Republic of Slovenia: Selected Issues

This paper provides a background on the key policy challenges for Slovenia in the euro zone. Then, it assesses the discretionary scope to adjust spending and proposes initial steps to enhance budget flexibility so that fiscal adjustment can be targeted on relatively inefficient spending. This study also discusses the long-term fiscal sustainability position of Slovenia using a generational accounting framework. A simulation of retirement incentives suggests that the pension system will encourage individuals to retire earlier than the statutory full pensionable age. These incentives are stronger for low-income earners.

Abstract

This paper provides a background on the key policy challenges for Slovenia in the euro zone. Then, it assesses the discretionary scope to adjust spending and proposes initial steps to enhance budget flexibility so that fiscal adjustment can be targeted on relatively inefficient spending. This study also discusses the long-term fiscal sustainability position of Slovenia using a generational accounting framework. A simulation of retirement incentives suggests that the pension system will encourage individuals to retire earlier than the statutory full pensionable age. These incentives are stronger for low-income earners.

IV. Retirement Incentives in the Pension System in Slovenia 31

A. Introduction

67. The labor force participation rate among the elderly in Slovenia is very low, consistent with a trend of early retirement. Compared with the EU–15 countries, labor participation rates are lower by nearly 10 percentage points for the population aged between 50 and 59. This is a sharp drop from the high activity levels—higher than that of the EU–15 among women—for the working–age population between the ages of 25 and 49. These early exits from the workforce have led to an average effective retirement age that is the lowest among the EU–25 countries (World Bank, 2005). For a society expected to age at one of the fastest paces in Europe, such a retirement problem will exacerbate the fiscal pressures arising from age–related spending over the coming years.

A04ufig28

Labor Participation Rates in Slovenia and EU–15, 2005

(In percent)

Citation: IMF Staff Country Reports 2006, 250; 10.5089/9781451835786.002.A004

Source: Eurostat.
A04ufig29

Average Effective Retirement Age, 2001–03

(Age)

Citation: IMF Staff Country Reports 2006, 250; 10.5089/9781451835786.002.A004

Source: World Bank (2005).

68. Recognizing this problem, the Slovene government began implementing a pension reform in 2000 that sought to increase working years for the elderly. The full pensionable age of retirement—for which a minimum number of years is required to qualify—was increased and gradually phased in. For men, the 2005 full pensionable age stood at 60 years and 6 months; this is expected to rise to 63 years by 2009 for 20 minimum years of work. Similarly, for women, the full pensionable age as of 2005 stood at 55 years and 4 months and is expected to reach 61 years by 2024. At the same time, incentives to continue working have been built in. Workers can retire earlier, with a penalty, provided a minimum qualifying period of 40 years has been achieved, and they can earn a bonus accrual for working beyond the full pensionable age.

69. While the average retirement age has been gradually rising (text figure) as a result of these rules changes, there still remains scope for further improvement. The newly approved retirement age still remains low by current EU–15 standards (text figure), and the new rules also allow a reduction in the full pensionable age, depending upon the number of children. Furthermore, a large number of pensioners retire through alternative paths, such as the disability pensions, due to their generous benefits. In 2005, 12 percent of the population aged 55–59 years was on disability pensions. Nearly 4 percent of the new old–age pensioners retired early with a penalty. This situation raises concerns that the newly approved increase in the statutory retirement age may not be binding over the longer term.

A04ufig30

Average Retirement Age, 1990–2005

(In years)

Citation: IMF Staff Country Reports 2006, 250; 10.5089/9781451835786.002.A004

Source: Ministry of Labor, Family and Social Affairs.
A04ufig31

Statutory Retirement Age

(In years)

Citation: IMF Staff Country Reports 2006, 250; 10.5089/9781451835786.002.A004

Source: OECD (2004); and Slovene authorities.

70. Using a simulation of retirement benefits to calculate the optimal retirement age, this chapter examines whether the new public pension system provides incentives for early withdrawal from the labor market. Several studies have documented that the retirement incentives built into the pension system are one of the key factors for deciding the timing of the exits from the labor market and, thus, the effective retirement age (Coile and Gruber, 2000). The analysis finds that the currently approved system may still provide incentives to withdraw early from the labor market. Estimates of retirement incentives show that, for men, it could be beneficial to retire as early as age 61, two full years ahead of the already–low full pensionable age. A scenario analysis shows that these incentives exist even under alternative assumptions on valorization and indexation. The incentives are particularly strong for low–and–high income earners. This situation calls for a further review of the penalties and bonuses and other parameters in the pension system to ensure that the effective retirement age increases.

B. Literature

71. In this chapter, the retirement incentive is being estimated using the social security wealth (SSW) accrual method, to provide an indicator of possible retirement behavior. This accrual methodology is based on the incremental gains in retirement wealth from one additional year of work. Similar estimates have been used to test whether these retirement incentives indeed explain the retirement behavior in the population, after taking into account other social and institutional factors that affect retirement decisions (Hausman and Wise, 1985, and Yuan and Yun, 2005). Using a survey data set of workers’ work and earnings histories, along with a projection of earnings, the incremental benefits of retirement at different ages and their distribution are simulated to derive the retirement incentives faced by the population and the optimal retirement age. After controlling for other factors that affect retirement behavior, such as marital status, health, education, and type of employment, they find that SSW and retirement incentives were significant factors in affecting retirement decisions of workers in China and Korea.

72. This chapter will also take into account the literature focusing on more forward–looking measures of incentives. The studies have also examined retirement incentives based on the evolution of future wealth with additional years of work, not limiting the analysis to an incremental benefit over one year alone. This is because accrual patterns are nonmonotonic, and multiyear accruals can have very different incentives than a single–year accrual. Working beyond the statutory retirement age is then equivalent to buying an option on the more–than–fair actuarial adjustments. Stock and Wise (1990) use an option value methodology to calculate the optimal retirement decision as a function of the difference between the utility from retirement today and the utility from an optimal date in the future. This methodology is based on the indirect utility function over work and leisure and calculates the optimal retirement date in the future. An alternative methodology is the peak value measure, which combines the accrual methodology with the option value methodology principles (Coile and Gruber, 2000). This chapter also uses a peak value measure to supplement the analysis.

C. Methodology

73. As a first step for the simulation, the pension benefit for an individual is calculated based on pension rules approved under the 2000 reforms. The pension benefits are earnings related, and eligibility depends upon a combination of the minimum qualifying period and age (text table). Workers can retire as early as age 58, provided the minimum–pension–qualifying period of 40 years (38 for women) is met. However, if the years of service—which can be lower than the pension–qualifying period, since the latter can be purchased under specific conditions—are still below 40 (38 for women), a penalty will be imposed depending on the age of the retiree (see Appendix I).

Full Pensionable Age

(In years)

article image
Source: Slovene authorities.

74. The amount of pension benefits depend upon a few key policy variables. they are valorization of wages, which is the method used for assessing wages when calculating the pension base; and, (ii) the service factor, which is the rate at which pension benefits are accrued:

  • The valorization of wages depends upon the valorization rate and the time period used for assessing wages. In Slovenia, the valorization rate is linked to the rate of pension indexation, which has been lagging wage growth. As a result, it has been a key factor in containing pension expenditure. However, with the reindexation of pensions to wages, the valorization rate is expected to gradually pick up from its current level. The assessment period for wages is expected to gradually increase from the 10 to the 18 best consecutive years as part of the 1999 pension reforms. This will have the effect of reducing the pension base as lower wage levels are included in the calculation. More specifically, the pension base is the average of the18 best consecutive years’ annual wage assessments:

    Pensionbase=Σt=A18A(annualwage(t)*Πs=tAvalorizationrate(s)),18

    where A is the age of retirement

  • The service factor is determined by the accrual rates, years of service, and penalty and bonus rates that provide actuarial adjustments for early and deferred retirement. More specifically, the accrual rate in the Slovene pension system is 35 percent for the first 15 years of service and 1.5 percent for every additional year of service. Depending upon the age of retirement, different penalty and bonus rates would apply as follows32:

Servicefactor={(35+1.5*(Serviceyear15))*(100-Penaltyrate)/100beforeFPA,(35+1.5*(Serviceyears15)atFPA,(35+1.5*(Serviceyear15))*(100+Bonusrate)/100afterFPA,

where FPA denotes the date of full pensionable age. The pension benefit is thus obtained as

Pension benefit = Pension base * Service factor/100.

75. Pension wealth is defined as the present discounted value of expected future pension benefits, conditional on probability of survival. Thus, the estimate of pension wealth is sensitive to the assumptions on remaining life expectancy, pension indexation, and the discount rate. For a married worker, survivor benefits and joint survival probabilities of the worker and dependents would also need to be factored in. Pensions are also taxable in Slovenia. Since pensioners are allowed a higher income deduction, personal income tax becomes binding only for those workers earning above the average wage levels, starting at around 150 percent of the average wage. The effective tax schedule used in calculating the net pensions is provided in Appendix II.

76. Pension accrual is the difference in pension wealth due to an additional year of work. In other words, if the pension wealth from retiring next year is higher than the pension wealth from retiring today, then the positive pension accrual implies it is optimal to defer retirement. The extra year of work affects the pension benefits through two channels. First, the accrual effect implies that the pension wealth increases when working an additional year because the inclusion of a higher wage—for example, due to seniority—increases the pension base. In addition, a larger service factor due to an additional year of service and a larger bonus or a smaller penalty also increases the accrued pension benefit. Second, the wealth effect implies that pension wealth is less since benefits are lost for an extra year. We thus estimate the effective implicit tax on deferring retirement from time t to the following year:

Effectiveimplicittax=Pensionwealth(t)Pensionwealth(t+1)Wage(t)=-Pensionaccrual(t)Wage(t)

A negative value for the pension accrual and a positive effective tax rate thus indicate that the pension system likely provides a strong incentive to exit the labor force. A positive effective implicit tax means that the wealth effect dominates the accrual effect, and vice versa. As an alternative indicator that looks at a longer horizon, we also measure the peak value, which is derived as the difference between the pension wealth from retiring at the current date and the maximum value of pension wealth achieved by retiring in the future.

D. Simulation Assumptions

77. For the baseline scenario, we consider a hypothetical male individual who joins the labor force at age 24 and is eligible for full pensions at the age of 63 years (currently being phased in). The following assumptions are used to characterize the earnings history of this worker and to calculate the pension base:

  • Over the 40–year working period, wages are assumed to grow annually at the same rate as the economy–wide average wages—5 percent, with real wages growing annually at 2.5 percent and inflation at 2.5 percent—plus a seniority increment rate of 1 percent.

  • The rate of valorization—which transforms the wages into the pension base—of past earnings is based on pension indexation and has been varying every year. For simplicity, we set the valorization rate equal to the average economy–wide wage growth in the baseline case, as per the rules effective since 2005. However, pension indexation is still expected to lag wages as the new pension rules on accrual factors and assessment period for calculating the pension base—which also affect existing pensioners under the indexation rule—are phased in; this implies an implicit valorization tax. Hence, an alternative valorization tax rate of 0.77 percent of wage growth is used under sensitivity tests in line with the data observed in 2005.

  • Pensions are assessed on the 18 best consecutive years of earnings since 1970. Based on the assumption of a monotonic increase in wages, this corresponds to the last 18 years before retirement. Thus, as an example, the annual assessment of 1000 Slovenian Tolars (SIT) earned 18 years ago will be SIT 1000 * (1+.025+.025) ^18. Based on this assessment, the pension base will be calculated as the following:

    W=Σt=A18A(annualwage(t)*Πs=t(avgwage(s)/avgwage(s1)),18

    where A is the age of retirement

  • Under the current pension system, the wage levels used for calculating the pension base do not correspond to the actual net wage because net wage data are not recorded in the system. Instead, a synthetic net wage is used that corresponds to about 63 percent of the gross wage of the individual.

  • In calculating the pension wealth, we consider a single worker who survives till age 77, which is the estimated remaining life expectancy for men in Slovenia, conditional on having survived till age 58. See Appendix III for details on life expectancy data.

  • We also assume a discount rate of 3 percent and the indexation of pension benefits to nominal wage increases every year. Under alternative scenarios, these assumptions will vary to take into account the exiting trend of pension indexation lagging wage growth.

  • Pensions are also taxable. The effective tax schedule used in calculating the net pensions is provided in Appendix II.

E. Simulation Results

78. Estimates of pension accrual and the implicit tax show strong incentives for men to retire early. For a man with an expected life expectancy of 77 years and earning an average wage, an additional year of work creates an implicit tax of 2 percent at age 61 and 13 percent at age 62 (text figure). Retiring one year later would increase the pensions for two reasons. First, since the final 18 years of earnings are used in calculating the assessment base, an additional year of work would mean that a higher income in the final year is added while a lower income from 8 years ago is deleted, thus increasing the assessment base. Second, an extra year of pension contribution would also increase the accrual factor by eliminating the applicable penalty. But retiring one year later would also have a negative wealth effect, as pension wealth would be reduced due to a loss of one year of benefit. The accrual numbers indicate that the increase in benefits is outweighed by the loss of the additional year of benefit at age 61. If the worker considers the benefits accrued between age 58 and any year up to the age of 66, the maximum pension wealth would be accrued at age 61, suggesting that this would be the optimal age to retire. One peculiarity is the kink in the implicit tax curve at the age 63 years. This arises from the nonlinearity of the applicable penalty and bonus rates. For example, under the bonus and penalty rate schedule, the service factor for retiring one year before the full pensionable age of 63 is reduced by 2.35 percent. On the other hand, retiring one year after the full pensionable age raises the service factor by 4.2 percent. Given this large bonus when deferring retirement from age 63 to 64, the implicit tax of deferring retirement drops sizably from the prior year.

A04ufig37

Implicit Tax

(In percent)

Citation: IMF Staff Country Reports 2006, 250; 10.5089/9781451835786.002.A004

Source: Staff calculations.
A04ufig38

Peak Value

(In SIT)

Citation: IMF Staff Country Reports 2006, 250; 10.5089/9781451835786.002.A004

Source: Staff calculations.

79. The incentive depends significantly on the individual’s expected life expectancy. It is estimated that life expectancy increases on average by a year for every decade. Thus, considering a horizon of 2050, and recalculating pension accrual with a longer life expectancy of 81, the analysis shows that the implicit tax would remain negative until age 64. Similarly, the peak value of pension wealth turns negative only at age 65, suggesting that this is the optimal age to retire. Increasing life expectancy by 4 years removes the motivation for early retirement; in fact, there is an incentive to defer retirement by a year.

80. This finding is robust to alternative parametric assumptions (text table). For example, a higher discount rate of 5 percent shows that the optimal retirement age could be advanced by almost a year to age 60. With a lower discount rate of 1 percent, however, the implicit tax becomes positive at age 62. This could be explained by the fact that the larger pension amount accrued from deferring retirement is now worth less in present value terms. These calculations suggests that the incentive for early retirement exists irrespective of the discount rate assumed. Also, when no seniority wage growth is assumed in the earnings history, the optimal age for retirement moves forward to 60 years. Without the seniority increment, the increase in the pension assessment base from deferring retirement is now smaller than in the baseline case.

Implicit Tax

(In percent)

article image
Source: Staff calculations.

81. In the case of a male worker who becomes eligible for retirement by fulfilling the minimum years of service, there is little incentive to defer retirement. We consider a male worker who at age 59 has fulfilled 40 years of service. He is thus faced with the decision to retire with a full pension or defer retirement for a year and accrue a permanent bonus. Other assumptions are as discussed in the baseline scenario above. Given the bonus system he faces, it is optimal to retire at age 60, a year more than the age at which he is eligible, as demonstrated by the positive implicit tax and negative peak value.

A04ufig39

Implicit Tax

Citation: IMF Staff Country Reports 2006, 250; 10.5089/9781451835786.002.A004

Source: Staff calculations.
A04ufig40

Peak Value

Citation: IMF Staff Country Reports 2006, 250; 10.5089/9781451835786.002.A004

Source: Staff calculations.

82. For a women, however, the new system does not appear to provide incentives to retire early. We consider a woman earning average wages who at age 58 is eligible to retire, having achieved 35 years of service and purchased 3 further years of service. As in the baseline case, she can retire with a reduced pension or defer retirement to obtain a permanently higher pension. The key differences with the baseline case are the (i) expected remaining life expectancy of 83 years (approximating the average retirement age of 56 years and remaining life expectancy of 26 years as per current data) and (ii) penalty rates. Alternate life expectancies of 78 years (current life expectancy at birth) and 88 years (expected remaining life expectancy in 2050) are also used. In this case, simulations show that the implicit tax of deferring retirement remains negative up to the age of 63, two years beyond the full pensionable age. This is because the higher life expectancy of women creates a stronger accrual effect on pension wealth, rather than the effect of losing one additional year of benefits.

83. The incentives to retire early are particularly strong for both low–and highwage earners (text figures). A comparison across the wage scale indicates that the incentive to retire increases for workers earning half the average economy wage and those earning more than twice the average wage. The disincentives to work among lower–wage earners can be attributed to the rules ensuring a minimum pension base, which stood at close to 60 percent of the average net wage in 2005. To the extent that the minimum pension base is binding, an additional year of work and the associated increase in wages do not affect the pension base, weakening the accrual effect. As the wealth effect dominates, the incentive to retire early strengthens. Similarly, at the higher end of the wage spectrum, the larger pensions accrued pushes the income into a higher tax bracket. The increase in the effective tax rate (see appendix) thus negates the impact of higher wages accrued so that the accrual effect is weakened. The implicit tax of retirement deferment rises when the effective tax rate on the pension becomes binding.

A04ufig41

Implicit Tax

Citation: IMF Staff Country Reports 2006, 250; 10.5089/9781451835786.002.A004

Source: Staff calculations.
A04ufig42

Peak Value

Citation: IMF Staff Country Reports 2006, 250; 10.5089/9781451835786.002.A004

Source: Staff calculations.
A04ufig43

Slovenia: Implicit Tax of Deferring Retiring by One Year

(In percent)

Citation: IMF Staff Country Reports 2006, 250; 10.5089/9781451835786.002.A004

Source: Staff estimates.

F. Alternative Scenarios

84. Retirement incentives depend crucially on the policy parameters in the pension system. The simulations above are based on the parameters approved under the 1999 pension reform. Because these parameters are time varying since they are still being phased in, alternative scenarios are also considered to analyze the sensitivity to the these policies. Furthermore, additional pension reform would still be needed to restore pension viability and improve incentives to remain in the workforce. Some of these policy reform scenarios are also simulated to examine their impact on retirement incentives.

Pension indexation

85. A simulation of alternative indexation mechanisms for pension benefits shows that incentives to retire early are strongest under wage indexation and weakest under price indexation (text figure). This is because, under the price indexation, the wealth effect is smaller than the accrual effect, as the additional year’s pension benefits that are foregone are smaller. Similarly, an alternative indexation rule is simulated in line with the current rule that pension growth will effectively lag wage growth.33 As in the case of price indexation, the accrual effect dominates. The incentives to retire early weaken, and it becomes optimal to retire at age 62.

A04ufig44

Implicit Tax (Men)

Citation: IMF Staff Country Reports 2006, 250; 10.5089/9781451835786.002.A004

Source: Staff calculations.
A04ufig45

Peak Value

Citation: IMF Staff Country Reports 2006, 250; 10.5089/9781451835786.002.A004

Source: Staff calculations.

Valorization of wage earnings

A04ufig46

Implicit Tax (Men)

Citation: IMF Staff Country Reports 2006, 250; 10.5089/9781451835786.002.A004

Source: Staff calculations.
A04ufig47

Peak Value

Citation: IMF Staff Country Reports 2006, 250; 10.5089/9781451835786.002.A004

Source: Staff calculations.

86. The rate at which wages are valorized in calculating the pension base does not appear to affect the incentives substantially (text figure). Since this rate depends upon pension indexation—which, in turn has lagged wage growth—there is an implicit valorization tax on wages in calculating the pension base. In 2005, this amounted to 77 percent of wages. While the magnitude of the implicit tax changes under the different rates of valorization, the sign of the implicit tax does not change, and the optimal retirement date remains at 61 years—the age at which the implicit tax turns positive and the peak value turns negative.

Assessment period for pension base calculation

87. As in the case above, changing the assessment period for calculating the pension base does not have a significant impact. Raising the assessment period from the 18 years assumed in the baseline to 25 years does not change the date of the optimal retirement age (text table). Even though this affects the level of the benefit considerably more than the baseline scenario, the effect on the pension base of working an additional year is very small.

Implicit Tax

(In percent)

article image
Source: Staff calculations.

Accrual rate

88. Changing the accrual rate that determines the service factor can have a significant impact on retirement incentives. Under the current system, the accrual rate is highly front–loaded, with 35 percent for the first 15 years and 1.5 percent for every additional year of service. If this is changed so that the accrual rate is 30 percent for the first 15 years and 1.7 percent for every year of additional service—which, as in the baseline, maintains the same service factor of 72.5 percent for a man with 40 years of service retiring at age 63—the optimal retirement age rises to 62 years (text table). This suggests that back–loading the accrual rate over time could be useful in increasing the effective retirement age. Changing the penalty and bonus rates would also have a direct impact on the accrual rate. However, these changes would have a more significant trade–off in terms of the amount of pension benefit and cost of pension expenditure.

Increase in full pensionable age

89. Raising the statutory full pensionable age does not ensure a higher effective retirement age. It is assumed that the full pensionable age increases from 63 years to 64 years, with a corresponding increase in the minimum pension–qualifying period. In this case, the optimal retirement age, at 62, is still two years ahead of the new full pensionable age. A further increase in the full pensionable age, however, does not change the optimal retirement age. As in the case of a shorter life expectancy, increasing the statutory retirement age for a given life expectancy would strengthen the wealth effect, as benefits can be enjoyed for fewer years. This suggests the need for a careful review of other policies that can affect the incentives to retire even as the statutory retirement age is raised.

G. Conclusions and Policy Implications

90. The labor force participation rate is considerably lower among the elderly population in Slovenia than in the EU–15 countries. This situation reflects the low full pensionable age under the Slovene pension system. Recognizing the impending challenges of aging and early retirement, the authorities introduced reforms in 2000 to increase the pensionable age and incentives to defer retirement through pension bonuses and penalties. These reforms and benefits are being phased in through a transition period. Despite these changes, there is a possibility that the effective retirement age may not rise significantly, due to provisions allowing retirement earlier than the full pensionable age and the implicit incentives to retire early given the parameters in the public pension system.

91. This paper simulates the retirement incentives built into the public pension system based on the accrual methodology. Calculations of the implicit tax based on this methodology suggest that the pension system parameters will likely encourage workers to leave employment early; this applies particularly to men, who can expect a shorter life span. The redistributive nature of the pension system—through its minimum pension base and progressive effective tax rate—also means that these incentives are stronger for workers earning at the low and high ends of the wage spectrum. These incentives appear robust to differing assumptions on discount and seniority wage growth rates.

92. The pension parameters need to be reformed to raise the effective retirement age With a large demographic shift expected over the coming decades, the role of the pension system in inducing an early exit from the labor market needs to be reviewed to prevent an exacerbation of aging–related spending pressures on the economy. In addition to changing the bonus and penalty rates that have a directly impact on the incentives, more back–loading of the accrual rates would also help to defer retirement decisions. Retirement incentives also weaken more under price indexation than under wage indexation. The simulations also suggest that increasing the assessment period for calculation of the pension base can lower pension expenditure significantly without weakening retirement incentives. These changes need to be considered even if the statutory retirement age is raised, as these early–retirement incentives could make it difficult to raise the effective retirement age.

Appendix I: Penalty and Bonus Rates

Penalty and Bonus Rates Under Slovenia’s Pension System

article image
Sources: Slovene authorities; and World Bank (2004).

Appendix II: Tax Rates

Effective Tax Rate on Pensions

article image
Sources: Slovene authorities; and World Bank (2004).

Appendix III: Life Expectancy

Estimated Remaining Life Expectancy as a Function of Age

article image
Source: World Bank (2004).

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31

Prepared by Anita Tuladhar.

32

See Appendix I for applicable penalty and bonus rates.

33

Existing pensioners’ benefits are adjusted downward to ensure consistency with the 1999 pension reform measures that lowers benefits for new pensioners due to the higher number of years used for assessing wages in calculating the pension base and the lower accrual rate. This is expected to increase pensions for existing pensioners at a rate that lags wage growth by .065 percent through 2024.

Republic of Slovenia: Selected Issues
Author: International Monetary Fund