Cover Image

PAPERBACK
$57.00



View/Hide Left Panel

14
Pension Reform in the Post-Communist Transition Economies

Louise Fox

INTRODUCTION

One of the main social and economic features of the transition in Central and Eastern Europe and the New Independent States has been a crisis in pension systems. The crisis is most acute in Central and Eastern Europe, where the demographic transition has proceeded more rapidly, and the dependency burden weighs more heavily on the working-age population. However, even in the younger countries, pension financing crises have erupted.

These crises have been economically, politically, and socially painful. From an economic perspective, high and often growing pension expenditures have frustrated stabilization efforts and crowded out other needed government expenditures, such as new social and economic infrastructure (Barbone and Marchetti, 1994). The payroll tax financing of these expenditures provides incentives for informalization of the labor force and lowers labor demand. Politically, the demands of pensioners (and soon-to-be pensioners)—that the government keep its entitlement promises—have proven very difficult to resist, despite the economic cost. Socially, the insecurity associated with declining pension payments for those who have already withdrawn from the labor force has been a major hardship, especially for the small minority of pensioners who have no other source of income or assets. At the same time, the burden of financing these payments has lowered real wages, probably contributing to the growing poverty of households with children (see also Ferge, in this volume).

Most analysts agree that the entitlements promised under the central planning system are not affordable in demographically mature countries. Nor are



The National Academies | 500 Fifth St. N.W. | Washington, D.C. 20001
Copyright © National Academy of Sciences. All rights reserved.
Terms of Use and Privacy Statement



Below are the first 10 and last 10 pages of uncorrected machine-read text (when available) of this chapter, followed by the top 30 algorithmically extracted key phrases from the chapter as a whole.
Intended to provide our own search engines and external engines with highly rich, chapter-representative searchable text on the opening pages of each chapter. Because it is UNCORRECTED material, please consider the following text as a useful but insufficient proxy for the authoritative book pages.

Do not use for reproduction, copying, pasting, or reading; exclusively for search engines.

OCR for page 370
Transforming Post-Communist Political Economies 14 Pension Reform in the Post-Communist Transition Economies Louise Fox INTRODUCTION One of the main social and economic features of the transition in Central and Eastern Europe and the New Independent States has been a crisis in pension systems. The crisis is most acute in Central and Eastern Europe, where the demographic transition has proceeded more rapidly, and the dependency burden weighs more heavily on the working-age population. However, even in the younger countries, pension financing crises have erupted. These crises have been economically, politically, and socially painful. From an economic perspective, high and often growing pension expenditures have frustrated stabilization efforts and crowded out other needed government expenditures, such as new social and economic infrastructure (Barbone and Marchetti, 1994). The payroll tax financing of these expenditures provides incentives for informalization of the labor force and lowers labor demand. Politically, the demands of pensioners (and soon-to-be pensioners)—that the government keep its entitlement promises—have proven very difficult to resist, despite the economic cost. Socially, the insecurity associated with declining pension payments for those who have already withdrawn from the labor force has been a major hardship, especially for the small minority of pensioners who have no other source of income or assets. At the same time, the burden of financing these payments has lowered real wages, probably contributing to the growing poverty of households with children (see also Ferge, in this volume). Most analysts agree that the entitlements promised under the central planning system are not affordable in demographically mature countries. Nor are

OCR for page 370
Transforming Post-Communist Political Economies they desirable in market economies, since their purpose was to reduce labor supply and create dependency. From an economic perspective, there are a number of feasible options. The political and social dimensions of the reform are what has prevented countries from resolving the issues. The future social safety net of the transition economies will need to be anchored by an old-age security system. Fixing the old-age security system involves, first and foremost, a strong effort to convince the population of the need for reform. This effort must be combined with plans for a new, economically viable system that is affordable and equitable and promotes growth. Experience from other countries, both members of the Organization for Economic Cooperation and Development (OECD) and middle-income countries in other parts of the world, indicates that a successful pension system will have more than one pillar, with a significant role for privately managed savings and insurance programs (see also Kornai, in this volume). For the post-communist states of Central and Eastern Europe and the New Independent States, this means scaling back the public system while building up the funded, privately managed one to take the pressure off the pay-as-you-go system. As in other key areas of the transition, innovation and risk taking will be necessary. The new Latvian system is an example of just such action. It involves a whole new approach to providing pensions in the public system, while adopting some of the successful features of recent Latin American reformers in building a funded system. Three features of the package seem key to its political success. First, it offers something for all key stakeholders, even if not as much as they originally sought. Second, the new public system—a "notional" defined contribution one—has fundamentally changed the tone of the debate. By making explicit much of what is normally hidden in a traditional, defined-benefit pension system, it has revealed the cost of providing guarantees and special benefits, thereby reducing antireform political pressure. Third, the new system is flexible, allowing a high degree of individual choice and automatically adjusting to significant demographic and economic changes. This chapter examines the legacy of central planning as regards pension systems in the post-communist states, the prospects for change, and the new Latvian system as an example of the potential for reform. THE LEGACY OF CENTRAL PLANNING Under central planning, the command economy promised cradle-to-grave income security, including pensions replacing roughly 80 percent of wages. These systems have been viewed as compensation for relatively modest wages during the working years. By Western standards, they were quite generous. Retirement ages were set very low: in every country except Poland, the statutory retirement age was 55 for women and 60 for

OCR for page 370
Transforming Post-Communist Political Economies men. There were also generous special provisions for disabilities and selected occupations, which reduced the average effective retirement age to about 57 for men and 53 for women (Fox, 1994). In most of these countries, this continues to be the case. The main economic effect of this generous system was to inflate artificially the dependency burden on the working population. Indeed, this is the root cause of the pension problem facing these countries today (Fox, 1994). Under central planning, the high value of nonmarket time to the household (e.g., of having a nonworking family member available for queuing and child care) may have corrected for this dependency in terms of overall income to the household. High payroll taxes and the resulting low wages were also not such a problem, when the shops were mostly empty anyway. Younger families pooled resources with pensioners in order to survive, with each contributing resources to the common household budget. In this situation, the pension system appeared sustainable. However, the combination of declining gross domestic product (GDP) and market-determined wages and prices made the system unsustainable as the transition progressed. The true cost of the system to the working generation also became clear.1 Despite recent declines in health indicators, the average postretirement life span in most post-communist countries still exceeds that in most OECD countries. In other words, the post-communist states of Central and Eastern Europe and the New Independent States, with much lower incomes and tax collection capabilities, have promised higher benefits (in relation to their resources) than some of the richest countries in the world, many of which are now finding their generous welfare systems unaffordable. As Table 14-1 shows, while demography accounts for some of the high pension spending, many Western countries—with the same share of their population over 60 and longer life expectancies—spend less on pensions as a share of GDP than do the post-communist states, owing largely to the higher age of eligibility. The size of the prematurely retired group makes the situation of the latter countries unique in the world, and complicates any solution. Moreover, health indicators are expected to rebound over the next decade, exacerbating the problem further. This situation has both economic and social costs. The Economic Cost In most of the post-communist states, pensions as a share of GDP increased in the initial years of the transition. Today in Eastern Europe, pension expenditures are frequently the largest single item in the government budget, accounting for about 15 percent of GDP in Poland and Slovenia and 10 per- 1   Disney (1996) discusses the inevitability of generational conflict in countries with pay-as-you-go pension systems as societies age.

OCR for page 370
Transforming Post-Communist Political Economies TABLE 14-1 Pension Spending as a Share of GDP Country Share of Population over Age 60 (%) Pension Share of GDP 1990 Pension Share of GDP 1993/1994 92 Country Sample Poland 14.8 8.80 15.0 3.479802 Czech Republic 16.9 8.00 8.0 3.881087 Slovak Republic 16.2 7.40 9.4 3.747325 Ukraine 18.7 9.60 9.0 4.225045 Bulgaria 19.7 7.80 8.8 4.416133 Hungary 19.3 9.10 10.3 4.339698 Israel 12.1 — 4.3 — Portugal 18.7 — 7.7 — Uruguay 16.4 — 8.8 — Japan 17.3 — 5.0 — United States 16.6 6.50 - — Germany 20.3 — 10.8 — Canada 15.6 — 4.2 — Latvia 17.9 5.60 10.2 4.072175 Estonia 17.2 5.6 6.4 3.938413 Lithuania 16.2 6.77 5.2 3.747325 cent in Hungary, Bulgaria, Latvia, and Slovakia. Two factors account for most of the increases.2 Pensioners held on better. As with all other incomes, pensions fell in real terms during the initial period of price decontrol and inflation. However, as prices stabilized, pensions recovered some of their lost ground. In many countries, pensioners managed to recover more of the purchasing power lost during inflationary periods than did wage earners—the aging were able to capture a larger share of the falling GDP. Eligibility expanded. The policy measures taken by many of the postcommunist states to cope with the social costs of transition have significantly worsened the financial position of the public pension system. In hopes of reducing unemployment, countries allowed workers to retire up to 5 years earlier and receive a full pension. Disability criteria were also applied less stringently. Today in Poland and the Czech Republic, for example, more than two-thirds of pensioners are under age 60. Countries increased payroll tax rates dramatically to finance these expenditures—up to 40 to 60 percent of employees' gross wages (Andrews and Rashid, 1996). Nevertheless, most systems experienced financing crises, requiring additional financing from other sources of revenue or resulting in pension arrears. In many parts of the New Independent States, benefits have 2   See Andrews and Rashid (1996) for a country-by-country analysis of these trends.

OCR for page 370
Transforming Post-Communist Political Economies come late (if at all) for a long period of time. Weak tax collection systems contributed to the financing crises. However, the eligibility expansion also hurt public finances. This well-intentioned move swelled the ranks of those claiming benefits while reducing the ranks of those paying taxes. Since pension benefits are often reduced if the pensioner continues to work, many pensioners quit the formal sector, but continued to work in the informal sector. Today, an estimated 50 to 70 percent of pensioners continue to work during the first decade of their ''retirement," but most are now outside of the tax net (Fox, 1994). At the same time, many in the working-age population have escaped taxation by moving out of the formal sector, leaving the burden of paying for pension benefits to those left in the public sector, who cannot evade taxes. The Social Cost At a high fiscal cost, the pension systems of the post-communist states of Central and Eastern Europe and the New Independent States have kept most pensioners out of poverty. For the most part, the available evidence suggests that the social cost of the transition has not fallen disproportionately on pensioners. While almost all analyses of household income show an increase in poverty during the transition (World Bank, 1996), none find pensioners over-represented among the poor. Given that pensions are now quite low in absolute terms in many countries, how do pensioners stay above the poverty line? First, most continue to work, especially in the first decade after receiving their pension. This is especially true in rural areas. Second, most pensioners still have access to relatively cheap housing. Many also started the transition with more consumer durables than did younger households. Finally, most pensioners do not live alone, so are being sustained by intrahousehold transfers. While many pensioners may be better off than the average citizen, anecdotal evidence suggests that there are pockets of very vulnerable old people. In Estonia, it was found that the pensioners most likely to be in poverty were those who lived in pensioner-only households with no outside income. Other studies have identified pensioners living alone as vulnerable. In all surveys, pensioners have reported a high degree of psychological stress, which is normal given their fixed incomes and uncertain inflation. Families with children constitute the growing poverty group in the post-communist states (World Bank, 1996). Many of these families are poor because the two incomes coming into the household are simply not enough. Part of the reason these incomes are low is the high tax burden. Although not the only cause, the generous pensions systems bequeathed by central planning are now compromising the living standards of pensioners' children and grandchildren. The former economic system left a set of rules and expectations that is very difficult for the current generation to honor, but is also very difficult for

OCR for page 370
Transforming Post-Communist Political Economies the working generation to abrogate. This may be the greatest social cost of the central planning pension legacy. PROSPECTS FOR CHANGE Almost without exception, the debate about pension reform in the post-communist states is about what kind of system should be put in place for the pensioners of the twenty-first century—today's workers. Most countries envision leaving the pensions already granted to current pensioners as is (with some form of purchasing power guarantee, either partial or full), as the politics of taking away a benefit already granted are almost insurmountable. In demographically mature countries, old-age security systems should achieve the following goals: Prevent poverty in old age. Assist with income smoothing by supporting savings and insuring against the risk of long life. Equitably support economic growth and development. While the systems of the post-communist states have been effective in preventing old-age poverty during the transition, they have done so at a cost, as discussed above, and thus have not contributed to the third goal above. The high and growing number of the aging relative to workers means that this cost will only continue to rise. By relying on pay-as-you-go funding, these systems have also not encouraged savings. Based on an analysis of pension systems around the world, the World Bank (1994) recommends a combination of pay-as-you-go and funded pension systems.3 Achieving such an arrangement involves setting up a multipillar system that includes the following elements: Pillar 1—a mandatory pay-as-you-go public pension system designed to provide an income floor for all elderly persons Pillar 2—a mandatory funded and privately managed pension system—one whose current reserves are equal to or greater than the present value of all future pension payment liabilities, based on personal accounts (the Latin American approach) or occupational plans (the OECD approach) Pillar 3—a voluntary system (also funded and privately managed), with strong government regulation, to provide for additional savings and insurance. Reform of pension systems to bring them closer to the World Bank's recommendations implies (1) longer working lives and (2) less income re 3   Similar recommendations are offered in Disney (1996). For a critique of these recommendations, see Beattie and McGillivray (1995). James (1996) offers a response.

OCR for page 370
Transforming Post-Communist Political Economies placement from tax-funded pay-as-you-go systems. The post-communist states need to place greater reliance on prefunding of pension obligations (with private management of reserves) to (1) smooth out contribution rates as the "baby boomers" retire, and (2) deepen capital markets, and thus enhance growth, through the development of a contractual savings industry. The main difficulty in applying these recommendations in transition economies is that prefinancing in a mature pay-as-you-go system implies that the members of one generation must bear an additional burden—saving for their own retirement while simultaneously paying for that of their parents.4 This is affordable only if the current transfers can be gradually reduced through a major reform. In the typical post-communist system, governments can reduce future entitlements by the following means: Raising the effective retirement age (eliminating early retirement and raising the normal retirement age) Changing the formula to lower the average benefit Reducing indexation provisions (to, for example, the lower of wage or price increases) Prefunding can be achieved in the public system only by building up a reserve fund. The World Bank (1994) recommends that these reserves be allocated to individual accounts (the Latin American approach), as this reduces the "taxation" element of the public pension system, thereby reducing labor market distortions. It also improves the management of the reserves. Funding can also begin through the development of optional, privately managed programs (private pension systems). Few governments in Eastern Europe have tackled this entire agenda. All of the Baltic countries, Albania, Georgia, and the Czech Republic have tackled major parts of it, with some success. Of these, only Latvia and Georgia have adopted radical pension reforms. While Lithuania, the Czech Republic, and Estonia have been able to avoid the kinds of pension cost explosions faced by Poland, Bulgaria, and Slovenia, even the former three countries are experiencing steady growth in expenditures, as they have simply not reformed entitlements sufficiently. Estonia was able to implement a steady increase in retirement age, but left in place all the exemptions from the Soviet period, even adding a few. Lithuania and the Czech Republic courageously eliminated almost all early retirement, but chose generous formulas as they attempted to return to the status quo ex ante. Lithuania and Estonia have also 4   Strictly speaking, the savings of the working generation is not a "burden" since the money saved will come back to them later. Saving represents postponed consumption, however, which has a cost. Were the members of this generation able to obtain from future generations the equivalent on a per capita basis to what they are transferring, they would be better off than under a reformed approach that includes more funding and less reliance on current transfers. However, this is an unrealistic scenario.

OCR for page 370
Transforming Post-Communist Political Economies experienced a large growth in disability pensioners, probably as a result of lax certification. Hungary and the Czech Republic were the pioneers in starting private pension systems, demonstrating that transition capital markets can respond to a supply of long-term funds. In the Czech Republic, where subsidies are offered as an alternative to tax concessions, roughly 20 percent of the labor force is now participating in these programs. Russia and the Baltic countries hope to follow their lead shortly. In other countries, the strategy has been to muddle through, hoping that a resumption of economic growth—including growth in real wages and improved tax systems—will solve the problem. Why has reform proven so difficult? First, the claims of current pensioners have not been resolved. Their pensions were originally based on some kind of earnings-related formula and barely replaced their monetary income. The policy response during hyperinflation (e.g., fixed-amount compensations for price increases) has for the most part eliminated these differences, so that the structure of benefits paid today in most of the countries is relatively flat. Most pensioners are not happy with this, and oppose pension reforms even though pensions are untouched. While the macroeconomics of fiscal stability and growth suggest that future entitlement payments should be reduced and savings by the current working generation increased, the political agenda is often quite different. Second, the weaknesses of the system are poorly understood by most of the voters. Pay-as-you-go systems are inherently nontransparent, which is why reform is so difficult. Until a crisis occurs, most pensioners imagine that their contributions have been placed somewhere safe, that their entitlement is actuarially fair, and therefore that they are entitled to their benefits. After years of central planning, most of the active and retired populations are used to thinking of income as an obligation of the state and are unaware of the issues identified above. And of course, those groups entitled to special early retirement provisions want to keep them. In short, there is not yet a constituency for reform. The active population has not focused on the cost of this system to them, as the contributions are paid by their firms. Even among policymakers, the depth of the problems is poorly understood. The extent to which the post-communist systems are at variance with both Western European systems and the systems of countries at their income level is not well known. And even in the high-income welfare states, public pay-as-you-go systems are facing pension financing crises. Innovation and risk taking will be needed to move forward on this ambitious agenda of reform. Over the last year, a handful of countries have been developing major reforms that involve prefunding through a mandatory second pillar. In Hungary and Croatia, the governments have decided in principle to create a mandatory second pillar, despite the painful reductions this will

OCR for page 370
Transforming Post-Communist Political Economies produce in the pay-as-you-go system. Similar proposals are also circulating in Poland and the Czech Republic. In 1995, the Latvian government became the first in Eastern Europe to enact a radical reform of the system, including a commitment to developing the second tier for the purposes of prefinancing. Latvia achieved this goal by adopting a whole new approach to the benefit formula. The remainder of this chapter discusses that reform and draws from it lessons for further reforms. THE NEW LATVIAN PENSION SYSTEM Since achieving independence from the Soviet Union in 1990, Latvia has moved steadily toward the establishment of a market economy and the development of democratic institutions. An initial reform of the Soviet system was undertaken in 1990. But the reformed system left in place most of the Soviet eligibility conditions (retirement at age 55 for women and age 60 for men, with earlier retirement permitted for certain occupations and categories of people). The benefit formula provided a flat guarantee of 30 percent of the national average wage, with an increase of 0.4 percent for each year of service. By July 1995, the average old-age pension was 33 lats, or 50 percent of the average net wage (pensions are not taxable). This formula implied full wage indexing for pensions, although in practice this indexing did not take place when revenues were inadequate. In January 1995, the government submitted to Parliament a new pension reform concept, calling for the introduction of a three-tier system. The first tier would be a modified pay-as-you-go system, with stronger links to contributions and a minimum pension to protect the lifetime poor. The second tier would be a mandatory, funded system of privately managed savings accounts. Participation would be limited to new entrants and the younger members of the current labor force. The third tier would be voluntary, privately managed pensions, organized primarily (but not exclusively) through employers. The new concept was accepted by Parliament, and work began immediately on the first stage of the reform—new legislation for the first tier. This legislation was submitted to Parliament in July 1995 and approved in November 1995 as part of the package of welfare system reforms. The new system took effect in January 1996. The new public pension system has two main elements: Pensions are linked directly to an individual's total contributions and the retirement age on the basis of a new formula. Provision is made for introduction of the second tier. Beginning in 1998, contributors will have the option of assigning a portion of their contributions to privately managed individual savings accounts. This will result in a partial funding of the system, reducing the debt for future generations.

OCR for page 370
Transforming Post-Communist Political Economies The new public pay-as-you-go pension system is a notional defined contribution one. It is designed to mimic the contribution-based pension that would be offered in the private sector by an efficient insurance company. The system starts by giving an account to everyone paying the social tax. As contributions earmarked for the pension system are paid, the account is credited as if it were a savings account. The "capital" in the account earns a rate of return just as a savings account would. This rate of return is equal to the growth of the sum of wages on which contributions are collected (the contribution wage base). At retirement, the pension paid is equal to the total capital in the person's account, divided by the expected postretirement life span for all those of that person's age. For example, if a person has 10,000 lats in his or her account at retirement and is expected to live 10 more years, the pension will be 1000 lats per year or 83 lats per month. The pension will be indexed, adjusting for price changes.5 In this system, individual benefit levels are not specified until retirement. However, each contributor gets an annual statement showing the capital in his or her account. A table of average life expectancy at retirement (called the G-value) is also published every year by the government. Since life expectancy changes very slowly, and the amount of capital in the account is known, those nearing retirement can roughly estimate their future pensions (as they did under the old system). In the new system, there is no mandatory retirement age and no "full pension." The minimum retirement age will be 60 years for most participants. However, the system provides strong incentives to work longer. Longer working years will shorten the number of payments, allowing each to be higher, and increase the initial capital. As a result, assuming a constant wage, the pension will double when an individual works until age 70 instead of 60. The new system also includes a minimum guaranteed pension for all those who reach the age of 60. This minimum is set at the level of the social pension, a social assistance pension for those adults who were disabled at birth. The social assistance pension is also available to those who reach the age of 65 but do not have 10 years of service. The nominal level of the social pension is set by government. It is currently 25 lats (60 percent of the average pension and 20 percent of the average wage). Once the second tier is in place, the minimum will include both first- and second-tier funds, providing a floor under the total pension. Transitory provisions in the new law gradually enforce the minimum retirement age of 60. Some politically sensitive exceptions remain, including a provision for early retirement at 55 for women and a few occupations (e.g., wind instrument players, ballet dancers). However, the minimum guarantee does not apply to anyone who takes a pension before age 60. Thus, these 5   For a detailed analysis of the new system, see Fox et al. (1996).

OCR for page 370
Transforming Post-Communist Political Economies groups will be entitled only to an actuarially fair pension, which for average workers is about 50 percent of what they would get at age 60 and 55 percent of what they would have gotten under the old system. It is expected that most will find this pension to be so low that they will continue to work, and this will greatly reduce the number of early retirees. Hidden subsidies in the form of pension credit for noncontributory periods have also been removed. All subsides are now explicit, as any pension credit for noncontributory periods requires actual contributions into an individual's notional account. For time spent in higher education (maximum of 8 years), in military service, or at home taking care of children (maximum of 3 years per child), contributions to the pension fund are made by the state budget in the form of budget transfers, using the minimum wage as the contribution wage for transfer purposes. The cost of these transfers to the state budget is estimated at roughly 17 million 1996 lats (0.3 percent of GDP). For those receiving social insurance benefits (e.g., unemployment or disability benefits), transfers are made from these funds to the pension fund. The formula for disability pensions has not been changed in the new pension law. However, the new law converts disability pensioners into old-age pensioners at age 60. A new disability formula was submitted to Parliament in September 1996. How do the actual benefits compare under the old and new systems? Assuming that under the old system, the required quarterly indexing would have taken place in 1996,6 most new pensioners with full years of service retiring after 60 do not suffer a benefit decline as compared with the old system. For those who work longer, benefits increase—by over 200 percent for those who work another 10 years. Benefits are larger as well for those with higher incomes (who in the future will also contribute more). Benefits may be smaller for those whose lifetime incomes are low. This is a disadvantage of the contribution-related formula—it is not redistributive within the age cohort toward the lifetime poor. However, given that the old system was unaffordable, the projected benefits under that system are probably on the high side. Under the new system, early retirees will be penalized. For example, a woman who retires at 55 will experience on average a 25 percent decrease in her pension under the new system if she stops contributing. With regard to the macroeconomic impact, after 10 years the expenditures on pensions are projected to be one-third lower than they would have been under the old system. As a result, the contribution rate (payroll tax) allocated to pay pensions will fall from about 26 percent of payroll to 20 percent by 6   This is a strong assumption. Indexing due under the new system (semiannually) was delayed from April to May in 1996 because of a lack of funds.

OCR for page 370
Transforming Post-Communist Political Economies 2001. This represents primarily the effect of delayed retirement and decreased benefits for early retirement, but it also results from switching to price indexing of benefits in the face of growth in real wages. This savings will be allocated to second-tier accounts through a process of gradual participation. It is expected that by 2005, about 10 percent of total contributions will be invested—a potentially large increase in national savings. All new entrants into the labor force after 1998 are expected to participate in the second tier, so the ratio of invested resources to the revenue inflow will increase over time. For Latvians under age 40 (who will begin receiving pensions in about 20 years), about 40 percent of their pension is expected to come from second-tier funds. The system dependency ratio will fall steadily from about 80 percent to below 50 percent by the end of the period. Provided Latvia realizes at least some economic growth, the system should be affordable. Affordability is maintained in the first instance through the indexing provisions. During the accumulation period, contributions in the "notional" account are indexed to the inflow of resources, so that liabilities do not grow more rapidly than resources. Investment of reserves in second-tier funds helps ensure affordability as well. Pensions are also indexed to life expectancy, automatically adjusting to demographic changes. Finally, during the payment period, pensions are price indexed until 2002, and after that indexed to a mix of wages and prices; this will avoid rising liabilities during an economic downturn. Since benefits are completely and fully dependent on contributions in the new system, a large part of the disincentive effect of a traditional social insurance tax disappears. When benefits are unrelated to contributions, the social insurance contribution becomes a tax, and like any other tax embodies a loss of income and utility to the payee. The more closely benefits are related to contributions, the less loss of income and utility the system implies, and the easier administration becomes. There is always some loss of income and utility associated with a mandatory contribution system, however. This is because even if pension benefits are considered 100 percent deferred compensation, a lat today is always worth more than the promise of a lat in the future. (This consideration is even stronger if that promise comes from an unaffordable public pension system subject to short-term political pressures.) The new system also permits a flexible adjustment of benefits to changes in life expectancy, thus avoiding the whole acrimonious debate over retirement age. Moreover, the system has the advantage of containing one simple formula that covers all circumstances. In so doing, it provides a wider range of options for older workers. Anyone over the age of 60 can take a pension if he or she desires, or continue working and get a higher pension later, or do both and get a slightly higher pension later, or stop working for a while and then start again. These options can be especially important for women, who

OCR for page 370
Transforming Post-Communist Political Economies tend to have greater responsibility for taking care of dependent family members, and those who may have uncertain health, who may work part of the time and may require limited income support at other times. As noted earlier, the new system also provides for a smooth transition into the second tier. Grafting a funded system, especially a defined contribution scheme, onto a defined benefit scheme can be expensive for those already covered by the existing scheme (as many Latin American countries have discovered).7 With the notional defined contribution structure, benefits in either scheme depend solely on contributions. These contributions can be allocated to the second tier on either a mandatory or voluntary basis without creating any negative labor supply incentive problems. LESSONS FROM THE LATVIAN REFORM The Latvian pension system is not perfect—no pension system is. In particular, because of the high costs of pensions already granted and the desire to compensate with increased pensions those who lost the right to early retirement, the system remains expensive in the initial period. As a result, the target rate for pension expenditures is 20 percent of payroll (well above, for example, the costs of the generous Swedish system), but even this target will not be achieved until 2000, under the optimistic scenarios. The provision for early retirement for women may induce them to leave the labor force too early, possibly resulting in an increase in poor widows later on. Nonetheless, the new system represents a major reduction in entitlements and a strong break with the Soviet guarantee approach, perhaps serving as a new model for a pension system that provides old-age security without compromising economic growth objectives. How did the Latvians succeed in their radical approach? First, the pension reform offered something for all key stakeholders. The most vocal opposition came from existing pensioners, who realized that no increase was promised for them. However, they also came to understand that the reform offered them some certainty with respect to purchasing power. In addition, the proposals to allow pensioners to work and still receive a pension helped garner support. Future pensioners liked the idea of a higher pension if they worked longer. A few special groups also won the right to receive a lower pension early.8 7   Disney (1996) provides an excellent analysis of the problems OECD countries have experienced in trying to add funded programs. 8   From an economic point of view, there is no reason why everyone should not have the right to retire early, since the formula is actuarially fair. However, such a provision runs the risk of creating a group of poor retirees who retire early, but prove unable to live on their low pensions. Such a result would defeat the social purpose of the system.

OCR for page 370
Transforming Post-Communist Political Economies Second, the notional defined contribution system fundamentally changed the tone of the debate. It established the principle that everyone's benefit is based on his or her contribution. It also helped neutralize the groups who claimed to be especially deserving by making explicit the cost of providing the benefit. Under the previous system, redistributions could occur simply through the addition of favorable treatment for one group to the pension law—requiring no analysis of the costs to the rest of the pensioners or to future contributors. As a result, Latvia had a large number of these redistributions. Examples are (1) early retirement for special groups (which encouraged retirement at the earliest possible date) and increases in pensions for longer service, and (2) pension credit for noncontributory periods, such as maternity leave or military service. In all of these cases, the favored group received more benefits for the same contribution. Under the new system, noninsurance redistributions, such as subsidies for maternity leave, require explicit contributions into an "account" (e.g., into the social insurance fund or the second tier). This feature makes the new system much more transparent than the previous defined benefit system. Finally, Latvia is one of the transition leaders. Its commitment to a market economy is strong, since transition is seen as an essential part of restoring the country to its former (pre-Soviet occupation) greatness. This nationalist commitment is bolstered by significant assistance from the Latvian diaspora. Significantly, an early Minister of Welfare was a Latvian-Australian with 40 years of experience in private insurance in Australia. This political context provided fertile ground for a market-oriented pension solution. REFERENCES Andrews, E.S., and M. Rashid 1996 The Financing of Pension Systems in Central and Eastern Europe: An Overview of Major Trends and their Determinants, 1990-1993 Washington, DC: World Bank. Barbone, L., and D. Marchetti 1994 Economic Transformation and the Fiscal Crisis. A Critical Look at the Central European Experience of the 1990s. World Bank Working Paper No. 1286, Washington, DC. Beattie, R., and W. McGillivray 1995 A risky strategy: Reflections on the World Bank report "Averting the Old Age Crisis." International Social Security Review 48:3-4. Disney, R. 1996 Can We Afford to Grow Older? Cambridge, MA: Massachusetts Institute of Technology Press. Fox, L. 1994 Old-Age Security in Transitional Economies. World Bank Working Paper No. 1257, Washington, DC. Fox, L., E. Palmer, and D. McIsaac 1996 Latvian Pension Reform. Unpublished paper, World Bank, Washington, DC.

OCR for page 370
Transforming Post-Communist Political Economies James, E. 1996 Providing better protection and promoting growth: A defense of averting the old age crisis. International Social Security Review, 49:3-20. World Bank 1994 Averting the Old-Age Crisis: Policies to Protect the Old and Promote Growth. New York: Oxford University Press. 1996 World Development Report 1996: From Plan to Market. New York: Oxford University Press.