Republic of Poland: Background Paper

This Background Paper examines sources of net international reserve inflows for Poland. It shows that once estimate of unrecorded border trade is included, both the current and capital accounts are in surplus. The paper illustrates the methods through which estimates of unrecorded trade can be obtained. It offers a complementary view of Poland’s inflation problem from a medium-term perspective. Specifically, the paper shows that relative price adjustment, combined with indexation and inertia, has been part and parcel of Polish inflation.

Abstract

This Background Paper examines sources of net international reserve inflows for Poland. It shows that once estimate of unrecorded border trade is included, both the current and capital accounts are in surplus. The paper illustrates the methods through which estimates of unrecorded trade can be obtained. It offers a complementary view of Poland’s inflation problem from a medium-term perspective. Specifically, the paper shows that relative price adjustment, combined with indexation and inertia, has been part and parcel of Polish inflation.

V. Pension Reform in Poland

1. Introduction and summary

Pensions have recently been the fastest growing component of public expenditure in Poland. The rapid growth in pension expenditure during the transition reflects both increased incentives for early retirement and relatively generous increases in the average pension, especially following the introduction of pension indexation in 1991. Unless the pension system is reformed, pension expenditure will continue rising, because of a projected further increase in the ratio of retirees to contributors and the effect of declining inflation on real pension expenditure. Seen against the background of other weaknesses in the structure of the budget (including reliance on substantial revenue from privatization and relatively low expenditure on investment and maintenance), reform of the pension system is urgently needed to ensure continued fiscal sustainability.

The authorities have recently decided to suspend the automatic and full indexation of pensions for one year (1996) and have prepared a preliminary program for a broad pension reform. While the temporary suspension of indexation will prevent substantial growth of pension expenditure relative to GDP in 1996, the proposal for the overall reform (with many crucial details still undecided) is unlikely to yield substantial savings or improve the efficiency of the pension system. The main weakness is that the proposal has not convincingly addressed the issue of privileges for early retirement, the main cause of Poland’s very low average retirement age.

The surest way to put the public pension system on a healthy foundation would be to eliminate the privileges for retiring before the general statutory retirement age. However, if a general option for early retirement is introduced, it should be combined with a penalty reduction in benefits. Further savings and efficiency gains would be obtained by extending the averaging period to the whole employment history at an accelerated pace, replacing the automatic quarterly indexation with an annual adjustment, tightening the procedures for receiving disability pensions, and imposing more effective restrictions on the benefits of retirees who continue working.

2. Recent developments in Poland’s pension system

Between 1988 and 1993, pension expenditure in Poland more than doubled relative to GDP (Chart V.1). 1/ With 15 percent of GDP, Poland today has one of the highest levels of public expenditure on pensions in Europe, although its population is one of the youngest (Table V.1). Poland’s pension expenditure also stands out in comparison with the other transition countries in Eastern and Central Europe (Table V.2).

CHART V.1
CHART V.1

POLAND EXPENDITURE ON PENSIONS AS SHARE OF GDP

Citation: IMF Staff Country Reports 1996, 019; 10.5089/9781451831788.002.A005

Sources: Polish authorities and staff estimates.
Table V.1.

Poland: A Comparison of Pension Expenditure in Poland and Selected EU Countries

article image
Sources: For pension expenditure in EEC countries: Social Protection Expenditure and Receipts 1980-1992, Eurostat. For population structure: Boe, E., and others, World Population Projections 1994-95 (Washington: World Bank, 1994). For Poland: IMF staff estimates.

Pension expenditure is for 1994.

Table V.2.

Poland: A Comparison of Pension Data in Eastern and Central European Countries

(In percent)

article image
Source: UNICEF, Central and Eastern Europe in Transition: Public Policy and Social conditions, (Geneva: UNICEF 1993).

Refers to 1991.

Polish data indicate the ratio of 72 percent.

This dramatic increase in pension expenditure has been the result of both a growing number of retirees and increases in the average pension during the transition. First, while the number of retirees in Poland was growing faster than the old age population during the whole of 1980s (Chart V.2), the pace of retirement substantially accelerated following the economic reforms in 1990. The surge in retirement was closely related to declining employment and rising unemployment. Between 1988 and 1993, the number of retirees increased by 30 percent, or 2 million individuals. During the same period, overall employment declined by some 2.6 million, or 15 percent, and unemployment increased by 2.9 million (Chart V.3). In such circumstances, many individuals chose to retire before the general statutory retirement age. As a result, the average retirement age for old age retirees declined to 59 years for men and 55 years for women, substantially lower than in OECD countries (Table V.3).

CHART V.2
CHART V.2

POLAND NUMBER OF PENSIONERS AND THE AVERAGE REPLACEMENT RATE

(In Thousands)

Citation: IMF Staff Country Reports 1996, 019; 10.5089/9781451831788.002.A005

Source: Rocznik Statystyczny 1994, Warszawa, 1994.1/ Includes old age, disability and family pensioners.
CHART V.3
CHART V.3

POLAND NUMBER OF PENSIONERS, EMPLOYED, AND UNEMPLOYED

(In Millions)

Citation: IMF Staff Country Reports 1996, 019; 10.5089/9781451831788.002.A005

Source: Polish authorities.
Table V.3.

Poland: Average Retirement Age in Public Old-Age Schemes in OECD Countries and Poland in 1990

article image
Sources: For OECD countries OECD, New Orientations for Social policy (Paris, 1994), p. 90. Retirement age is a weighted average for the basic pension and early old-age pensions. Data for Belgium and Luxembourg are for 1983/84. Data for Poland are for the main social security fund, FUS. Because of different classification, the OECD average in this table excludes France.

Second, during the 1980s pensions were not regularly adjusted for inflation (Chart V.2). After the transition triggered higher inflation, the authorities introduced an automatic indexation mechanism in 1991. On this occasion, all pensions were recalculated, and in this way corrected for losses over the previous years. As a result, the average replacement ratio between 1989 and 1991 increased by 34 percent (Chart V.2). 1/ Furthermore, the position of retirees relative to those employed improved even more than reflected in the replacement rate. The elimination of various nonwage benefits that state-owned enterprises directly provided to employees, like subsidized housing, vacations, child care, and food supplies, affected employees to a larger extent than retirees.

As a result of the push factors coming from the labor market and the pull factors reflecting the improved relative rewards of retirement, a large number of people retired and total pension expenditure surged. The substantial deficit of the social security became in this way a major burden on Poland’s fiscal position.

3. Basic characteristics of the pension system in Poland

The following characteristics of the pension system in Poland have contributed to the dramatic increase in the number of retirees and expenditure on pensions.

First, exemptions from the general statutory retirement age in Poland are more important than the rule itself. In principle, the retirement age is 65 years for men and 60 for women. However, women can retire after the age of 55 if they have 30 qualifying years. Moreover, workers in a large number of sectors can retire at 60 years for men and 55 for women. 1/ In addition, teachers with 30 years of service and pit-working miners with 25 years of service can retire regardless of age, as may employees of enterprises under liquidation or restructuring with 40/35 qualifying years. For some groups, the privilege of early retirement is combined with a higher accrual rate (50-100 percent higher than the standard rate). In addition, at the beginning of the transition, the Government granted additional opportunities for early retirement to those who lost jobs due to enterprise restructuring programs.

Second, there is no penalty for retiring before the general retirement age, and only a shorter accrual period modestly reduces the pension level. For example, an employee retiring at 64 years of age with 45 years of service and a wage during the qualifying period equal to the average wage in the economy is entitled to a pension that is only 1.6 percent lower than what he would receive at the age of 65. By comparison, Germany recently implemented a reform under which pensions for those retiring one year early will be reduced by 6.1 percent, as a combined result of the shorter accrual period and the early retirement penalty (before the reform, the pension was reduced by 2.5 percent). 2/ In Sweden, the pension in this case is reduced by 6 percent. In the United States, before the recent reform, the pension was reduced by 5.6 percent; after the reform the reduction is 7.4 percent. It has been calculated that to be neutral in actuarial terms, the pension in Germany would have to be reduced by 10.5 percent. 3/

For those retiring five years early in Poland the pension is reduced by only 8 percent, compared to 12.5 percent in Germany before and 30 percent after the reform, 1/ and to 30 percent in Sweden. 2/ To be neutral in actuarial terms, it has been calculated for Germany that the pension would have to be reduced by 40 percent. 3/

Third, early retirement in Poland is made more attractive by liberal regulations for employment after retirement. Before 1992, the pension was not reduced at all if the retiree continued to work. Since then, it has been reduced when earned income is between 60 percent and 120 percent of the average wage. However, the reduction is modest: it is only for additional earnings higher than 120 percent of the average wage that the pension is suspended. This creates strong incentives to combine retirement with work. For example, by working only part time and keeping monthly earnings below the 120 percent limit, an employee can increase his earnings over and above the pension by 96 percent of the average wage. In practice, even the limited reduction of benefits is not enforced, owing to the lack of coordination between the social security and tax administrations. 4/

Fourth, the replacement rate implied by Poland’s pension formula is high by international standards. The formula is composed of two parts. The equalizing part is 24 percent of the average wage in the economy. The earnings-related part accrues at a rate of 1.3 percent per year of employment and 0.7 percent for other qualifying years, and is based on the retiree’s average wage. The averaging period, which was only one year before the 1991 reform, is now gradually increasing, and by 1999 it is scheduled to reach ten out of the last 20 years of employment. Wages in the previous years are measured as a ratio to the average wage in the economy, then adjusted to the last quarter before retirement. The minimum pension is defined as 39 percent of the average wage, which also increases the average replacement rate.

Fifth, Poland has a very generous system of disability pensions. Eligibility is based on the criterion of damage to health, not inability to work. The procedure to receive the pension is very simple and those receiving the pension can continue to work, albeit not full time.

Finally, since 1991 Poland has had an automatic adjustment of pensions. The adjustment is triggered whenever the average wage in the economy in a quarter is more than 10 percent higher than in the last quarter in which the adjustment was made. The adjustment applies to the pension for the third month of the next quarter. The real loss due to delayed adjustment depends on how often the adjustments are triggered and on the inflation rate, but it is not cumulative.

Another characteristic of the indexation mechanism is that it makes it difficult to predict the balance of the pension funds. This is because a small deviation of the average wage from the projected path, which may imply only a modest increase in contribution revenue, can trigger a substantial increase in pension expenditure. For example, if the adjustment takes place one quarter earlier than expected, expenditure for that year can increase by as much as 0.5 percent of GDP.

The indexation mechanism is also sensitive to the quarterly profile of wage increases. For example, an ex-post compensation to budget sector employees for higher inflation paid in the fourth quarter of 1995 would, under the existing system, have the effect of triggering an exceptionally high adjustment of pensions at the beginning of 1996. This would imply a real increase in the average pension of some 12 percent in 1996, compared to the Government’s projection for real wage growth of only 3 percent. This fact provided strong motivation for the 1996 pension bill that will temporarily replace automatic indexation by a single adjustment in September 1996.

4. Prospects if the pension system is not changed

The burden of pension expenditure will increase in the future if the pension system is not changed. Thanks to the 1996 pension bill, the immediate outlook is not threatening. However, the number of retirees in 1996 is expected to increase by more than 2 percent, after an increase of 2.5 percent in 1995. By contrast, employment growth is likely to be more modest. Furthermore, even with favorable developments in employment, contribution revenue is likely to be adversely affected by a continuing shift in the structure of employment toward small-scale businesses and self-employment. These developments are symptomatic of the underlying pressures for pension expenditure relative to contributions to continue to grow over the next few years.

Over the medium and long terms, a number of factors, economic and demographic, will work to raise pension expenditure relative to GDP under the present system. To summarize the discussion below, the trends in inflation, population aging, and labor participation are all likely to push up pension expenditure. The effects of these trends could be offset, but only partly, by a decline in unemployment. The net effect of all these trends is likely to be a significant increase in the ratio of pension expenditure to GDP in the long term.

First, a planned decline in inflation over the medium term will increase pension expenditure in real terms, because it will reduce the loss resulting from the delayed adjustment of benefits. In 1993, this loss (with inflation of 38 percent) amounted to some 15 percent. With a decline of inflation to levels prevailing in Western Europe, the loss would be reduced to one half of the adjustment threshold, or 5 percent. This implies an increase in the replacement rate of almost 12 percent and in pension expenditure of one and a half percentage points of GDP.

Second, demographic changes will work toward increasing the burden of pension expenditure. The old-age population dependency ratio is projected to increase only modestly between 1995 and 2010, but after that it will start to rise at a much faster pace (Chart V.4). 1/ A pure effect of population aging (i.e., assuming no changes in the participation and unemployment rates) by the year 2035 would result in an increase in the ratio of the number of retirees to that of employees by almost 50 percent. Still, Poland would continue to have a younger structure of population than European countries on average.

CHART V.4
CHART V.4

POLAND OLD AGE AND TOTAL DEPENDENCY RATIOS IN EUROPE, GERMANY, HUNGARY AND POLAND, 1990–2035

Citation: IMF Staff Country Reports 1996, 019; 10.5089/9781451831788.002.A005

Source: The World Bank, World Population Projections; Estimates; and Projections with Related Demographic Statistics, 1994/1995, (Baltimore: Published for the World Bank, The John Hopkins University Press, 1994).

Third, while difficult to judge, prospective changes in the participation rate are also likely to have a negative effect on the dependency ratio. Poland’s aggregate participation rate, defined as the share of labor force in the population aged 15 and over, was 62 percent in 1993--lower than in European OECD countries. 2/ However, employment now amounts to 84 percent of the working age population that does not receive pension, which is high. 3/ An age-specific comparison shows that the participation rate for men and women between the age of 25 and 44 years in Poland is higher than, for example, in Germany, although it is lower for the younger and older age groups. The lower participation rate for the younger groups probably reflects high unemployment, and may therefore increase with time. The low participation for older groups in Poland reflects, however, the characteristics of the pension system and will therefore not change without a change in the system.

The only factor that could partly relieve the pressure on the balance of the pension funds would be a decline in unemployment. For instance, a decline in the unemployment rate from the early 1995 level of 16 percent to 8 percent, assuming a corresponding increase in employment, would reduce the dependency ratio in the pension system by 9 percent. Lower unemployment may also have the additional effect of reducing incentives for early retirement, but this effect is difficult to estimate. 1/

Putting all the above pieces together, calculations based on reasonable assumptions imply that Poland’s pension expenditure relative to GDP would increase from the present 15 percent to 22 percent by 2035--a hard-to-sustain outcome. The key assumptions yielding this result include an unchanged pension formula, population projections as in the recent World Bank study, unemployment declining to 8 percent, inflation declining to the lower single digits, an unchanged participation rate of those not receiving pensions, and an unchanged share of working age disability pensioners in the working population.

5. Policy response

Confronted with a growing burden of pension expenditure over the last few years, the authorities have decided simultaneously to take several stopgap measures and to start discussions about an overall reform of the pension system. Unfortunately, there is a substantial risk that the short-term measures will result in only modest cost savings, and the preliminary proposals for the overall reform do not seem to provide guarantees that efficiency of the system would improve.

a. Immediate measures

In 1995, the legislative process started on three issues:

  • As mentioned above, prompted by concerns that the current indexation mechanism would result in a real increase in the average pension by some 12 percent in 1996, Parliament approved a bill suspending the automatic indexation mechanism for that year. Instead, pensions in 1996 will be adjusted only once (in September), by a coefficient that will limit the real growth in the average pension to not less than 2.5 percent. 2/ If inflation exceeds the target of 17 percent during 1996, retirees will be compensated in 1997.

  • The Government has sent to Parliament a proposal to change the criterion for disability pensions from damage to health to inability to work and to tighten the procedures for granting disability pensions. The decision on these issues has, however, been postponed to 1996.

  • Trying to resolve a constitutional dispute about a 1993 decision, the authorities have amended the basic pension law with the effect that at each indexation the pension base will be corrected by 1 percentage point until 100 percent parity is reestablished. 1/ This will result in an increase in the average pension by some 6 percent over the next three years.

b. Proposal for a broad reform

In June 1995, the authorities sent a proposal for an overall reform of the pension system to social partners for comments. The new system would have three tiers:

  • The first tier would provide a flat state pension (for which no previous employment service would be required) at 30 percent of the average wage.

  • The second tier pension would be linked to employment history. The statutory retirement age for women would be gradually raised to 65 over the next 10 years. The right of women to retire after the age of 55 with 30 years of service would be eliminated in principle, but all women with 20 years of service at the time of reform would retain this privilege. The averaging period would be gradually extended to 20 years and noncontributing accruing years would be eliminated, but the minimum service years would be reduced to 15.

  • The third tier would be an additional private system, including company based schemes with book reserves, that would be supported by tax preferences and supervised by the Government. To support this tier, the contributions for the second tier would be limited to wages up to 250 percent of the average wage.

The first tier pension would be ex ante indexed to the projected inflation, and ex post corrected over the following fiscal year if inflation were higher. The second tier pensions would be indexed to wages, but conditional on the availability of resources in the pension fund.

After the end of the public debate in August, government officials have indicated that the proposal might be modified. In particular, the level of the state pension might be reduced and, instead of automatic indexation, annual adjustments could be negotiated each year in the context of annual budget decisions.

The plans for reform are still provisional, and many crucial details remain to be determined. On the promising side are the proposed elimination of the noncontributing accrual years, the gradual extension in the averaging period, and the equalization of the statutory retirement age for women with that for men. Unfortunately, the program has not defined how fast the averaging period would be extended, and it has proposed a very long period during which women could grandfather the right to early retirement.

The main weakness of the proposed reform is that it has not convincingly addressed the issue of occupational privileges for early retirement. By establishing a special pension fund that would collect higher contributions for all those entitled to early retirement, the reform would actually go in the opposite direction compared with reforms in other European countries, which over the last few decades have tried to unify their public pension schemes. The present variety of occupational privileges would actually require several occupational funds, or at least various contribution rates. Furthermore, it is difficult to see how the higher contributions would be imposed on sectors that have effectively opposed the elimination of occupational privileges in the past, and have even incurred substantial contribution arrears. The proposed solution has also left many questions unanswered, including why the opportunity for early retirement should be restricted to specific occupations, if the higher contributions are supposed to be fair in actuarial terms, and why it is better to impose higher contributions on individuals in specific occupations than to introduce penalties for early retirement and leave the choice to individuals (as is usually done in other countries). In addition, in Poland today all contributions are paid by employers, and none by employees, which will make the implementation of different contribution rates more difficult. These questions would have to be addressed before the current proposal could become a practical solution.

Furthermore, the proposal to introduce a state pension, for which no previous employment service would be required, would increase the number of recipients by some 640,000 persons. The reduction in the minimum service period for the second tier to 15 years would also increase the number of those eligible for pension.

Finally, the reform would increase the already high statutory replacement rate. This is because the proposed state pension would be higher than the equalizing component in the present pension formula, while the proposed earnings-related accrual rate would only slightly be reduced, to somewhere between 1.1 percent and 1.25 percent per year. The relative change in the two components would also weaken the link between the individuals’ contributions and their benefits, and in this way increase labor market distortions.

Concerning indexation, the authorities have recently changed their proposals on several occasions. 1/ It has not yet been resolved whether pensions would be adjusted by a combination of price and wage based indices, or whether automatic indexation would be replaced by annual discretionary adjustments. Indexation is, however, considered today in Poland a deeply entrenched right, and it may be very difficult to eliminate it completely. Furthermore, some mechanism of automatic adjustment exists in almost all countries with public pension schemes.

c. Suggested improvements

Many crucial details of the reform still remain to be specified, including the time schedule for implementation. This makes it difficult to estimate the overall effects of the proposed measures. In its present form, however, the proposed reform does not guarantee that the new system would be more efficient and that it would contain and reduce the high share of public sector pension expenditure in GDP. To achieve these objectives, the following improvements could be considered:

  • Elimination of occupational privileges and privileges for women for early retirement, combined with a reduction in the pensions for all who retire before the general statutory age, would be the most effective way to increase the average retirement age and in this way put the pension system on a more healthy foundation.

  • The gradual extension of the averaging period could be accelerated and extended to the entire working life, which would lead to an effective reduction in the average effective replacement rate. This would avoid the political problems that may arise if the reform tries to change the pension formula.

  • By reducing the benefits for retirees who continue to work after retirement, and by effective enforcement of this regulation, early retirement could be made less attractive and expenditure on benefits could be reduced.

  • Declining inflation by itself provides a good cause for reducing the frequency of adjustments. By replacing quarterly indexation with a single annual adjustment, preferably linked to a price index, or to a combination of price and wage indices, the system would provide security for retirees, and at the same time decelerate the growth in pension expenditure.

1/

Some 2 percentage points of the increase in pension expenditure in 1992 were due to the personal income tax reform, which grossed up both pension benefits and wages.

1/

The end-year replacement rate increased even more dramatically, by 43 percent.

1/

The list of sectors with early retirement privileges is long and includes miners, railroad employees, teachers, journalists, artists, creative professionals, customs officers, shipyard workers, fishermen, seamen, those working under physically strenuous conditions in the construction industry, the power sector, steel production, metallurgy, the chemical sector, forestry, the textile industry, transportation and telecommunications, public utilities, and the agricultural sector.

2/

See Axel Boersch-Supan, “Population Aging, Social Security Design and Early Retirement,” Journal of Institutional and Theoretical Economics, Vol. 148, No. 4, December 1992, pp. 533-57.

3/

See Boersch-Supan (1992). This calculation is based on a discount factor of 3 percent and current survival probabilities at age 60.

1/

Retirement at this age in Germany is restricted. See Boersch-Supan (1992), p. 540.

2/

See Robert Holzmann, Reforming Public Pensions (Paris: OECD, 1988), p. 132.

3/

Boersch-Supan (1992).

4/

Unfortunately, there are no reliable data on the number of retirees who continue working. However, census data for 1988 indicated that some 23 percent of nonfarmer retirees received additional employment income, and 6 percent received higher employment income than pension benefits. See Rocznik Statystyczny Ubespieczen Spolecznycg 1985-1990 (Social Security Yearbook 1985-1990) (Warsaw: ZUS, 1992), p. 47.

1/

See E. Bos and others, World Population Projections. Estimates and Projections with Related Demographic Statistics. 1994-1994 (Washington: World Bank, 1994).

2/

See Organization for Economic Cooperation and Development, Labor Force Statistics (Paris: OECD, Paris, 1993).

3/

This partly reflects the fact that retirees also continue to work.

1/

For a more optimistic assessment of the effects of declining unemployment on pension expenditure in Poland, see William Perraudin and Thierry Pujol, “Framework for the Analysis of Pension and Unemployment Benefit Reform in Poland”, IMF Staff Papers, Vol. 41, No.4, December 1994, pp. 643-74.

2/

As the number of retirees is expected to increase by 2.1 percent in 1996, pension expenditure relative to GDP would decline only modestly.

1/

The 1993 budget reduced the pension base from 100 percent to 91 percent, which was corrected in 1994 to 94 percent. In 1995, the Constitutional Tribunal declared the original decision unconstitutional, and while Parliament overruled the ruling, it decided to reestablish the original parity.

1/

At one stage, the authorities intended to switch the base of the indexation mechanism from wages to prices. Based on an assumption of real wage growth of 1.5 percent per year, the long run expenditure savings of such measure have recently been estimated at 14 percent for unchanged retirement age, and at 10 percent if the average retirement age is increased to 65. (See John C. Hambor, “Issues in Eastern European Social Security Reform”, Research Paper No. 9201, U.S. Treasury Department, 1992.) In practice, however, savings might be lower, because the authorities would likely face pressures to increase real pensions from time to time.

Republic of Poland: Background Paper
Author: International Monetary Fund
  • View in gallery

    POLAND EXPENDITURE ON PENSIONS AS SHARE OF GDP

  • View in gallery

    POLAND NUMBER OF PENSIONERS AND THE AVERAGE REPLACEMENT RATE

    (In Thousands)

  • View in gallery

    POLAND NUMBER OF PENSIONERS, EMPLOYED, AND UNEMPLOYED

    (In Millions)

  • View in gallery

    POLAND OLD AGE AND TOTAL DEPENDENCY RATIOS IN EUROPE, GERMANY, HUNGARY AND POLAND, 1990–2035