Making sense of pension reform
Publish Date: Jan 13, 2014
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By Jan Krzysztof Bielecki and Mark Allen

Pension reform has become one of the most troubling fiscal dilemmas facing developed countries, especially those with a shrinking workforce and an aging population.

The issues are both complex and controversial, while seeming quite dull to much, if not most, of the public. As a result, serious discussion is too often hijacked by those with an ulterior motive.

Consider the intemperate responses to recent proposals by Poland’s government to resolve its pension system’s problems. The proposals have been disparaged as the “nationalization of private assets,” a “pension swindle,” and “an asset grab worthy of Lenin or Stalin.”

In fact, the reforms are a sensible and sustainable response to the fiscal squeeze that many other developed (and some developing) countries are facing.

Since the mid-1990’s, many countries in Central and Eastern Europe have adopted the so-called three-pillar pension system, comprising a publicly managed, pay-as-you-go (PAYG) pillar; a privately managed, mandatory, defined-contribution pillar; and a supplementary, voluntary private pillar.

Like many pension schemes, compulsory employer and employee contributions underpin the system.

In 1999, Poland replaced its defined-benefits system, which sets pensions as a percentage of final salary at retirement, with one in which pensions are based on the accumulated value of contributions during a person’s working life.

This allowed the government to cap the system’s liabilities while reducing expected final-salary replacement rates by about one-half. The fiscal position was further strengthened when the government raised the retirement age to 67.

These changes put Poland at the forefront of international efforts to control aging-related budget deficits. The problem with the reform, however, lay in the decision to divert one-third of the compulsory pension contributions from the PAYG pillar to create a funded component of the system.

The hope was that this would diversify the sources of future pensions, with superior investment performance boosting the salary-replacement rate.

This second pillar remained within the state system, but its management, through “open pension funds” (OFEs), was outsourced to the private sector.

But, though the state guaranteed the pensions from both pillars, the diversion of contributions created a growing hole in the PAYG system as the resources available to cover current pensions dwindled.

These “transition costs” have been particularly high in Central Europe, because the new approach replaced a comprehensive system that promised pensions that were, to put it bluntly, unaffordable.

In Poland’s case, the annual funding gap, which had to be covered by more government borrowing, reached 2.4% of GDP in 2010. Since 1999, the accumulated PAYG deficit reached 18% of GDP, about one-third of Poland’s entire government debt.

The OFEs failed to boost overall savings, because the increase in public debt almost exactly matched the pool of assets in the funded part of the state pension system.

Moreover, the OFEs’ assets comprised mainly government bonds, which cost about €1.35 billion annually (or 0.3% of GDP) to service, while the OFEs’ high management fees swallowed up any hoped-for market premium.

It soon became obvious that, given Poland’s constitutional 60%-of-GDP debt limit and 3%-of-GDP cap on the budget deficit, together with the squeeze on public finances in the wake of the global financial crisis, the OFE funding model was unsustainable.

As a result, the government proposed replacing this unnecessary debt in the pension system with an equivalent claim on accounts in the PAYG pillar, indexed by nominal GDP. By modifying these accounts within the public-sector balance sheet, expected pensions will be unchanged, while the public debt/GDP ratio will fall by eight percentage points.

This change will allow Poland to continue its investment spending plans and access European Union funds, which together will create a sound basis for sustainable GDP growth and, ultimately, future pensions.

As the international rating agencies have noted, Poland’s economy has expanded by 20% since 2008, and, as a result of healthier public finances, will probably enjoy lower borrowing costs, too.

This virtuous circle is the reason why Poland is introducing a stringent anti-cyclical budget rule that prohibits any unwarranted fiscal loosening, while gradually lowering its debt/GDP ratio to about 40%. The government refuses to sacrifice future pensions, or financial stability, for the sake of short-term funding goals.

After all, the switch to a defined-contribution system, with actuarially justified pensions, guarantees the pension system’s long-term sustainability. And no economy with Poland’s development needs should be required to cut vital investment spending just so that it can sustain its fund-management industry.

One must always remember: pensions are ultimately a claim on future output, whether in the form of a tradable financial asset or a legally binding commitment of the state.

Poland’s experience serves as a warning to other governments that, unless a funded pillar is financed by additional private savings, the impact on overall savings and output can be negative.

Poland is now following the Czech Republic’s example by making further participation in the funded pillar voluntary. It will also liberalize the funds’ investment strategies, in order to increase competition and reduce excessive management fees.

Moreover, the government will encourage future pensioners to invest in the fully private and voluntary third pillar, which is more typical in mature economies. In this way, Poland’s pension funds will also make a major contribution to the country’s capital markets.

Detractors have argued that the reforms will deter foreign investment. This is unlikely, given Poland’s political stability, prudent macroeconomic policies, high GDP growth rates, skilled workforce, and liquid financial markets.

Under the premiership of Donald Tusk, Poland’s economy has outperformed all other OECD members since 2008. Indeed, the sobering lesson of Poland’s experience is that pension reform is difficult enough to implement in a strong economy, so no government can afford to wait until hard times force it to act.

Jan Krzysztof Bielecki, former Prime Minister of Poland, is President of the Polish Chancellery’s Economic Council. Mark Allen is a fellow at CASE Research, Warsaw, and former Director of Policy Development and Review at the IMF, as well as Senior Regional Representative for CEE.

Copyright: Project Syndicate/Europe’s World, 2014.

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