Cyprus: Selected Issues
Author: International Monetary Fund
Publication Date:
29 Nov 2011
eISBN:
9781463925888
Language:
English
Keywords:
ISCR; CR; authority; export; Cyprus; pay; growth-inflation differential; insurance scheme; wage bill; ceiling indexation; indexing wage history; Wages; Aging; Global
Download PDF (687.3 KB)

The Selected Issues Paper focuses on Cyprus' banking sector vulnerabilities and its pension system. The most salient risks for the banking sector come from commercial banks domiciled in Cyprus. These banks have the strongest links with the local economy and are likely to experience further deterioration of their loan portfolios in both Greece and Cyprus. The paper reveals that, in 2011, Cypriot banks face capital needs estimated at €3.6 billion on a preliminary basis.

Abstract

The Selected Issues Paper focuses on Cyprus' banking sector vulnerabilities and its pension system. The most salient risks for the banking sector come from commercial banks domiciled in Cyprus. These banks have the strongest links with the local economy and are likely to experience further deterioration of their loan portfolios in both Greece and Cyprus. The paper reveals that, in 2011, Cypriot banks face capital needs estimated at €3.6 billion on a preliminary basis.

II. The Cypriot Pension System: Issues and Reform Options1

Public Pension expenditures will roughly double by 2050 far outstripping planned increases in contributions. If unreformed, spending on public pension schemes is expected to rise from about 9 percent of GDP in 2010 to about 19 percent of GDP by 2050 and drive public pension expenditures to be among the largest in the EU. The increase in outlays is expected to exceed by a wide margin the planned increases in contributions from employees and employers of about 3 percent of GDP and would thus require an increase in government transfers of 7 percent of GDP. By 2020 the need for government transfers is projected to increase by about 1.5 percent of GDP. Spending on non contributory pension schemes would add further to the fiscal burden. These developments will put an unsustainable burden on public finances. Reforms to ensure fiscal sustainability should start now.

A. Introduction

1. Publicly provided schemes dominate the Cypriot pension system. The main pension schemes are the General Social Insurance Scheme (GSIS) run by the Social Security Fund (SSF) and the Government Employees Pension Scheme (GEPS) run by the Ministry of Finance. The first covers public and private sector workers while the latter provides an occupational pension for central government employees. GSIS pension spending was about 6 percent of GDP while GEPS pension spending was close to 2.5 percent of GDP, accounting for roughly 85 percent of 2010 total pension spending. Other public schemes include broader public sector pensions (BPSS), which cover local governments and a variety of public entities outside the central government including public corporations (about 0.5 percent of GDP), and non-contributory pension schemes (1 percent of GDP)2. Privately provided schemes include provident funds and occupational pension schemes which accounted for slightly less than 5 percent of total pension spending in 2008.

2. This paper analyzes the main factors behind the expected increase in the budget cost of public pension spending and discusses reform options. In its analysis, the paper compares the parameters of the Cypriot pension schemes with those of other OECD countries. The paper focuses on the GSIS, GEPS, and BPSS given that they account for the bulk of pension expenditures. Section B provides background on these schemes main parameters, Section C discusses main issues, and Sections D and E conclude with a discussion of reform options.

B. Background

General Social Insurance Scheme

3. The GSIS provides short-term benefits and long-term benefits to its insured population. Short-term benefits include the sickness benefit, the maternity benefit, a marriage grant, unemployment benefits, and an employment injury benefit. Long term benefits include pensions for old age, invalidity and survivors. The scheme was created in 1957 and since 1964 extends compulsory insurance to every person employed in Cyprus, both in public and private sector, including all categories of self-employed. In 1980, a supplementary earnings-related insurance scheme replacing the previous scheme of flat-rate contributions and benefits was introduced.

4. Contribution rates differ between the employed and self-employed persons. Contribution rates for employed persons are 13.6% of their gross insurable earnings, shared equally between the employer and the employee, and 12.6 for the self-employed. The contribution rate for employed persons includes about 1 percent of gross earnings for unemployment insurance. The central government pays an additional contribution of 4.3% of gross insurable earnings on top of its normal contribution as an employer.

5. The level of the pension benefit depends on the length of the contribution period and the level of gross insurable earnings. Pension benefits have two components: a basic pension and a supplementary pension based on the level of gross insurable earnings. The earnings on which contributions and benefits are calculated (gross insurable earnings), are divided into a “lower” and an “upper” band, with the “lower band” consisting of earnings up to a certain “basic” level. The “upper band,” consists of earnings in excess of the “basic” level up to a maximum limit of six times the threshold of the lower band. Insured persons are credited each year with “insurance points”. One insurance point is credited for each multiple of the yearly amount of annual basic insurable earnings defined by the government. The basic pension is indexed yearly to the annual increase of the average gross insurable earnings while the supplementary pension is indexed to the consumer price index. Box 1 in the Appendix discusses the pension formulas for the basic and supplementary pension and illustrates the computation of an old age GSIS pension for a hypothetical case.

6. The pensionable age is 65 years for both men and women but early retirement is common. Early retirement pensions can be drawn without reduction in benefits at the age of 63 under certain conditions 3. While incentives are provided for postponing retirement, these are not enough to offset the incentives provided by the absence of an early retirement penalty since the average effective retirement age is about 63.6 years 4. Old-age pensioners can continue work and earn income without prejudice to their pension benefits.

7. The GSIS has run small deficits in recent years excluding the additional government contribution and interest income (Table 1). For the purposes of this paper, which involve analyzing the financing needs that the GSIS places on the government, government transfers to GSIS excluding those related to its role as an employer are excluded from the revenues of the SSF. In particular, given that the reserves of the SSF are almost fully invested in government instruments (see below), the interest income paid by the government is akin to a transfer and thus excluded from the revenues. Given this definition of revenues, the social security fund has been running a small deficit which was stable in 2006-2009 but grew in 2010. Buoyant economic activity until end-2008 and an increase in pension contributions in 2009 supported revenues and contributed to the stable deficit in spite of increasing pension and unemployment benefit outlays. The latter reflect increasing unemployment related to the global crisis in 2009. Estimates for 2010 suggest a more rapid growth of benefit expenditure than contribution revenue.

Table 1.

Accounts of the Social Insurance Fund

(Percent of GDP)

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Sources: Final Accounts of the Social Security Fund 2006-2009 and preliminary 2010; and IMF staff estimates

8. The GSIS was designed to be partially funded but is de facto operating on a pay- as-you-go basis. Given that the total contribution rate including the government contribution was set a higher levels than needed to fund benefits at the inception of the scheme, the social security law establishes that annual surpluses should be deposited to a special reserve of the social security fund and the size of that reserve should not be below two years of total annual pension spending. In practice, however, the excess of annual contributions over benefits was invested almost exclusively in government securities. The size of this special reserve at the end of 2010 was about 7 billion euros (40 percent of GDP) and government securities represent 93 percent of the total. Thus, rather than a reserve to buffer imbalances between revenues and expenditures, it represents a commitment of the government vis-a-vis the GSIS to meet future shortfalls when they arise as in standard pay-as-you-go systems.

9. The last reform of the GSIS was in 2009 and focused on improving long-term financial sustainability. The main measure taken was a gradual increase in the contribution rate for employees and employers by 1 percentage point every five years raising it from 12.6 percent at end 2008 to 19.6 percent in January 2039, starting in January 2009 (Table 2). Other measures tightened the eligibility conditions including increasing the minimum qualifying period to be eligible for pension and restricting the crediting of contributions for full time education5.

Table 2.

Current and Future Contribution Rates Based on Legislation

(Percent)

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Sources: Ministry of Finance.

Pension Schemes for Public Employees (GEPS and OPSS)

10. The GEPS provides supplementary retirement and survivors pensions to central government employees. This includes civil servants, members of the educational service, the police, and the armed forces. The GSIS pays the pension of public employees just as for private sector employees (basic+supplementary) but the supplementary portion of the GSIS pension is counted as partial payment of the GEPS supplementary pension6. The GEPS supplementary pension has been financed until recent reforms in August 2011 (see below) almost entirely by general taxation since participation of employees in the financing of GEPS pension was limited to an average 0.8 percent contribution rate of their gross earnings to pay for survivors’ pensions.

11. The calculation of supplementary pension benefits is more generous than the one for private sector employees provided by GSIS (Table 3). Key differences are:

  • The scheme’s effective retirement age is lower. The effective retirement age is about 6 and one half years lower than the GSIS at 57 years of age. This is because early retirement is allowed from age 45 but the pension is frozen and will only be paid at the age of 55 (58 for government employees who joined the employer on or after 1 July, 2005) without any actuarial reduction of benefits. The mandatory retirement ages for civil servants are: 63 for the civil service, 60 for teachers, between 60 and 61 for police, and for the military it ranges between 52 and 60 depending on the position and rank.

  • The pension is calculated on the final salary at an accrual rate that produces a retirement benefit equivalent to 50 percent of that salary after 33 1/3 years of service.

  • A large lump sum gratuity is paid immediately when an employee retires and is a multiple of the annual pension. The size of the multiple ranges from 4.7 if retirement happens at 60 years of age to 5.2 if retirement happens at age 63.

  • The pension is adjusted for general salary increases in the central government and for inflation.

Table 3.

GSIS and Public Sector Employee Schemes Compared

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Source: Muhanna Report 2011

Weighted average of the pay as you go rates in the GEPS and BPSS before August 2011. To obtain the pay go rate after August 2011, 4.25 percent (the increase in the contribution rate for public servants passed in August 2011) is subtracted from the original pay go rate of 32.7 percent.

12. BPSS pension benefits are similar to those of GEPS. Benefits are provided under the same terms and conditions as for central government employees and the formula to compute the pension is also the same.

13. The net cost of the GEPS/BPSS schemes to the government has been increasing (Table 4). In 2010 benefit payments were 2.8 percent of GDP. These latter benefits imply an average pay as you go cost of 32.7 percent of the wage bill, far exceeding public employee’s contributions of 0.8 percent of the wage bill before August 2011 and the 5.1 percent after that date.

Table 4.

Net Cost of Pension Schemes for Public Employees

(Percent of GDP)

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Source: Ministry of Finance.

The expenditure for gratuities is unusually high in 2006 compared to the following years since in 2006 several members of the House of Parliament terminated their service after a Parliamentary election).

14. The last reform of the schemes was in August 2011. The reform aimed at reducing the cost of the system to the government and improving equity with private sector employees. The main measures were an increase in the permanent contribution rate for public employees from 0.8 percent to 5.1 percent of the wage bill and the abolition of access to public sector schemes for new public sector workers. In addition, an additional temporary contribution on public employees and pensioners in the public sector was also imposed, based on their income.

C. Main Issues

General Social Insurance Scheme

15. The GSIS is expected to continue to run growing deficits in the coming years. The overall balance of the GSIS excluding government contributions and interest income is expected to continue deteriorating in 2012 and 2013 as a result of increased pension spending due to long term factors (see Table 5 and below). While the increase in the contribution rate in 2014 will temporarily reduce the deficit of the GSIS, the GSIS is expected to end the decade with deficits of about 1.5 percent of GDP. This differs significantly from status quo analysis from existing studies that incorporate the 2009 reforms which suggest no deficit until the 2040’s. The difference with these studies arises mainly because of the exclusion of the government contribution and interest income as part of the revenues of the scheme.

Table 5.

Projected Accounts of the Social Insurance Fund

(Percent of GDP)

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Sources: Ministry of Finance; and IMF staff estimates

16. Spending on the GSIS is expected to accelerate markedly from 2040 onwards and will be among the highest in the Euro Area by 2050. Given demographic, macroeconomic, and labor market assumptions (see Box 2 in the Appendix) and the pension system parameters in the current legislation, the projection shows an increase in benefit expenditure of about 8 percent of GDP from 2010 to 2050. This compares unfavorably to increases in pension spending at the level of the OECD, which are expected to be around 3 percent of GDP between 2010 and 2050 (OECD 2011). On the revenue side, assuming the already legislated schedule of increases in the contribution rate and a wage bill that remains broadly constant as a share of GDP, this would imply a need for increased government transfers of about 5 percent of GDP by 2050. The accumulation of significant deficits by 2050 would generate an implicit pension liability close to 100 percent of GDP with a 4.5 percent discount rate 7.

Table 6.

Long -term Projections of the Social Insurance Fund

(Percent of GDP)

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Sources: Ministry of Finance; and IMF staff estimates

The evolution of the finances can be explained by the following formula8:

T = (DR*RR-CR)*W (Equation 1)

T=Government transfers as a share of GDP

CR=Contribution Rate

DR=Dependency Ratio (Number of pensioners/Number of contributors)

RR=Replacement Ratio (Average pension/average pensionable salary)

W= Covered wage bill as a share of GDP (Number of contributors*Average pensionable salary/GDP)

The formula states that the government transfer as a share of GDP that will be needed to finance the pension system will be larger the higher the dependency ratio, the higher the replacement rate and the lower the contribution rate, assuming all the rest constant.

17. A worsening DR is the main reason for the increased deficits of the SSF, followed by an increasing replacement ratio. Keeping RR, CR, and W at their 2010 values, and only allowing the system dependency ratio to worsen in line with the population projection, shows to what extent the worsening dependency ratio is responsible for the 5 percent of GDP increase in the transfer need/deficit by 2050. This calculation shows that the deterioration of the dependency ratio could explain a 4.8 percent of GDP higher transfer need. A similar calculation for the replacement rate explains an increasing transfer need of 1.2 percent of GDP 9. The result thus shows that the increase in the transfer need is expected to occur mainly due to the impact of ageing (i.e. declining fertility and mortality rates) on the dependency ratio but also due to the impact of scheme maturation (i.e. there will be more workers completing a minimum number of working years to qualify for a benefit from the supplementary part of the GSIS and retiring with a higher number of years of contributions at retirement) on the replacement rate.

18. Current scheme parameters are generous when measured in terms of a rate of return on contributions and compared to long term market returns. Given current and past scheme parameters, a recent actuarial study (Muhanna (2011)) has estimated a nominal internal rate of return on contributions of about 13 percent for current pensioners. Assuming a long term rate of inflation around 2 percent in line with ECB targets, this implies that contributions would need to be invested in a market portfolio that could generate a return exceeding 10 percent in real terms to be comparable to a real rate of return paid by the national pension scheme. However, achieving such high real returns in the market for long periods is highly unlikely as real long term returns on a market portfolio have averaged around 3 to 4 percent (OECD 2011, Muhanna (2011)).

19. Several pension scheme parameters contribute to the high internal rates of return for current pensioners:

  • An effective retirement age below the standard age due to early retirement. Between 65 and 70 percent of all new retirees retire at age 63, making the effective retirement age around 63.6 given the absence of actuarial pension reductions for early retirement which are common in many systems with early retirement (Appendix Table 1).

  • Increasing life expectancy at retirement. This means an increasing retirement period over which pensions will need to be paid with the same contribution period as life expectancy at retirement (65 years) is expected to increase on average 3.1 years for men and 3.6 years for women in the OECD between years 2010 and 2050 (Appendix Table 2).

  • A relatively generous indexation scheme for pensions in payment. The indexation scheme is de facto a weighted average of wage and price indexation where the weights are the shares of the basic (about 40 percent in 2010) and supplementary pension (about 60 percent in 2010) respectively. Most OECD countries with earnings related schemes index their pensions in payment to prices, while some use wages in several cases subject to sustainability constraints, and only a few index using a combination of wages and prices or wages only (Appendix Table 3).

  • Relatively low contribution rates for the provided level of benefits. While benefits in Cyprus for a full career worker (64.5 percent replacement rate) are somewhat above the OECD comparable average gross replacement rate (57 percent), the overall contribution rate for pensions that employees and employers pay at close to 13 percent is significantly lower than in most other OECD countries that provide similar gross replacement rates (Appendix Table 4) 10.

  • A management of pension system reserves that has not followed international good practices. Reserves have not been invested in a well diversified portfolio of assets subject to clear investment guidelines for risk, return, and liquidity. In addition, the function of reserves has not been to help absorb shocks in benefit payments and contributions and/or finance future pension payments as the pension system reaches its maturity as is standard in partially funded systems.

Pension Schemes for Public Employees

20. The pension schemes for public employees are costly and their cost will continue to increase if they are not reformed further. In 2010, 2.6 percentage points of GDP were spent on pensions net of contributions for public sector workers. This compares unfavorably to an average of 2 percent of GDP in OECD countries (Palacios and Whitehouse 2006). Without reforms the net pension cost would have increased by about 2 percentage points of GDP by 2050. The August 2011 permanent reforms were steps in the right direction (text chart). They are expected to bring down the net cost by 0.4 percent of GDP per year starting in 2012 and roughly maintain current expenditure levels by 2050 as the number of retirees start to decline as a result of closing the scheme to new government workers. However, spending on pensions for public sector employees will still be expected to increase for the next two decades given that retirees during this time period will be already existing contributors 11.

uA02fig01

Net cost of Schemes for Public Employees Before and After Recent Reforms

(Percent of GDP)

Citation: IMF Staff Country Reports 2011, 332; 10.5089/9781463925888.002.A002

Source: IMF staff estimates.

21. Beyond similar ageing forces that are operating for the GSIS, several factors are contributing to the continued fiscal burden of the public pension scheme and inequities with the private sector:

  • Public sector workers continue pay low contributions with respect to the cost of the benefits. The permanent contributions they pay even after the reform are about 5 percent of salaries while the cost of providing the benefits in 2011 is expected to be close to 33 percent of salaries (Table 3).

  • The benefit formula is relatively generous and creates distortions. Basing the pension on the last salary, which is typically the highest in the career of a public employee and is thus not representative of career earnings, provides an incentive to maximize earnings as retirement approaches, including through promotions before retirement. In addition, it creates inequities by discriminating in favor of individuals whose earnings rise rapidly over their career. Moreover, without including the impact of the gratuity, Muhanna (2011) suggests that the replacement rate over the final salary is estimated to be between 20 and 40 percent higher than the one in the GSIS, depending on salary levels.

  • The lump sum benefit at retirement increases considerably further the replacement rate. After including the impact of the lump sum benefit by converting it into a monthly pension, the replacement rate over the final salary is between 45 and 65 percent higher than in the GSIS, with replacement rates of close to 80 percent of the final salary for average earners.

  • Special regimes for different groups of employees including more favorable retirement ages. Teachers, the police, and the army constitute the bulk of public employees in government and these groups are subject to lower retirement ages than civil servants and private sector employees. Special and more generous pension rules also apply to state officials (including mainly senior government officials, parliamentarians, and the public and education service commissions).

  • Early retirement rules which allow retirement many years earlier than the statutory retirement age without any actuarial deduction. As a result, the effective retirement age is about 57 and pensions are paid for more years while contributions are received for fewer at a cost to the budget.

  • Indexation using growth of public salaries. This provision is not only more generous than for private sector employees but also exposes the budget to large increases in pension benefits automatically if large ad hoc wage increases are provided as was the case for example in 2009.

22. Moreover, comparisons with other public service pension schemes in advanced countries also point to the generosity of some parameters:

  • The statutory retirement age at 63 is relatively at the low end of the distribution. While schemes of public employees tend to have lower retirement ages than national schemes such as the GSIS, many schemes have retirement ages of 65 years and above (Appendix Table 5).

  • Benefits are on the high end of the distribution. After taking into account the impact of the use of the final salary as the definition of earnings and the lump sum gratuity, the replacement rate for the average earner close to 80 percent of the final salary combined with the possibility of achieving this in 33.3 years implies an accrual rate close to 2.5 percent per year. (Appendix Table 6).

  • Indexation is also on the generous side. A majority of countries index pensions in payments at least partially with the CPI. (Appendix Table 7).

D. Reform Options

General Social Insurance Scheme

23. Pension reform is needed to restore the long term financial sustainability of the scheme and to address the growing cash deficits in the coming years. Reforms are best implemented early so that abrupt adjustment to parameters are avoided. Gradual adjustments have the advantage of making reform more equitable as the burden of adjustment can be spread across many generations and workers have more time to adjust their work and savings decisions to the new parameter levels. As suggested by equation 1, main reform levers are: (1) retirement age increases (affect primarily DR), reduction in benefits (affects RR), less generous indexation (affects RR), and increases in the contribution rate (CR).

24. Several specific reform options are discussed below in line with what other OECD countries have done to address similar issues. These options should be taken only as illustrative of the possibilities of gradual reforms and their impact. Different combinations of measures could have a similar impact on the overall finances of the scheme and preferences on the mix have varied across countries. However, given the already considerable revenue to GDP levels in Cyprus and that contribution rate increases were already decided in 2009 to bring contribution levels close to the current OECD average by 2039, raising the contribution rate levels beyond the final level targeted by the planned increases could be counterproductive. This could unduly increase labor taxes with an adverse competitiveness impact on the economy and provide added incentives to informal economic activity. Moreover, the causes of the expected deterioration of GSIS finances also suggest that a combination of reforms that place a strong emphasis in extending the working life and adjusting down the level of benefits should be preferred.

25. The adoption of all of these reform options would eliminate the implicit pension debt through 2050. GSIS projected finances assuming all reforms are implemented are shown in the text chart below as well as the cumulated impact of the different measures with respect to the baseline, which includes the already legislated increases in the contribution rate for employees and employers in Table 2.

uA02fig02

GSIS: Overall balance under Selected Reform Options

(Percent of GDP)

Citation: IMF Staff Country Reports 2011, 332; 10.5089/9781463925888.002.A002

Source: IMF staff estimates.

Benefit policies

26. Increase the incentives to postpone retirement. This can be achieved by introducing an actuarially fair early retirement penalty for each year of early retirement to ensure that the cost of early retirement to the scheme is fully internalized by workers. As shown in Appendix Table 1, actuarial reductions in OECD countries vary, but in those where the reduction is considered effective in providing adequate incentives, the values range between 6 to 7 percent pension reduction per year of early retirement. Assuming this measure would lead to an increase in the effective retirement age to 65 in three years if implementation starts in 2012, the GSIS deficit would be reduced on average by 0.8 percent of GDP through 2050.

27. Increase gradually the retirement age from 65 years to 67 years and from then on automatically on the basis of life expectancy at retirement. If the retirement age is increased by 2 years in 10 years starting in 2015, the savings from the retirement age increase from 65 to 67 would reduce the GSIS deficit by 1.1 percentage points of GDP on average through 2050. At the same time, incorporating in the legislation an automatic adjustment provision that would be activated once the effective retirement age reaches 67 years will help depoliticize the adjustment of this critical pension parameter when needed and guard against faster than anticipated increases in life expectancy which have been the norm in the past (OECD 2011).

28. Lower the accrual rate to make benefits more in line with most OECD countries. To avoid an abrupt change in the benefit formula, the adjustment of the accrual rate could be phased in gradually. For example, a phased reduction of the accrual rate in 14 years from 1.5 to 1.2 percent, starting in 2012, would partially offset the impact of system maturation and thus create savings which, as illustrated in Figure 2 above, would reduce the GSIS deficit on average by 1.1 percentage points of GDP through 2050.

29. Index pension benefits fully by prices. A majority of OECD countries have chosen this approach as Appendix Table 3 suggests, and an important reason for this is affordability. However, by preserving the purchasing power of pensions, price indexation allows for the maintenance of pensioners’ standard of living at retirement defined as the purchasing power of the pension. For example, given an assumed wage growth-inflation differential, a phased shift to CPI indexation in 9 years could lead to an average reduction in the deficit of 0.3 percent of GDP on average through 2050.

Revenue policies

30. Increase the contribution rate more frequently with smaller steps to reach the currently planned level of contributions from employees and employers for 2039 faster. Achieving the final contribution rate levels targeted by the 2009 reform faster would bring contributions more in line with the level of benefits provided by GSIS and with contribution rates in other OECD countries. It would also help reduce current deficits and give time for other measures that affect new pensioners (e.g. measures that help increase the effective retirement age) and thus take longer to impact the system finances to have their full impact. For example, increasing the contribution rate by 0.5 percentage points per year starting in 2012 until reaching 19.6 percent in 2023 would increase revenues on average by an estimated 0.6 percent of GDP through 2050.

Investment policies

31. Review the management of surpluses and reserves to make it consistent with international good practices. The reforms discussed above could create cash surpluses through almost the end of the projection period and would therefore lead again to a considerable accumulation of reserves (text chart). To ensure these new reserves are invested and used to support the payment of pensions, investment guidelines should be adopted to facilitate the investment of the newly available funds into an internationally diversified portfolio of assets12. The guidelines should include such items as restrictions on the share of assets that can be held in any one company or country, a requirement that assets be managed by competent professionals selected through a transparent and competitive bidding process, restrictions on the amount of costs that can be incurred in managing the assets (e.g., less than 0.5 percent of assets) and the types of investments that are permissible (e.g. highly leveraged and other risky investments should be prohibited). Investments and investment returns should be publicly disclosed, benchmarked against an appropriate market portfolio, and independently audited.

uA02fig03

GSIS: Accumulation of New Reserves under Selected Reform Options

(Percent of GDP)

Citation: IMF Staff Country Reports 2011, 332; 10.5089/9781463925888.002.A002

Source: IMF staff estimates.

Schemes for Public Employees

32. Deeper reforms will be needed to prevent the large cost from pension schemes for public employees from persisting for decades. While the August 2011 permanent measures were an important first step at reform, the government will still be incurring high and escalating costs under realistic assumptions in the coming decades. Moreover, these schemes would remain significantly more generous than the GSIS, generating significant inequities not only with the private sector but also between current government employees and the new ones who will retire under the GSIS. Moreover, such stark inequities could threaten the sustainability of the reform risking partial or total reform reversals in the future.

33. Reforms should aim at making the residual public sector pension schemes self financing over a transitional period and ensure that benefits for public sector workers converge to those of the reformed GSIS. Given the current generosity of benefits and low retirement ages with respect to the GSIS scheme and in an international context, and that many workers paid only minimal contributions for these benefits for a significant part of their career, increases in the effective retirement age and a reduction in benefits for public employees who will still receive their pensions under the current schemes seem to be important options that would improve fairness with new employees and the private sector. Benefits should at least be reduced to GSIS levels and track them once GSIS levels are achieved. Remaining actuarial imbalances after these benefit reductions should be matched by employee contributions that fully finance the cost of the reformed benefits. The transitional period would allow workers close to retirement to be treated more favorably than younger employees, given that the former are at the end of their careers and have fewer options to adapt to the change in their retirement benefits.

34. Options that would contribute to achieving the above goals gradually include:

  • Increasing the effective retirement age. This could be achieved by converging to a uniform retirement age policy for most public sector employees equal to the one for the GSIS and exempting from this principle only those groups for which there are well defined reasons accepted internationally to justify early retirement. This includes setting the same statutory retirement age as the GSIS and the same early retirement rules including the introduction of an early retirement penalty. In addition, special regimes for specific groups should gradually be phased out13.

  • Shifting indexation from public wages to CPI for pensions in payment. For example, given assumptions for the public wage growth-inflation differential and a linear phasing over a 5 year period starting in 2012, this would save 0.1 percent of GDP on average through 2050. The effective de-linking of public sector salary increases that this measure generates also helps protect pension finances from large ad-hoc wage increases such as those observed in 2009.

  • Reducing gradually the lump sum benefit at retirement until eliminating it. For example, assuming this measure is phased in linearly over 10 years starting in 2012, this would save 0.5 percent of GDP on average through 2050.

  • Increasing the number of years over which pensionable earnings are calculated and indexing wage histories to an index of average pensionable earnings. Common international practice is to calculate average earnings over 25 to 40 years, with wages from past years typically converted into current euros using an index of the average pensionable wage of contributors. Assuming that this generates an additional 30 percent cut in the replacement rate on average, in line with Muhanna (2011) estimates, if this is phased in over 10 years starting in 2012, savings would amount to less than 0.1 percent of GDP on average through 2050.

  • Increasing further the contribution rate for public workers. Increasing the contribution rate from 5 percent to 10 percent in 10 years starting in 2013 would save on average 0.1 percent of GDP through 2050.

Figure 4 below illustrates the cumulative impact of some of the options above in addition to the permanent measures adopted in August 2011. It is important to note that since most measures affect new retirees, impacts shown in Figure 4 are smaller primarily at the end of the projection period given the limited number of new retirees that will remain by then. Combining these measures with an increase in the effective retirement age would result in larger impacts. This is because, all the rest constant, the number of contributors would be higher and retiree growth would slow. This underscores the importance of increasing the effective retirement age to improve the finances of the public pension schemes.

uA02fig04

Net Cost of Pension Schemes for Public Employees after Selected Reforms

(Percent of GDP)

Citation: IMF Staff Country Reports 2011, 332; 10.5089/9781463925888.002.A002

Source: IMF staff estimates.

E. Conclusion

35. Reforming the GSIS and pension schemes for public employees is key to reduce growing public pension costs and address long term fiscal challenges. Now is the time to initiate reform to ensure that the financial position of both systems is sustainable. The policy choice with unsustainable pension finances is not between reform or no reform but between a gradual and equitable reform shared across many generations of contributors and pensioners or a more abrupt and inequitable disruption if reforms are postponed until the mounting costs demand immediate action.

Appendix

Old Age Pension GSIS Formulas

The basic annual old-age pension is calculated as follows:

(60% x (Basic Insurance Points x Annual Basic Insurable Earnings in the retirement year)) / (Insurance Period up to the 63rd or 65th birthday)

The 60 percent coefficient in the formula is increased to 80% for a beneficiary with one dependant, to 90% for a beneficiary with two dependants, and to 100% for a beneficiary with three dependants.

The supplementary annual pension is calculated as follows:

1.5% x (Supplementary Insurance Points x Annual Basic Insurable Earnings in the year of retirement)

The total pension is the sum of the basic and the supplementary pensions. The total pension cannot fall below a minimum of 85% of the basic pension that would be paid to the beneficiary if he had full insurance in the basic part of the plan (i.e. if he had contributed during a full working career with a salary equivalent to the basic insurable earnings).

To illustrate the calculation, consider the case of an insured aged 63 that requests a pension in 2011 and meets the criteria for early retirement and the following information is given:

The insured has paid contributions as of his 24th birthday

The insured has earned or been credited with 47 basic insurance points (39 from paid contributions and 8 from credited contributions) and 76 supplementary insurance points (approximately 2 for each year of work). This latter fact means that his salary was approximately 3 times the basic insurable earnings during his career.

The level of annual basic insurable earnings is equal to € 8,435.

He has no dependents.

Then, the total annual pension is calculated as follows:

Annual Basic Pension = 60% * 47 * 8,435 / 47 = € 5,060

Annual Supplementary Pension = 1.5% * 76 * 8,435 = € 9,616

Total Annual Pension = € 5,060 + € 9,616 = € 14,676 (€ 1,129 per month)

Note that the number 47 in the denominator corresponds to the period of insurance which is calculated as the difference between 5/10/64 and the 63rd year of age.

Underlying Data Assumptions for Projections

General Social Insurance Scheme

Demographic Assumptions: The latest population projection available from Eurostat’s website for Cyprus was used to derive the working age population and retirement age population. Given that the population data is available in 5 year intervals, a simple linear interpolation was used to annualize it.

Macroeconomic Assumptions: Projections for real GDP growth and average HIPC inflation through 2016 are as in the Selected Economic Indicators Table of the Staff Report (Table 1). After reaching 3 percent in 2016, real growth declines gradually to 2.5 percent in 2020 and, subsequently, to 1.8 percent by 2050 in line with projections provided by the Ministry of Finance for the Actuarial Review of the Schemes for Public Employees in the Public Sector. With respect to average inflation, it converges to 2 percent after 2016 and stays constant at this level in line with the European Central Bank (ECB) inflation target.

Labor market Assumptions: These assumptions follow broadly the ones published in the 2010-2014 Stability Program of the Republic of Cyprus. The total labor force participation rate is expected to increase from about 74 percent in 2010 to close to 80 percent due expected increases in female labor force participation. The unemployment rate projection is as in Table 1 of the Staff Report until 2016. After 2016, the unemployment rate continues its decline to slightly above 5 percent in 2020 and from then on continues to decline to about 4 percent in 2050. Employment is determined endogenously given the demographic assumptions, the labor force participation rate assumption, and the unemployment rate assumption. Labor productivity growth is derived from the real GDP growth projection and employment growth.

Pension Schemes for Public Employees

The pre-reform baseline scenario in Figure 1 is built using in most cases the same assumptions of the baseline scenario in Muhanna (2011). This includes 1.5 percent general salary increase each year, the same public employment growth path, the same mortality implied in the projections of the number of contributors and pensioners, and the same evolution of the average replacement rate. The main assumption differences relate to macroeconomic assumptions. Real GDP growth and inflation in 2011-2016 are assumed to behave as in Table 1 of the Staff Report and long term inflation is assumed to be 2 percent instead of the 2.5 percent assumed in Muhanna (2011). These changes were made to ensure consistency with the macroeconomic framework for 2011-2016 and to have the same macroeconomic assumptions applied to the projections of both schemes.

Appendix Table 1.

Actuarial Penalties for Early Retirement 1/

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Source: OECD, Pensions at a Glance 2011.

Some countries have more than one component in their pension system and thus may have more than one set of actuarial penalties such as France.

Appendix Table 2.

Life Expectancy at Age 65

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Source: OECD, Pensions at a Galance 2011.
Appendix Table 3.

Pension Indexation Practices in National Pension Schemes

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Source: OECD, Pensions at a Glance 2011. [c] = indexation conditional on financial sustainability; d = discretionary indexation; p = indexation with prices; w = indexation with average earnings.
Appendix Table 4.

Public Pension Contribution Rates and Gross Replacement Rates in the OECD 34

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Sources: OECD (various years), Taxing Wages; OECD (2008), Revenue Statistics; Social Security Administration, United States (various years), Social Security Programs throughout the World; OECD pension and tax models.

A government contribution of 4 percent before 2009 and of 4.3 percent in 2009 is not included for comparability with other countries. The estimated pension contributions are computed deducting an estimated contribution for unemployment insurance close to 1 percent.

Gross replacements rates are computed for workers that earn the average salary during their whole careers and work for 45 years (i.e. a full career worker).

Appendix Table 5.

Age of Mandatory Retirement in Civil Service Pension Schemes

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Sources: Civil Service Pension Schemes Around The World, May 2006, Robert Palacios and Edward Whitehouse; Social Protection; the World Bank; and guides to retirement schemes offered to civil servants in the United Kingdom (classic, premium, classic plus, nuvos, partnership scheme guides).

For ordering purposes, mid-point is assumed.

Appendix Table 6.

Pension Accrual Rates in Civil Service Pension Schemes 1/

(Percent)

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Sources: Civil Service Pension Schemes Around The World, May 2006, Robert Palacios and Edward Whitehouse; Social Protection; the World Bank; and guides to retirement schemes offered to civil servants in the United Kingdom (classic, premium, classic plus, nuvos, partnership scheme guides).

For ordering purposes, mid-point is assumed.

In Sweden, the pension accrual rate changes depending on revenue level.

Takes in to account the lump sum gratuity.

Appendix Table 7.

Method of Pension Indexation in Civil Servants Pension Schemes

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Sources: Civil Service Pension Schemes Around The World, May 2006, Robert Palacios and Edward Whitehouse; Social Protection; and the World Bank.

References

  • European Commission (2009), “Pension schemes and pension projections in the EU-27 Member States-2008-2009” Occasional Paper Series 56, Volumes I, II, and III.

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  • European Commission (2009), “The 2009 Ageing Report: Economic and Budgetary Projections for EU-27 Member States (2008-2060)”, Main Report and Statistical Annex.

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  • European Commission (2010), “Progress and key challenges in the delivery of adequate and sustainable pensions in Europe” Occasional Paper Series 71, Main Report and Annexes to the Main Report.

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  • Kontolemis, Zenon, Matsi, Maria, and Stavrakis, Costas (2008) “Cyprus: Pension Fiche for the Ageing Working Group of the EPC”, Ministry of Finance and Ministry of Labor and Social Insurance of Cyprus.

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  • Muhanna and Company (2011), “Actuarial Study for the Computation of the Cost of Pension Benefits in the Public and Wider Public Sector” Reports 2A, 2B, 2C, 2D and 2E.

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  • OECD (2011), “Pensions at a Glance 2011: Retirement-Income Systems in OECD and G20 Countries” OECD Publishing.

  • Palacios, Robert and Whitehouse, Edward (2006) “Civil service Pension Schemes Around the World”, Social Protection Discussion Paper 602, The World Bank.

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1

Prepared by Alejandro Simone (EUR).

2

The non contributory pension schemes are the special allowance to pensioners (SATP) and the social pension. (SP). In 2010, the SATP paid an allowance for pensioners whose total pension income from any other schemes did not exceed a minimum per year guaranteeing a minimum pension benefit. The SP provides pensions to Cypriot residents of 65 years or more who have no pension income from any other source.

3

The conditions for being eligible for early retirement in the GSIS are: (1) have paid contributions in at least three years and have insurable earnings in the lower band not less than 156 times the weekly basic earnings; and (ii) have a weekly average of insurable earnings (paid or credited) in the lower band of at least 70% of the weekly amount of the basic insurable earnings (paid or credited).

4

Incentives for postponing retirement translate into an increase of 0.5 percent in the pension benefit for every postponed month from age 65 up to a maximum of age 68.

5

The minimum qualifying period of paid contributions for old age pension was increased from three to ten years and the total period, including credited contributions, from 12 to 15 years within a period of three years starting from 2009. In addition, the minimum contribution period for entitlement to an old age grant (payable where there is no entitlement to pension) was raised from three to six years. The crediting of contributions for full time education for old age pension was restricted to 6 years.

6

Formally, public employees pay a 3.45 percent contribution rate to the GSIS and the government pays 10.15 as an employer contribution.

7

The implicit pension debt is the present value of all overall balance results for the GSIS between 2012 and 2050 computed assuming a certain discount rate. The 4.5 percent discount rate was used to be consistent with the one assumed by Muhanna (2011) for the schemes for public sector employees.

8

This formula is derived from the budget constraint of the social security fund where transfers+contribution income+ other income = pension benefit expenditure + other benefit expenditure +administrative costs. Assuming for simplicity that other income, other benefit expenditure, and administrative costs are 0, and carrying out some algebraic manipulations yields the formula above.

9

The increase in the transfer need due to a worsening dependency ratio and an increasing replacement rate, which add up to 6 percentage points of GDP, is partially offset primarily by the impact of an increasing contribution rate. This leads to an overall impact of a 5 percent of GDP additional transfer need.

10

The definition of a full career worker in OECD (2011) is a worker had a 45 years career. This definition was used to be able to compare the replacement rate that the Cypriot system provides at retirement for a full career worker that earns the average salary with that of other OECD countries.

11

For simplicity, the impact of temporary measures adopted in August 2011 is excluded given that these measures expire in 2013.

12

It is important to indicate that only newly created reserves on the basis of surpluses created by reforms of the GSIS would be invested in private assets. Existing reserves, i.e. government paper, would not be invested in private assets as this would require conversion of the government paper into liquid assets and would thus generate additional financing needs to the government.

13

Fiscal impact estimates for this measure were not computed given that a distribution showing the number of pensioners in public schemes of a given age and their average pensionable salaries was not available.

Same Series

Other IMF Content

Other Publishers

Cover IMF Staff Country Reports
Cyprus: Selected Issues Paper
Author: International Monetary Fund
Volume/Issue:
Volume 2011: Issue 332
Publisher:
International Monetary Fund
ISBN:
9781463925888
ISSN:
1934-7685
Pages:
53
DOI:
https://doi.org/10.5089/9781463925888.002
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    Net cost of Schemes for Public Employees Before and After Recent Reforms

    (Percent of GDP)

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    GSIS: Overall balance under Selected Reform Options

    (Percent of GDP)

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    GSIS: Accumulation of New Reserves under Selected Reform Options

    (Percent of GDP)

  • View in gallery

    Net Cost of Pension Schemes for Public Employees after Selected Reforms

    (Percent of GDP)