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This is a slightly revised version of a paper presented at the conference on “Social Security Reforms: International Comparisons” sponsored by the International Association of Italian Economists, held in Rome, March 16–17, 1998. We are indebted to a number of colleagues for providing basic information on pension developments and reform for the countries in our sample. We also would like to thank Marta de Castello-Branco, Lorenzo Figliuoli, Peter Heller, Richard Hemming, and Neven Mates for useful suggestions, and Branko Milanovic for providing data on the living standards of the elderly in transition economies.
The shift from a pay-as-you-go to a fully-funded system involves (among other things) a switch from a defined-benefit to a defined-contribution pension system.
The acronym BRO refers to the Baltics, Russia and other countries of the Former Soviet Union.
Johnson, Kaufman, and Shleifer (1997) estimate that in the first half of the 1990s the share of the unofficial economy in the countries in our sample (excluding FYR Macedonia and Slovenia) grew from 17 percent in 1989 to 34 percent in 1995, shrinking moderately only in Poland and Romania. The expansion of the unofficial economy was more pronounced in the BRO countries, where it increased from 12 percent to 40 percent over the same period.
Moghadam (1998) estimates that 80 percent of the 1 million decline in the labor force in Hungary during 1990–96 was due to social programs (such as early retirement and disability pensions), excluding official unemployment benefits.
The increase was less pronounced than expected in the early 1990s (see, for example, Kopits (1992), Table 1, p. 293), possibly reflecting the unexpected jump in mortality rates in some countries during the transition. Note also that during 1990–95 the increase in the elderly dependency ratio was accompanied by a decline in the overall dependency ratio (the ratio between youth (0–14) and elderly (over 64) and working age population (15–64)), thus cushioning in part the effect of demographics on public finances.
In Kazakhstan the number of pensioners declined between 1993 and 1996, possibly reflecting strong emigration toward other BRO countries.
Other countries (Hungary, Kazakhstan, and Latvia), however, have recently started reducing their contributions rates slightly. In Hungary, this was accompanied by a broadening of the pension base, which is now the same as the base for the personal income tax.
Usually, the notional cash balance differed significantly from the balance of the pension funds, as the latter were burdened by expenditures of different nature and transfers from the central government budget unrelated to the PAYG system.
However, population dependency ratios in transition economies are on average higher than in developing countries with similar living standards.
This is not true of all transition economies. The demographic structure of the population of central Asian BRO countries is still quite young.
An additional problem is that in many countries, benefits have a ceiling while contributions are levied on total wage income, without a ceiling. The overall effect is to encourage evasion since beyond a certain income there is no return on the contribution. This is also a problem shared with PAYG systems in many industrial countries.
While these privileges may have a distributive justification, cross financing through a common PAYG may not provide the right incentives to best utilize human resources or to better reflect social costs.
For the Czech Republic, see Ministry of Labor and Social Affairs, Czech Republic (1996).
For Russia, see Ministry of Labor and Social Development of the Russian Federation (1997); for Bulgaria, see National Social Security Institute, Republic of Bulgaria, 1997.
Under the new system, early retirees will be penalized. For example, a woman who retires at 55 will experience on average a 25 percent cut in her pension under the new system if she stops contributing. Those who retire even earlier will suffer an even greater loss of benefits.
As a way to improve administration, these countries have unified the base for social security contributions and personal income taxes.
Agreement on the implementation of a similar system has been reached in January 1998 in Sweden, based on guidelines sent to Parliament in 1994. The implementation law is expected to be sent to parliament in the Spring of 1998. The approach also presents similarities with the 1995 Italian pension reform, in which, however, the notional yield is the nominal GDP growth rate.
Engen and Gale (1993) find that only 2 percent of the elderly own individual annuities in the United States. Friedman and Warshawsky (1990) attribute the thinness in private annuity markets to their actuarially unfair nature (primarily resulting from adverse selection).
Moreover, insofar as the weak link between contributions and benefits in traditional PAYG systems leads to contribution evasion and the development of a underground economy (see below), there may be further distortions. However, labor market distortions induced by high contribution rates and a weak link between contribution and benefits are not limited to PAYG systems. As long as the rate of return of fully funded schemes is below the market rate of return, a fully funded scheme may produce the same undesirable effects.
The IMF has usually supported the introduction of FF components. However, it has argued against them in cases where supervisory institutions were not regarded as adequate.
A Guarantee Fund, financed by a contribution of 0.3 percent of wages has been set up to back up the state’s contingent liability (Ruggiero, 1997).
The Supervisory authority will have wide discretion in setting the minimum rate of return below which the guarantee will be triggered (Palacios and Rochas, 1997).
Of course, even in FF systems, it is necessary to guarantee a minimum pension level, financed out of general revenue, in order to protect those workers who cannot accumulate enough funds. In Kazakhstan, the state will top up the contribution-related pension to achieve a minimum pension level.
Chile has experienced a sharp increase in administrative costs (Diamond, 1994). Mitchell (1996) has estimated that on average administrative costs reduce the real return of private funds by one percentage point.
A parallel risk is the one linked to the political cycle so that generous benefits are granted when politically convenient.
Even in the absence of formal government guarantees, governments may feel obligated to provide some guarantee, hence may equally perceive a similar “conjectural” liability. Heller (1998) claims that the political bind might increase the more involved the government is in supervising and regulating the private fund.
The voluntary FF pillar has developed quite rapidly in some advanced transition countries; for example, it covered about 15 percent of the workforce in Hungary in mid-1997.
The contributions can be seen as implicit debt because (unlike conventional taxes) they give rise to an obligation to pay future benefits.
Moreover, if the new system involves a government guarantee of a minimum pension, it may be necessary to set aside funds for its financing.
However, the present discounted value of the transitional costs has been estimated to be 40 percent of GDP.
Privatization receipts could be used to pay off existing public debt. In principle, the government could then earmark, formally or informally, the budgetary savings arising from the reduction in debt service payments to an investment fund that could be used to finance the cost of the transition to a FF system.
See Palacios and Whitehouse (1997) who argue in favor of a voluntary switching as this would be more palatable to workers, thus helping the political approval process. They argue that the main disadvantage of voluntary switching—the non-predictability of the process—is not important, from a practical standpoint. Given the parameters of the system, the percentage of workers who will switch can be predicted fairly accurately.
A similar solution, albeit in a different context, has been adopted in Latvia with the introduction of the notional accounts. An alternative, adopted in some Latin American countries, is to convert the old contributions into bonds, the so-called recognition bonds, with an immediate effect on public debt.
This means that, initially only 40 percent of contributions will go to the FF system.