the richest countries in the world (many of which are now finding their own generous welfare systems unaffordable). Aging societies in both OECD and ECE countries imply that the fiscal burden will only become heavier in the future.

Fixing this problem involves, first and foremost, a strong effort to convince the population of the need for reform. This effort must be combined with plans for a new, economically viable system that is affordable, equitable, and promotes growth. Key elements of this plan will have to include reforms of the public pension system, such as increasing the retirement age (either through incentives or legal limits, or both), removing the inequitable and costly special regimes for favored occupations and other groups, tightening up disability regulations, and developing privately managed, funded pension systems, in order to take the pressure off the PAYG pension systems in the medium term.

Early mistakes

The policy measures many ECE countries took to cope with the social costs of transition have significantly worsened the financial positions of their public pension systems. In hopes of reducing unemployment, some countries allowed workers to retire up to five years earlier than usual and still receive a full pension. This well-intentioned move swelled the ranks of pensioners while reducing the ranks of taxpayers. Since pension benefits are reduced if the pensioner continues to work, most quit the formal sector to work in the informal sector. Today, an estimated 50-70 percent of pensioners continue to work during the first decade of their “retirement,” but most of their income is outside of the tax net. Although the average pension in ECE countries is only about $15-25 per month, recent results derived from survey research show that most pensioners are not poor and have not suffered disproportionately during the transition.

It is working families with children who tend to be poor. To pay for social insurance benefits, countries raised payroll taxes from 10-25 percent of employees’ gross wages to 40-60 percent. This substantial differential between the cost of labor to firms and employees’ take-home pay has lowered real wages and probably exacerbated unemployment. Many working-age people have fled these tax rates by moving out of the formal sector entirely (with up to a third of them employed in the informal sector in some countries), leaving the burden of paying for pension benefits to those who cannot evade taxes.

Shock therapy?

In its study, Averting the Old Age Crisis, the World Bank argued that the best way for most countries to meet their populations’ needs for income security is by setting up a multipillar pension system that includes the following elements:

  • pillar 1: a mandatory PAYG public pension system designed to provide an income floor for all elderly persons;

  • pillar 2: a mandatory privately managed, funded pension system—that is, one whose current reserves are equal to or greater than the present value of all future pension payment liabilities, based on personal accounts (the Latin American approach) or occupational plans (the OECD approach); and

  • pillar 3: a voluntary system (also funded and privately managed), with strong government regulation, to provide for additional saving and insurance.

Missed opportunities for pension reform

Although Estonia, Hungary, Lithuania, and Poland all began their transitions with similar, Soviet-style systems, they have taken different paths to pension reform over the past five years. Nevertheless, the medium-term prospects of all of them are compromised by large implicit pension debts.

Missing the boat in Central Europe. Both Hungary and Poland started their transitions with favorable initial conditions for pension reform. Possibly as a result of these more favorable conditions, the seriousness of the problem was not grasped and hard decisions on pension reform were not taken. On the contrary, the policy choices made have exacerbated their problems.

Poland began the transition with a system that provided for higher retirement ages than those of all other ECE countries—60 for women and 65 for men—which should have been an advantage during the transition period. However, throughout the stabilization period (1990-92), the retirement age was lowered as an “employment-generating” measure. During this period, the number of pensioners grew by more than 10 percent per year. Poland already had a lax disability policy—in 1989, there were almost as many disability pensioners as old- age pensioners. At the same time that Poland’s ratio of pensioners to contributors (dependency ratio) was increasing, pensions were indexed to wages, starting when real wages were at their lowest point since the transition began. Today, Poland spends a higher percentage of GDP on pensions than almost any other transition economy—approximately 16 percent in 1995, which is roughly 50 percent higher than the corresponding share of GDP of an OECD country with comparable demographics.

Six years into the transition, Hungary has a large fiscal deficit and a large pension debt. Unlike some other countries, Hungary has not raised the retirement age. Legislation to equalize the minimum retirement age for women and men (at 60) was passed in 1992 but rescinded later the same year. Early retirement has been on the increase since 1989, and the growth rate of disability pensions has doubled since the transition. Given that Hungary has the highest payroll taxes of all the ECE countries, payroll tax evasion is growing. Today, each Hungarian contributor supports two thirds of a pensioner. If the retirement age in Hungary were similar to that of the OECD average, pension expenditures would be about 20 percent lower.

Incomplete reforms in the Baltics. Estonia and Lithuania have avoided the early mistakes made by their southern neighbors. Faced with demographics and labor-market dilemmas similar to those of Hungary, Poland, and the Balkan countries, these two Baltic countries did not permit pension expenditures to get out of hand during the initial transition period. Both countries introduced flat-rate pensions and discretionary nominal pension adjustments as stabilization measures. Early retirement was not used to facilitate the shedding of workers in the state sector. Reformed public pension systems were introduced in 1993 (Estonia) and 1994 (Lithuania). Nevertheless, despite their success in controlling current expenditures, both countries face the same dilemma—how to cope with looming fiscal problems owing to incomplete reforms, on the one hand, and increasing voter discontent with the public system, on the other. Although these two countries have taken the politically painful step of cutting PAYG entitlements, their failure to capitalize on these cuts by introducing a funded scheme or addressing the remaining problems in the system may have undercut efforts to boost economic growth.

Lithuania still spends a smaller share of GDP on pensions than any of its neighbors. But the recent reform of its public system included creation of an earnings-related benefit, which is indexed to the average wage in the economy, implying that the pension burden grows as real wages grow. The system also allows credits for noncontributory periods (such as time spent at home taking care of children). Retirement ages were also raised rather slowly—by two months per year for men and four months per year for women. The law originally provided for increasing the retirement age—from 55 for women and 60 for men—to 65 for both sexes, but subsequent legislation halted this in 2009 at 60 for women and 62.5 for men.

Estonia’s reform of its public pillar raises retirement ages faster—by six months per year for men and women—from their former levels of 55 for women and 60 for men, to maximums of 60 for women and 65 for men. But, in addition to Lithuanian-style credits for noncontributory periods, the Estonian system continues most of the entitlements to early pensions that prevailed before the transition, which entails an additional costly intragenerational redistribution. The disability pension system is also weak—the number of disability pensioners has jumped by 30 percent since 1990. With Estonia’s payroll taxes already at 38 percent of gross payroll, the scope for increasing taxes in order to finance the looming liabilities is very limited.

Applying this multipillar approach is more complicated in ECE countries than in the recently reformed and currently reforming Latin American countries or in countries elsewhere that are in the early stages of developing formal social security systems, owing to the ECE countries’ large existing pension debts. Adding a funded pillar implies capitalizing some of the future pension debt while continuing to service the current pension liabilities.

This is similar to making payments for two home mortgages at the same time—one on your own house and one on your parents’ house. If your parents’ house is small and your income is rising (which is analogous, for example, to the situation in Chile during the past decade), the payments are manageable. If, however, your parents’ house is large and your income is low and/or shrinking, the burden on the working generations will be high.

In the ECE countries, the pension debt is large—about 1.5 times GDP. The large debt is caused mostly by the large number of current pensioners, for whom pensions must still be paid for long periods out of current revenues, but also by the number of labor force participants near the current, low retirement age.

Unlike a mortgage, however, the pension debt of ECE countries increases every year, despite the payments made to pensioners during the previous year. This is because demographic trends cause pension benefits to grow faster than GDP at current retirement ages.

Putting in place an additional funded pillar in a manner affordable to generations of current workers requires renegotiating the informal agreement between generations embodied in the current pension system—in effect, forcing the parents to pay part of the mortgage on their house by accepting lower pensions and/or longer periods of employment before retirement. This has proved to be difficult to achieve, however, since older workers know they will not benefit directly from the development of additional funded pillars.

Simulations prepared for ECE countries show substantial gains in the future accruing from a “shock-therapy” approach to pension reform. The main shock required is a one-shot, three-to-five-year increase in the effective retirement age—to be achieved by taking the measures recommended above. Payroll taxes could then be cut by at least one third. Part of the reduction in contributions made possible by implementing these reforms could be used to start a funded pillar, which would build up savings in order to finance the retirement of the generations currently working. In return for accepting the increased retirement age, older workers could also be offered an actuarially fair structure in the PAYG system—which rewards delayed retirement—and a partial wage indexation, which would allow workers over 50 to share in the benefits of the economic growth their sacrifices have helped to create.

Modest reforms to date

Unfortunately for most ECE countries, there is not yet a consensus in favor of this type of shock therapy. Indeed, most pensioners feel they have already endured enough shocks. Raising the retirement age has been fiercely resisted by the generation that suffered the most under central planning and political repression. Even among today’s workers, few understand the full costs of the current system in savings and economic growth terms. Nor do many of them understand that the only way they can avoid the trap that their parents’ generation fell into—in which inadequate old-age security for all was created by paying too little, too early, to too many people—is to reform the system now. Reducing entitlements—a necessary condition for restoring a sustainable fiscal balance, as well as restoring incentives for efficient resource allocation—is no more popular in transition economies than anywhere else. Finally, recent banking system crises have made some countries hesitant about the ability of capital markets to effectively intermediate funds.

The strategy in most ECE countries seems to be to muddle through, hoping that a resumption of economic growth—including real wage growth—combined with the gradual increases in the retirement age that countries have enacted or are about to enact (to about 60 for women and 65 for men by about 2020) and a policy of holding the value of pensions constant in real terms will resolve the problem. Economic projections do not support this expectation. ECE demographic trends point to aging populations in these countries, and as their baby-boom generations reach retirement age, existing pension systems will simply not be able to support the entitlements, even in countries that have already implemented partial reforms (see box). In addition, the distortions and heavy fiscal burdens embodied in the current systems impede saving and growth, implying that pension reform is a precondition for economic growth and not the reverse. The experience of Hungary and Poland also suggests that the longer reforms are delayed, the harder the problems of pension debt are to solve.

The path to successful reform

Many ECE countries view West European countries as models on which to base their plans for transition to multipillar pension systems. The latter countries’ experience may offer ECE countries only limited guidance today, however, because, in Western Europe, the funded pillars were put in place when public pension systems were young, economies were growing rapidly, and much lower benefits were promised (for example, in the Netherlands, Sweden, Switzerland, and the United Kingdom). Thus far, none of the OECD countries has needed to carry out a shock program (although some countries may come to this if they do not implement reforms soon). What ECE countries can learn from OECD countries is how to build the consensus needed, in a democratic society, for reform of social policy. The experience of Latin American countries that have reformed their pension systems, such as Argentina and Peru, can also offer lessons for ECE reformers, since it demonstrates that radical reform is possible in a democracy.

As in other key areas of ECE countries’ transitions, progress on pension reform is unlikely to be made unless the authorities are willing to take bold and innovative steps. (The experience of voucher privatization—a whole new approach developed in ECE countries—is instructive here.)

The proposed new Latvian system is one such model. The principal elements of this proposed system are as follows:

  • Improved incentives and a lighter fiscal burden. The existing pension debt (and thus the fiscal burden) will be reduced by tying benefits in the public PAYG system completely to contributions through adopting a “notional defined-contribution” approach. This involves reducing promised benefits to those who retire before 65 to much less than the target of a 50-60 percent replacement rate—that is, the percentage of workers’ average wages that are replaced by their pensions—and increasing substantially the benefits for those who work longer and continue to contribute. Favorable treatment for special groups is also to be abolished, although those who have already begun to receive their pensions will not have them taken away; and

  • Increased savings resulting from introduction of a funded pillar. By 2000 or so, the savings from the reform of the first pillar will allow roughly one quarter of expected contributions to be channeled to the second, funded pillar. These contributions will be held in reserve or invested by private managers.

Croatia is also developing a reform program involving a major reduction in benefits for future retirees and a proposed mandatory second pillar. In one version currently under discussion, the second tier would be financed initially by privatization proceeds, which would allow it to have a wide coverage at an early stage. Using privatization of government assets to pay off pension obligations is an often-discussed idea in transition economies. However, it has not been used effectively to date, since it inevitably involves concentrating illiquid assets whose value is uncertain in the hands of the age group most in need of liquidity and income security. In Estonia, where privatization vouchers were given to workers on the basis of their years of service, pensioners’ dissatisfaction with the weak voucher market has created pressure to allow them to swap vouchers for an annuity—a potentially costly transfer to this age group, given that vouchers are currently trading at less than 20 percent of their face value.

One important lesson drawn from other countries is that a successful pension reform strategy in an open political system must offer something to most of the key stakeholders. Systemic reform, including the creation of a multipillar system, does this by offering the working generations more generous future pensions in return for increased savings. Systemic reform could also benefit older generations by offering them more secure pensions in the future. But the starting point for change has to be a recognition that the promises made by the centrally planned system cannot be honored and that attempting to do this will ensure a slower and more painful transition to a robust market economy.

This article is based on the author’s study, “Old Age Security in Transition Economies,” World Bank, Policy Research Department Working Paper No. 1257, February 1994.

Suggestions for further reading: World Bank, Averting the Old Age Crisis: Policies to Protect the Old and Promote Growth, Oxford University Press, New York, 1994.

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