Hungary—Selected Issues

This Selected Issues paper analyzes empirically the main determinants of Hungary’s inflation rate during 1990–96. Although there exist a number of possible methodologies to analyze this issue, the one proposed in the paper takes explicit account of the time-series properties of the variables that are potential candidates for explaining Hungary’s inflation performance. This leads to the specification of a long-term equation, linking consumer prices to a number of macroeconomic variables as well as to proxies for relative price shocks. The paper also examines the external current account and net foreign assets in Hungary.

Abstract

This Selected Issues paper analyzes empirically the main determinants of Hungary’s inflation rate during 1990–96. Although there exist a number of possible methodologies to analyze this issue, the one proposed in the paper takes explicit account of the time-series properties of the variables that are potential candidates for explaining Hungary’s inflation performance. This leads to the specification of a long-term equation, linking consumer prices to a number of macroeconomic variables as well as to proxies for relative price shocks. The paper also examines the external current account and net foreign assets in Hungary.

III. Pension Reform 1/

The Hungarian government has initiated a wide-ranging reform of the country’s pension system. In this paper we will review the main characteristics of the current pension system, discuss its main problems, and outline the wide-ranging reform measures that are being undertaken by the authorities.

1. The Current pension system; institutional characteristics

The Current Hungarian Pension Fund is a mandatory, national, pay-as-you-go (PAYG) scheme. The pension system provides old-age and disability pensions to both the insured (own-right pensions) and several categories of their dependents (dependent-right pensions). The Pension Fund is financed through social security contributions of 30.5 percent (24.5 for the employer and 6 percent for the employee). 2/ The statutory retirement ages are 55 for women and 60 for men, though some lower retirement ages exist for specific professions. 3/

In January 1995, there were 3 million pensioners (out of a total population of 10.3 million), of whom 2.7 million received benefits financed by the Pension Insurance Fund (PIF) and Health Fund (together known as Social Security Funds), and 300,000 received provisions financed from budgetary sources. 4/ The average monthly benefit paid by the system was Ft. 13,500 (US$121).

Important characteristics of the mono-pillar PAYG system include: near universal coverage; relatively high levels of expenditure as a fraction of GDP; very high system dependency ratio (mostly caused by low retirement ages and lax certification of disability pensions); high contribution rates coupled with growing evasion and sizeable arrears; and imperfect inflation indexation. These factors will be discussed in the following section.

The Pension Fund—and the Health Fund—are self-governing administrations, fairly independent from the central administration and directly responsible to Parliament. However, starting from 1997, the budgetary procedures of the social security administrations will follow the State budgetary cycle, and the social security self-governments will be subject to stricter (quarterly and yearly) reporting requirements towards the government and the Parliament. 1/ This will improve the government’s ability to project and monitor the fiscal performance of the central government.

2. The current pension system: main issues

The Hungarian pension system, like those of several other Eastern European countries, is experiencing growing financial problems. These problems are mostly related to the large and increasing number of pensioners, and, more recently, to the erosion of the contribution base. These forces, so far, have not brought about a deterioration of the balance of the PIF (Chart 12), nor an increase in the ratio between pension expenditure and GDP (Chart 13). Rather, they have resulted in low and diminishing pension levels.

Chart 12
Chart 12

HUNGARY: DEFICIT OF PENSION FUND, 1992-96

(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 109; 10.5089/9781451817829.002.A003

Source: Ministry of Finance, Hungary.
Chart 13
Chart 13

HUNGARY: TOTAL PENSION EXPENDITURE, 1990-95

(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 109; 10.5089/9781451817829.002.A003

Source: World Bank, January 1996.

a. Low and diminishing pension levels

The average pension benefit declined by around 25 percent in real terms from 1990 to 1995 (Chart 14). This decline was mainly due to a less-than-full adjustment of pensions to prices, and to a fall in the real value of pensions at entry. During 1990-93, pensions were not automatically linked to any price or wage index, but were adjusted by Parliamentary or government decisions, and typically by less than inflation. In 1994-95, pension benefits were indexed to the expected increase in the net average wage during the upcoming calendar year. As of 1996, they have been indexed to the net average wage during the previous year. Thus, because of the ex-ante indexation and the large drop in real net wages in 1995, the indexation mechanism failed to provide an adequate hedge against inflation also during 1994-96.

Chart 14
Chart 14

HUNGARY: REAL PENSIONS, 1986-95 1/

(Index: 1986 = 100)

Citation: IMF Staff Country Reports 1996, 109; 10.5089/9781451817829.002.A003

Sources: Hungarian authorities; and staff estimates.1/ Nominal average pension divided by CPI.

The real value of pensions at entry has also been eroded, because of the lack of a full actualization of past contributions for wage growth. The annual wage history since 1988 is taken into account for the determination of new pensions, but past contributions are adjusted for wage growth only through 1992. Basically, there is no adjustment for wages earned and contributions paid after 1992. The result is that the pension of retiring workers of all income levels has been falling both in real terms and in relation to the average wage in the economy.

With the loss in the real value of pension benefits, their ability to provide income support has eroded. In the first quarter of 1994, nearly one-third of own-right old age pensioners received a monthly benefit lower than the legally prescribed minimum wage (Ft 10,500), and two-thirds received a benefit which was under or close to the subsistence, or rather, poverty level (around Ft 12,000, based on World Bank estimates). Though more recent data are not available, the income distribution of pension benefits must have continued to worsen, because average nominal benefits increased by less than the CPI from 1994 to 1996.

b. The number of pensioners

The number of pensioners is high and has been growing steadily over the last decade (Chart 15). In order to facilitate comparisons with other countries it is useful to focus on two ratios, the demographic dependency ratio and the system dependency ratio.

Chart 15
Chart 15

HUNGARY: NUMBER OF PENSIONERS, 1986-95

Citation: IMF Staff Country Reports 1996, 109; 10.5089/9781451817829.002.A003

Source: Ministry of Finance, Hungary.

The demographic dependency ratio (DDR)—the number of people over age 60 divided by those aged 20-59—was around 36 percent in 1995, which is high compared to other countries, reflecting the low retirement age (among the lowest in Europe 1/), and widespread early retirement, mostly for disability reasons (see below). It is important to note that demographic trends are not behind the recent increase in the number of pensioners, as the DDR has actually declined by some 2 percentage points since 1990, thanks to two baby-boom blips working through the pyramid. The DDR is expected to continue to decline marginally until 2003, when it will start a steady ascent—to 42 percent in 2015, 52 percent in 2035, and 65 percent in 2050. 2/

The increase in the number of pensioners is mostly due to the fast rise in the number of disability pensioners, particularly during the 1990s. This phenomenon is illustrated by the upward trend in the system dependency ratio (SDR)—the number of pensioners divided by the number of contributors—which increased from 50 percent in 1990 to a strikingly high 67 percent in 1995. The SDR is in fact one of the highest in the world, particularly in relation to the age structure of the population (Chart 16). The main factors explaining the gap between the SDR and the DDR are the low retirement age, the large and increasing number of disability pensioners, and the growing portion of the working population engaged in the informal sector (see below).

Chart 16
Chart 16

HUNGARY: SYSTEM VS. OLD AGE DEPENDENCY RATIO

Citation: IMF Staff Country Reports 1996, 109; 10.5089/9781451817829.002.A003

Source: Palacios, January, 1996.

Though certain occupational groups enjoy preferential early retirement, the low effective retirement age (53.3 years in 1993) is largely the result of under-age disability as a form of social safety net. The number of disability pensioners as a percentage of old-age pensioners has increased from 34 percent in 1986 to 45 percent in 1995, with most of the increase materializing after 1990 (Chart 15, right-hand side). In fact, the economic transition brought about an explosion of disability pensions, as these were used as a safety net to provide income support to vulnerable groups, in preference to unemployment benefits which have limited duration. In 1993, 27 percent of all pensioners received benefits originally awarded on disability grounds, and then commuted to old age pensions. Disability pensions are still growing at twice the rate of pre-1989, though there is no medical evidence that morbidity is rising this rapidly: this suggests that disability pensions are largely a function of soft layoffs and collusion between employers and employees.

c. The base erosion

The contribution revenue of the public pension system has plummeted as a share of GDP between 1990 and 1995 (Chart 17). This decline is due to several factors. First, the wage bill, as a proportion of total labor income, has declined, reflecting the shift to self-employment, and the growth of non-public enterprises, particularly of small-to-medium sized ones, which may underreport their income to the tax authorities. Second, the share of wages and salaries in GDP has declined. This was mostly due to falling labor force participation, underreporting of wages in small firms (which are usually more labor-intensive), and early retirement through disability. In addition to these factors, the decline in the labor share to GDP in 1995 is largely due to the income redistribution from wages to profits after March 1995.

Chart 17
Chart 17

HUNGARY: CONTRIBUTION REVENUE AND BASE, 1991-96

Citation: IMF Staff Country Reports 1996, 109; 10.5089/9781451817829.002.A003

Source: World Bank, January, 1996.

These trends are, to a great extent, related to the high contribution rates, which stimulate evasion and avoidance. At 30.5 percent, the contribution rate of the PIF is quite high by international standards, even after adjusting for the demographic structure of the population (Chart 18). Moreover, payroll taxes for pension insurance are in fact only a portion—albeit the largest—of the indirect labor costs that go to finance the Hungarian social security system: other main payroll taxes include those for health and unemployment insurance. Total contributions currently account for 59.5 percent of gross wages and for 32.4 percent of labor costs for the employer. 1/ Tax evasion is essentially connected to the nonregistration of economic activity, with potential effects going well beyond the insolvency of the SSF. It has been estimated that evasion of social security contributions in Hungary is around 11.5 percent of due contributions, or around 1.6 percent of GDP (World Bank, 1996). Tax avoidance is pursued through shifting incomes to tax-exempt wage-like remunerations—such as side benefits or dividends (both exempt from social security contributions).

Chart 18
Chart 18

HUNGARY: PAYROLL TAX FOR PENSIONS AND OLD-AGE DEPENDENCY RATIO: SELECTED COUNTRIES, 1990

Citation: IMF Staff Country Reports 1996, 109; 10.5089/9781451817829.002.A003

Source: Palacios, 1996.1/ Population over 60/population aged 20 to 59.

The current pension system generates low rates of returns on forced savings (mandatory contributions). 2/ This establishes a strong incentive to evade. The structural reform of the system addresses this issue by establishing a much clearer link between contributions paid and promised benefits (Section 4). This should contribute to reversing the base erosion.

3. The new retirement age legislation

This section discusses the new regulations regarding the retirement age approved by Parliament in July. These will apply to both the current pension scheme, and to the yet-to-be-established new multi-pillar pension system (discussed in Section 4). To understand the changes to the current system, a brief review of its main regulations is needed.

As noted, in the current system, the statutory retirement age is 55 years for females and 60 years for males. The eligibility conditions for the full old age pensions are: (a) reaching the statutory retirement age; and (b) having contributed for at least 20 years. Eligibility for the partial old age pension requires: (a) reaching the statutory retirement age; and (b) having at least 15 years of service. 3/ Thus, in the current system, achievement of the statutory retirement age is a necessary condition for eligibility for either the full or partial old age pension. Apart from special professions and disability-related factors, retirement before the statutory age is not permitted. In the current system, the minimum pensionable age coincides with the statutory retirement age.

A benefit schedule determines the percentage of the base salary to be received as pension benefit as a function of the years in service. 1/ In the current system, a worker retiring at the statutory retirement age with 20 (30; 40) years of contributions will receive 50 (65; 80) percent of his/her base salary. 2/ For example, a worker who has contributed for at least 20 years can stop working before he/she reaches the statutory retirement age of 60/55 and he/she will receive a pension benefit of 50 percent of his/her base salary, but only upon reaching the statutory retirement age.

The new retirement age regulations raise the statutory retirement age, and allow for early retirement, but subject to a “minimum service period” (or minimum years of contribution), which depends on whether the workers wishes to retire early with a partial or a full pension. The new regulations also introduce explicit penalties for early retirement in case the condition on the minimum years of contributions for a full pension is not met.

The new regulations will take effect as of January 1, 1997, with a transitional period lasting until 2001 for men and 2009 for women. 3/ During the transition, the new regulations will be phased in through a gradual increase in the statutory retirement age and in the minimum number of years of contributions. The system at the end of the transitional period is discussed below; the regulations during the transition are discussed in Box 1.

The new statutory retirement age for men and women will reach 62 years by 2001 and 2009, respectively. A worker retiring at age 62 will be entitled to full pension, as defined in the benefit schedule. 4/ A worker can, however, opt for early retirement. To be eligible he/she has to satisfy both of the following conditions: (i) women must have reached the minimum pensionable age of 57 years (60 for men), and (ii) he/she has to have worked for at least the minimum service period for early retirement (33 years). 1/ Therefore, in the new system, a distinction has been introduced between the minimum pensionable age (57 for women and 60 for men) and the statutory retirement age (62 for both sexes).

If a worker retires early, he/she is still entitled to a full pension, as long as he/she has fulfilled the minimum years of contributions for a full pension at early retirement (38 years). If he/she has worked for less than 38 years and wishes to retire early, the level of his/her pension will be defined by the combination of the benefit schedule and the penalty rates. The penalties are defined on a monthly basis and are an increasing function of the difference between the years in service required for receiving a full pension at early retirement (38 years) and the actual years in service (which cannot be less than 33; see above). The monthly rates vary from 0.1 percent (if the worker retires with 37 years of contribution) to 0.5 percent (if the worker retires with 33 years of contribution). 2/ Therefore, on an yearly basis, the penalty can vary from 1.2 percent to 6 percent.

Retirement Age Regulations During the Transition

In the interim period, the statutory retirement age will be lower, and softer pre-retirement conditions will apply, in terms of the minimum contributory period for early retirement without penalty, and of the minimum contributory period for early retirement with full pension. For example, the statutory retirement age for a woman born in 1942 is 57 years of age—which she will reach in 1999—compared to 62 years at the end of the transition. However, she can retire as early as 1997, at the minimum pensionable age of 55 years (compared to 57 years at the end of the transition). The minimum number of years in service for her to retire with a full pension before the statutory retirement age of 57 years is 34 years (38 at the end of the transition). If she has contributed for less than 34 years (38 at the end of the transition) and she wants to retire before reaching the statutory age of 57, a penalty would apply to her pension. If she has contributed for less than 29 years (33 at the end of the transition), she can retire early, but she will have to wait until she reaches the statutory retirement age of 57 to receive her pension.

The transition period regulations for men only apply to those born before 1939. Any man born before 1938 will continue to have a statutory retirement age of 60—therefore he will be unable to retire before 1998. The statutory retirement age will increase to 61 years for those born in 1938—which they will reach in 1999. However, a man born in 1938 can retire with a full pension at the minimum pensionable age of 60—as early as 1998—as long as he has contributed for 37 years (38 at the end of the transition). He can retire at 60 with a partial pension, as long as he has contributed for at least 32 years (33 at the end of the transition). If he has contributed for less than 32 years, he can still decide to stop working, but he will have to wait to receive his pension until he reaches the statutory retirement age of 61. All those born from 1939 onward will fall under the steady-state regulations.

The new pension age and early retirement regulations represent a structural improvement with respect to the past. The Hungarian statutory retirement age for women and men is currently slightly below the average for Eastern Europe and the FSU countries (Chart 19). The approved increase in retirement age will take Hungary much closer to the OECD average; and in fact to higher retirement ages than in France, Japan, and Italy, who all have longer life expectancies than Hungary. As to the minimum retirement age, it has been raised from 55 to 57 years for women, and left unchanged at 60 for men. Moreover, the minimum service period of at least 33 years to be eligible for early retirement is a fairly stringent condition. 1/ Though the expenditure savings for the PIF generated by the increase in retirement age will not be relevant in the short term, they may be significant in the medium to long term (see section 4.e).

Chart 19
Chart 19

HUNGARY: STATUTORY RETIREMENT AGE IN SELECTED COUNTRIES, 1991

Citation: IMF Staff Country Reports 1996, 109; 10.5089/9781451817829.002.A003

Sources: World Bank, 1994; and USA Social Security Administration, 1995.

However, the improvement is watered down by the regulatory framework accompanying the relatively long transition period, particularly for women. The increase of 7 years in retirement age for women is achieved in 12 years. This increase of around 1 year in retirement age to be achieved each two years is not unusual by international standards. 2/ However, the accompanying regulations reduce the impact of the phased increase in statutory retirement age significantly. The minimum service periods for early retirement with full and penalized pensions are set at 34 and 29 years, respectively, during the first year of the transition, compared to the 38 and 33 that will prevail during the steady state.

Penalty rates are also somewhat low. A relevant benchmark is the insurance-based penalty. Strictly, on an insurance basis, one year less of contributions should involve, on average, a reduction of around 7.4 percent of the pension benefit. 3/ In the new regulations regarding the early retirement, the maximum yearly penalty is 6 percent, when retirement is taken 5 years earlier than the penalty threshold of 38 years of service. But, if retirement is taken one year earlier, the penalty is only 1.2 percent. Therefore, only when the early retirement option is exercised to its full potential does the penalty rate approach an actuarially fair value.

4. The structural reform of the pension system

Some part of the current problems of the Hungarian pension system are related to the attempt to achieve two partially conflicting objectives at the same time: intertemporal insurance for individuals and intertemporal distribution within the society. The structural reform of the pension system, discussed in this section, tries in fact to address this conflict by introducing an effective distinction between the redistributive function and the insurance function in the public pension system. Moreover, the current pension levels represent a low return on the—high—mandatory social security contributions (see Section 2). The insurance-based leg of the new pension system addresses this problem by re-establishing an explicit link between social contributions and promised benefit level. This will reduce the incentive to evade—and avoid—paying social security contribution.

The government has recently approved a concept paper for pension reform, jointly drafted by the Ministry of Finance (MoF) and the Ministry of Welfare (MoW). The proposal essentially envisages the transformation of the public managed PAYG system into a multi-pillar system, including mandatory and voluntary components. The Government has also set a timetable for parliamentary approval of the reform, scheduled to take place by end-February 1997—that is, before the completion of the second review of the stand-by arrangement with the IMF. The new three pillar pension system is expected to become effective in January 1998, after one year of preparatory work. The proposal is currently being debated among the social partners. Therefore, several technical aspects are undefined at this stage, and working groups have been set up to work out the technical details. The proposed changes are outlined in sections 4.a through 4.d, and simulations of the financial impact of the reform are discussed in section 4.e.

a. The government proposal: overall design

The government proposal consists of the improvement (“modernization”) of the current PAYG system (already discussed in Section 3), and the simultaneous introduction of a new, multi-pillar system: 1/ (i) a PAYG mandatory pension scheme; (ii) a mandatory fully funded pension fund; (iii) voluntary non-profit and profit-oriented pension insurance regulated by the government, but privately-managed; and (iv) a state-funded system of welfare benefits for those unable to generate a minimum level of income from the first three pillars (Table 10). This multi-pillar system would satisfy the requirements of intra-generational solidarity (first pillar), intergenerational redistribution (first and fourth pillar), and mandatory and voluntary personal insurance against old age (second and third pillars, respectively). The first 3 pillars will all share the retirement age regulations that already apply to the existing Pension Insurance Fund (discussed in Section 2). The proposal states that the switch to the new system should be mandatory for people under 40 years of age. People above that age would have the option of staying in the “modernized” PAYG system or switching to the new system.

Table 10.

HUNGARY: Main Characteristics of the Proposed New Multi-Pillar Pension System.

article image

The concept paper states that the target average replacement rate in the new system would be 60 percent, two-thirds generated by the first pillar, and one third from the second pillar. The government expects these replacement rates to be achieved with contribution rates of 18 and 10 percent for the first and second pillar, respectively (compared with an overall contribution rate of around 35 percent in the current system).

b. The “modernized” system

The current Pension Insurance Fund will continue to apply to workers above 40 years of age, but will be “modernized” with the introduction of several new regulations, apart from the new, more stringent retirement age regulations already approved. First, new indexation rules will be introduced. The Government is still considering the precise indexation formula but an average of price and wage indexes (similar to the Swiss and Czech formulae) is likely to be adopted. 1/ Though both mechanisms are an improvement with respect to the current practice, the Swiss formula would clearly be better for the financial equilibrium of the Pension Fund.

Second, most non-contributory service periods will be removed, though the accrued rights will be respected. According to the concept paper, the central budget will no longer pay social contributions to the PIF for periods spent at the university, on maternity leave, sick leave, and technical training—though the unemployment and the compulsory military service periods will continue to be covered by this system.

Third, the proposal envisages the possibility for workers to purchase contribution years, though it does not specify the price for each year. This proposal could open the door to abuse and manipulation, especially if the price were set below its actuarial value. However, the latter is very difficult to calculate in the current environment. In particular, a flat price for each year of contribution would have a serious drawback, given the recently approved retirement age regulations. Because the monthly penalty rates are a positive function of the number of years taken as early retirement, a flat price would automatically set the price threshold below which it is convenient to buy years of contribution. 1/

c. The new first and second pillars

The concept paper outlines the main features of the first pillar of the new system. These features include an average replacement rate of 40 percent, to be achieved with a contribution rate of 18 percent levied on the employer. Also, there would be ceilings on contributions of four times the average wage and ceilings on benefits of two times the average wage. These ceilings ensure a strong redistributive character to the first pillar.

The first pillar of the new system would share several features with the “modernized’ system, including the same retirement age, disability rules, indexation rules, some eligibility criteria (e.g., minimum 20 years of contributions), the possibility to “buy” contribution years), and a broadened tax base. 2/ However, some rules would be stricter than in the modernized system. Most notably, early retirement in the new system would be subject to an annual penalty rate of 0.5 percent per month (6 percent per year), which is much closer to actuarially fair rates than the ones approved for the modernized system.

The mandatory second pillar will also share the retirement age regulations of the “modernized” system and of the first pillar. The concept paper targets an average replacement rate for the second pillar of 20 percent to be achieved with an employee contribution of 10 percent. Its main defining characteristic is that it will be a fully funded pension fund, based on individuals’ accounts, and it will respond to the need to provide for old-age security, while establishing a clearer relationship between contributions and pension.

The second pillar allows more flexibility to the pensioner in terms of choosing the kind of benefit that he will receive upon retirement. The concept paper indicates that the worker will be able to choose among three possible types of payments upon retirement: (i) a life annuity; (ii) scheduled withdrawals from a total accumulated amount; and (iii) a lump-sum, for that part of the pension that exceeds the subsistence level.

The latter restriction ensures that the worker has an adequate annuity after the lump-sum payments, in order to avoid his retirement income falling close to the minimum level guaranteed by the government through the fourth pillar.

The importance of the second pillar is that, by being a fully funded pension scheme based on individual accounts, it establishes a strong explicit link between mandatory contributions (savings) and promised benefit levels. Provided the funds perform well and information regarding such performance is disseminated to the public, the explicit link is likely to reduce the incentive to evade, and avoid, payment of social security contributions.

d. The third and fourth pillars

Though the concept paper does not go into the technical details of the third and fourth pillars, it outlines their main features. The third pillar will be built around, and expand on, the voluntary Mutual Benefit Funds established since 1993 in Hungary. Its aim is to establish a safe, government-regulated environment for insurance companies to provide additional income security to individuals during their old age. Participation to these fully funded insurance schemes would be voluntary, and there would be no ceiling on the contributions and pension benefits. The key question here is the establishment of guarantees for the secure operation of the insurance system. The government will have to specify rules with regard to the investment activities of the insurance companies, the extent of state supervision, the modalities for guaranteeing investment, and the transparency of their operations. Several working groups, with the participation of from different ministries and foreign consultants, are currently working out the details of the regulatory environment.

The fourth pillar will aim at “securing the provision of the physical minimum” for those that have failed to accumulate a minimum amount of savings for their old age. The concept paper identifies this minimum as 25 percent of the average net wage. If an individual’s income does not reach that level, the fourth pillar will top up his income. Eligibility will be based on means testing, and triggered by the individual’s request. The administration of the system will be decentralized at the local level, though the financing would be shared by the State and the local governments—in percentages yet to be specified. Also, it is not yet clear to what extent the fourth pillar will be part of the government’s regular social assistance program, or only targeted to the old.

e. Simulations of reform scenarios

This section discusses the effects of the increase in retirement age and the establishment of the multi-pillar system on the financial equilibrium of the Hungarian pension system. 1/ The projection of the deficit of the current PAYG system and the effects of the reform on the combined current PAYG and the new first pillar (henceforth, public pension system) are presented in Chart 20. The effects of the reform on the total balance of the new pension system (which includes the “modernized” current PAYG and the first and second pillars) are presented in Chart 21.

Chart 20
Chart 20

HUNGARY: PUBLIC PENSION DEFICITS WITH AND WITHOUT REFORMS

(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 109; 10.5089/9781451817829.002.A003

Source: World Bank, June 1996.
Chart 21
Chart 21

HUNGARY: PENSION SAVINGS WITH NO REFORMS VS. FULL REFORMS

(In percent of GDP)

Citation: IMF Staff Country Reports 1996, 109; 10.5089/9781451817829.002.A003

Source: World Bank, June 1996.

The simulations are based on population projections up to 2050. Total population falls from over 10 million in the 1990s to only 8.4 million by the year 2050. The share of the population above 60 increases from around 20 percent over the next ten years to 30 percent by the middle of the next century. The population of working age shrinks from around 56 percent in 2000 to 49 percent in 2040. The underlying demographics imply that, in the absence of adjustment, the system dependency ratio will eventually approach one from the current 67 percent.

While wage growth is assumed to equal GDP growth at 3 percent, the labor force is shrinking due to demographic reasons (only partially offset by the expected increase in labor force participation rates and a gradual decline in the unemployment rate to about 8 percent beyond 2030). As a consequence, the wage bill and the contribution revenue decline as a percentage of GDP: the former from slightly above 25 percent in the second half of the 1990s to around 22 percent in 2040—after peaking to 27 percent in 2009; the latter from above 9 percent in the second half of the 1990s to 8 percent in 2040.

At the same time, the aging of the population leads to a significant increase in the spending to GDP ratio, which peaks in the mid-2030s to around 12 percent. The divergence between spending and revenue results in gradually increasing deficits of the current system (with no reform) throughout the period (Bold line in Chart 20). After small average deficits of about 0.3 percent of GDP through 2005, the gap increases dramatically, averaging more than 2 percent of GDP between 2015 and 2025, 3 percent over the following decade, and 4 percent over the final 15 years of the projection. 2/

The authorities’ concept paper proposes a mandatory switch to the new system for people under 40 years of age. Chart 20 shows what the effect of this switch would be on the deficit of the combined current PAYG and the new first pillar (line Opt-Out With No reform in Chart 20). 3/ With no other reforms, the deficits are, on average, 1.5 percent of GDP higher during the first decade of the reform, due to the revenue shortfall caused by the share of contributions allocated to the second pillar. However, the deficit actually begins to fall after 2020, because the new first pillar expenditures are lower than the expenditures which would have occurred under the old first pillar, and finally catch up with the—lower—contributions paid by the new insured in the first pillar. 1/

Moreover, the deficit of the public pension system (“modernized” current PAYG and first pillar) is significantly reduced by the proposed reforms (Lines ‘Retirement Age (RA) Increased’, ‘RA Increased and Disability’, and ‘RA Increased, Disability, and Swiss Indexation’). The three major components of the modernization of the PAYG system (the increase in retirement age, the reduction in the rate of new accepted disability claims, and the switch to a Swiss formula of indexation) result in smaller pension deficits than those in the unreformed PAYG scenario as early as 2024, even considering the revenue shortfall due to the 10 percent opt-out. The vertical distances between the different scenarios illustrate the effect of the three reform measures. Of these measures, the most important in the long-run is the change in the indexation method.

The persistence of deficits in the Full Reform scenario in Chart 20 are not due to a failure of the reform to correct the large imbalances of the public pension system, but to the revenue shortfall due to the opt-out scenario. If the mandatory contributions to second pillar revenue are taken into consideration, the reforms would generate an increase in private savings (Chart 21).

The No-Reform scenario in Chart 20 is also reproduced, for comparison’s sake, at the bottom of Chart 21. The top two lines show the sum of the public pension deficits under the Full Reform scenario and the net savings from the second pillar, with a 4 percent and 5 percent rate of return on the investments of the pension funds, respectively. The combination of the full reform in the PAYG system and the accumulation of net savings in the second pillar would lead to an overall pension system surplus of close to 1 percent of GDP in the early phase of the reform. Note that the second pillar would start paying pensions only in 2020.

The surpluses of the pension system decline after 2025, with the re-emergence of deficits after 2030. However, these trends would be primarily due to the deterioration of the underlying demographics, not to the creation of the second pillar. Therefore, in the very long run, there may be a need to make further adjustments to the PAYG scheme, such as further increases in the retirement age and additional changes in the indexation rules.

1/

Prepared by Edgardo Ruggiero.

2/

Approximately 88 percent of public pension expenditures are managed by the Pension Fund, and 12 percent by the Health Fund in the form of under-retirement-age disability pensions. Once a disabled person reaches retirement age, his pension is paid by the Pension Fund. The latter also pays a health insurance contribution on behalf of pensioners and the Health Fund pays the pension insurance contribution on behalf of disability pensioners below retirement age. Therefore, while pension expenditure is easily defined as total spending on benefits for old age, disability, and survivors’ pensions, no symmetrical revenue figure exists. Disability insurance, moreover, is not linked to a defined portion of either the health or pension contribution.

3/

See Section 3 on the increase in pension age that will take place as of January 1, 1997.

4/

There are around 1.6 million old age pensions and 0.7 million disability pensions. Of the latter, about 50 percent were under age disability pensions financed by the Health Fund. The provisions financed directly by the budget are not the object of the reform and will not be discussed in detail here.

1/

Starting with the 1997 budget, the social security funds will have to present their budgets to the Ministry of Finance before submission to Parliament. The Ministry will be able to modify the budgets before sending them to Parliament.

1/

Though the life expectancy at birth [E(0)] of 64.5 years for males is quite close to the statutory retirement age, the female E(0) of 73.8 years is much higher than their statutory retirement age.

2/

Thus, the expected deterioration in the underlying demographics underlines the importance that a structural pension reform be implemented (Section 4).

1/

Employers pay 24.5 percent of gross salaries for pensions, 18 percent for health insurance, 5 percent for unemployment insurance, and 0.5 percent for the wage guarantee fund (related to bankruptcies), totalling 48 percent. Therefore, social contributions amount to (48/148) 32.4 percent of employer costs—slightly lower than the 33 percent in 1995, when the health contribution was set at 19.5 percent. Employers also withhold from wages of employees 6 percent, 4 percent, and 1.5 percent, respectively, for pension, health, and unemployment insurance.

2/

The internal rate of return for new entrant low income workers and high income workers has been estimated at 0.54 percent and 0.73 percent per year, respectively (World Bank, 1995).

3/

Workers having reached the statutory retirement age between January 1, 1991 and June 30, 1993, need only to have 10 years of service. Like in most Eastern European and FSU countries, special professions are entitled to earlier retirement with full pension.

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Given the mandatory nature of the pension system, years in service are equivalent to contributing years.

2/

The penalties for early retirement introduced by the reform apply to the pension benefits as defined by this schedule.

3/

Women born after 1946 fall into the regulations of the final stage of reform (starting in the year 2009). The transitional regulations apply to all women born before 1947. Transitional regulations for men apply only to those born before 1939.

4/

The full pension is defined as the percentage of the base wage that corresponds to the number of years in service in the benefit schedule, with no penalty applied to this percentage. For example, a worker retiring at 62 years of age after 38 (30) years of work will receive a pension equivalent to 76 (68) percent of his base wage. As in the current system, the worker has no right to a pension unless he/she has contributed for at least 10 years.

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Note that a worker can always choose to stop working, even when these conditions are not met. However, if condition (i) is not met, a woman will have to wait until she reaches age 57 to receive her pension (60 for men). If condition (i) is met, but condition (ii) is not met, the worker will have to wait until he/she reaches age 62 to receive his/her pension.

2/

For example, if a worker retires at age 57 (less than the statutory age of 62), and he has contributed for only 35 years (less than 38 years), he will incur a penalty. The penalty is calculated as follows. First, the worker has 3 years less (38-35) than the maximum expected contributing years at retirement. The monthly penalty rate that applies in this case is 0.3 percent/month or 3.6 percent/year. The penalty, in percentage terms, is 18 percent, that is: 3.6 * (62-57); where 62 is the statutory retirement age and 57 is the actual age at retirement. This early pensioner will get a pension of 55 percent (73-18) of his net wage (73 percent is the pension level as determined in the benefit schedule for 35 years of contributions). If the worker retires at age 57 having contributed for 38 years, no penalty applies, but he will retire with 76 percent of his pension—as defined by the benefit schedule.

1/

It implies that a woman who started working at age 24 and contributed for 33 years to be able to retire at age 57, would still incur a penalty—in this particular case of 30 percent. She would then receive a pension of 41 percent of her base salary. In the previous system, with 33 years of contribution the same worker would have obtained a higher pension of 69.5 percent of her base salary. A male worker retiring at the minimum retirement age of 60, with 33 years of contributions, will receive 59 percent of his base salary, compared to 69.5 percent in the previous system. It is important to note that for women born before 1947, the service periods are reduced by 1 year (1.5 if handicapped) for each child, up to a maximum of 3 years. The same regulations apply to single male parents born before 1940.

2/

For example, both the Czech Republic and the USA have decided to raise the statutory retirement age. The former will increase retirement age for women from age 55 to 57-61 (according to the number of children reared) from 1996 to 2007. Retirement age for men will be raised from age 60 to 62 over the same period. In the USA, the increase in statutory retirement age from age 65 to 66 (both sexes) will start in 2000 and end in 2005. Then, another increase will be implemented to age 67 from 2016 to 2022.

3/

The actuarially fair penalties are age and sex specific. The 7.4 percent is an average estimated by the Hungarian Ministry of Finance on the basis of actual retirement profiles.

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The authorities typically refer to a three pillar system, but, as discussed below, pension benefits will be de facto granted by four distinct systems.

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The Czech formula indexes the benefit for two thirds to inflation, and for one third to wages. The Swiss formula uses equal weights for wages and prices.

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Consider, for example, a worker that wanted to retire early with only 33 years of contribution—who therefore would pay a penalty of 0.5 percent per month of early retirement. If the flat price of a month of contributions is set at 0.3 percent of the full pension, he would find it convenient to purchase 2 years of contributions. The cost of purchasing each month (0.3 percent) would be lower than the related increase in pension benefit (0.5 percent).

2/

The concept paper does not elaborate on how the disability scheme will be reformed, nor how the tax base will be broadened.

1/

The projections have been prepared by the World Bank, as part of the work for the Public Sector Adjustment Loan Preparation Mission (May, 1996).

2/

The simulations assume that the recent decline in entry pension does not continue after 1997. Therefore, the increasing deficits merely reflect the maintenance of current benefits under adverse demographic trends.

3/

The Opt-Out refers to the fact that workers below age 40 will mandatorily have to contribute 10 percent of their wage to the second pillar. In this chapter, it is assumed that no worker older than 40 exercises the option leave the old PAYG and switch to the new system.

1/

The target replacement rates in the first pillar are around 40 percent, compared to around 60 percent in the current PAYG. That means that new pensioners in the first pillar get lower pensions than the pensioners in the current PAYG. The former start being paid out in 2020, as the old PAYG pensioners die out.

Hungary: Selected Issues
Author: International Monetary Fund