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A Pension Reform Proposal for Spain By José Piñera The pay-as-you-go pension system is the single most costly program funded by the Spanish State. In 1994 expenditure on that system amounted to _5.5 trillion, representing 8.5 percent of gross domestic product (GDP). Even based on conservative assumptions, that cost shows a clear tendency to increase in the future, both in absolute terms and as a percentage of GDP. Three propositions are put forward in this study: 1. The present pay-as-you-go pension system is headed, from an economic standpoint, toward bankruptcy; 2. A system of Pension Savings Accounts (PSAs), administered by the private sector, is superior to the pay-as-you-go system, both for workers and society as a whole: and, 3. The proposal being presented here, which advocates a gradual transition from one system to the other, is viable from a fiscal standpoint. To demonstrate numerically the first and third propositions, a complete model of the Spanish pension system has been devised. That allows us to project the future evolution of the system based on different assumptions concerning the underlying key parameters and show the results in a clearly intelligible form. It is thus possible to obtain the model for any given set of assumptions and at the same time to simulate the effect of a reform with all its possible variants. 1. The Present System Is Headed toward Bankruptcy Using a set of exogenous data, such as the most recent population projections, and incorporating "reasonable" assumptions as to the evolution of crucial macroeconomic parameters such as the growth rates of employment, GDP, and real wages, we reach the inevitable conclusion that the current system is not viable in the medium term, provided that the rules on which it is currently based, especially with regard to contributions and benefits, are maintained. The fact that the pay-as-you-go system has succeeded in maintaining a precarious financial equilibrium over the last few years can be explained to a large extent by the significant increase in the contributions made by the active participants, and also by the greater state input into the system. The first of those factors reflects the higher rates of contribution and the growth of wages, while the second is due to the larger disbursements which the Spanish Treasury has been obliged to make to cover the contributions of the unemployed and supplement pensions that are below the guaranteed minimums. Obviously, contribution rates cannot continue to rise. Furthermore, the higher wages of the past few years will inevitably mean (assuming the current rules are maintained) bigger pensions in the future, a burden that the pay-as-you-go system will be incapable of bearing. The possibility of continually increasing the state's contributions to the system seems highly unlikely, given Spain's huge national debt and the large fiscal deficit that exists at the present time. The pension system deficit will grow exponentially in the coming years until reaching _5.5 trillion (1994 pesetas) in the year 2025, i.e., 37 percent of the expenditure on pensions in that year. Assuming that GDP will grow at a mean annual rate of 2.5 percent, the deficit of the pay-as-you-go system will exceed 4 percent of GDP by the year 2025 (figure 2). Obviously it is possible to make adjustments to the existing system, along the lines of the agreements comprising the so-called Toledo Pact, all of which will involve higher contributions from existing workers or lower benefits for future pensioners, as a means of reducing that deficit. However, other studies also conclude that none of the modifications envisaged in the public debate is, by itself, sufficient to eliminate the deficit, much less reverse the trend. All that is achieved is to slow down the rate of increase. The inevitable fact that condemns the Spanish public pension system to bankruptcy from an economic standpoint (i.e., an inability to deliver the promised benefits out of its own resources) is the demographic trend. The decline in the birth rate and the gradual ageing of the population means that the ratio between active workers and the retired segment will become smaller and smaller. Since in a pay-as-you-go system the former finance the pensions of the latter, the burden will become unsustainable. Continuing to increase the tax on the hiring of employees--which is what the high payroll taxes actually amount to--will result in even more unemployment. The present system makes it impossible to escape from this dilemma: either more unemployment or lower benefits for present or future pensioners. 2. The PSA System Is Better Given this situation, a primary reason for reforming the existing Spanish pension system is the ever-increasing cost that the maintenance of that system will represent for the workers, the state and the Spanish economy. But it is a mistake of perspective to believe that that is the only reason for undertaking a reform. The second major reason is that the creation of a system based on pension savings accounts (PSAs), administered by the private sector under conditions of competition, generates such benefits that that reform would be necessary even if the pay-as-you-go system were financially viable. The benefits of the PSA system have been emphasized in a great many publications. Those benefits have been borne out by the Chilean experience, now in its 15th year, the results of which speak for themselves. The advantages of that system may be summarized as follows: > It increases pensions. Indeed, the yield of an investment portfolio in a PSA system will almost certainly be higher than the rate of increase in wages over a period of 40 years (as is well known, the rate of increase in wages represents the ceiling for any possible increase in pensions in a mature pay-as-you-go system). > It increases employment. A PSA system is financed by the compulsory savings of the workers, which, in so far as they are perceived as being individually owned, do not represent a tax on the hiring of labor. Moreover, the system can operate with a much lower compulsory rate of savings than the payroll tax required by the pay-as-you-go system. A distortion in the labor market which hinders the creation of jobs is therefore eliminated. (The state subsidy guaranteeing the minimum pension is financed out of general revenues.) > It increases savings. As a minimum rate of savings is imposed and incentives for additional savings are offered, it is highly probable that the net result will be an increase in national savings, especially if the state cooperates by reducing superfluous expenses as a contribution to financing the transition. > It improves capital productivity. Because those savings are channelled through competitive and transparent capital markets, without any obligation of using them to finance public expenditure or the deficit of state-owned enterprises, the efficiency of the economy's savings-investment process is improved. > GDP growth rate is boosted, as a result both of increased savings and employment and of the increased productivity of labor and capital. > It reduces the state intervention in the economy. By transferring to the private sector the control of the resources associated with the provision of pensions, the reform represents a gigantic devolution of power from the state to private society. > It depoliticizes the pension system. Since the level of benefits of the pension system no longer depends on legislative decisions, this matter ceases to be an issue of permanent political discussion, thus eliminating the uncertainties of present and future pensioners. > It encourages a work ethic of saving and disciplines national economic management. Because workers can design their retirement plans at will (age of retirement and level of pension) savings and personal effort become decisive factors for achieving personal goals in old age. Similarly, the link created between the value of the individual account and the smooth progress of the economy transforms all workers under the PSA system into "watchdogs" of the efficient running of business and the economy. 3. A Gradual Transition Is Possible in Spain. The reform proposed in this study--based on a deliberately gradual and prudent transition--consists in giving all workers under 45 years of age currently included in the public pension system, the freedom to opt for a system of pension savings accounts administered by specialized private firms. Those who enter the work force in the future will automatically be included in the PSA system. Workers over 30 years of age who opt to transfer will receive a "recognition bond" which will compensate them, in whole or in part (depending on their age), for the contributions made to the pay-as-you-go system. Those who decide not to change systems, those over 45 years of age, and existing pensioners will remain in the present pay-as-you-go system subject to all its rules, including the revaluation of pensions. It is assumed that 60 percent of workers under 45 years of age will transfer to the new system, at the rate of 10 percent per year beginning in January 1997. It has also been assumed that the state will attract 50 percent of the resources managed by the Pension Fund Administration companies, by issuing government bonds at market rates of interest. The state will be able to start redeeming this transitional "bridge debt" when the future fiscal expenditure on pensions is reduced. In the PSA system workers will contribute 13 percent of their wages to their own, individual PSA, a rate that is lower than the existing payroll tax of 21.35 percent of salary. On the other hand, it has been assumed that the difference between the current payroll tax (21.35 percent for both the general and the self-employed regimes) and the rate of contribution in the PSA system (13 percent) will be maintained during the transition, for those transferring to the new system, as a temporary transition tax. The proposed solution represents a long-term saving of fiscal resources. Indeed, the meaningful comparison is between the evolution of the fiscal deficit without the reform and with the reform. Only until the year 2003 (seven years after the start-up of the new system) will the reform entail, in the most likely scenario (defined here as the Intermediate Scenario), a fiscal cost in excess of the fiscal cost of maintaining the existing system. Indeed, in the Intermediate Scenario, in which the rate of economic growth increases by 1 percent per annum as a consequence of the process initiated by this reform (from 2.5 percent to 3.5 percent per annum) the fiscal cost of the transition to be financed from outside sources shows the following trend over the next seven years (as a percentage of GDP): 1997: 0.12 percent; 1998: 0.27 percent; 1999: 0.37 percent; 2000: 0.41 percent; 2001: 0.38 percent; 2002: 0.32 percent; 2003: 0.09 percent; and, finally, in 2004, the first surplus is registered as against the case of no reform, amounting to 0.12 percent of GDP. Thereafter, that surplus increases until reaching 5.4 percent of GDP in the year 2025 (figures 12 and 13). No account has been taken in those calculations of the possible additional positive fiscal effect that the reform would produce. We are referring to the fact that, once a structural reform of the pension system has been implemented along the lines advocated by such institutions as the World Bank and the OECD, the international financial markets will almost certainly reduce the risk premium they demand for the Spanish national debt. Conclusion Therefore, the bad news for Spain is that its present pension system is not viable. The good news is that there is an alternative model which has been shown to work and that there are scenarios that make a gradual transition from the existing pay-as-you-go system to a PSA system possible. Spain has the opportunity to become the first European country to resolve definitely the crisis in the pension system. A PSA system would not only provide Spanish workers with real social security but give a competitive edge to employers and the Spanish economy in the unified Europe of the 21st century. Appendix: The PSA System in 12 Questions 1. Why not apply the Toledo Pact and avoid further complications? No. Because all independent studies conclude that the Toledo Pact is only a temporary remedy for the crisis. It does nothing to eliminate the huge deficit that is going to build up under the state-run, pay-as-you-go pension system, but only delays its impact for a certain period. In a few years' time, however, a second Toledo Pact will be necessary. And then, a great many more. It should be pointed out that the Toledo Pact basically involves maintaining the pay-as-you-go system and reducing the benefits of future pensioners by changing the formula for calculating their pensions and raising the age of retirement. But if that method of handling the crisis in the pension system is adopted, the state-run system will turn into a "social insecurity" system, because workers will never know what cuts in their benefits will be decided on by the legislators in order to avert subsequent crises. This is borne out, moreover, by the experience of other European countries with a pay-as-you-go pension system. And all the time the cost of resolving the problem will increase. The solution proposed in this study entails a structural reform that has the merit of resolving the pension problem once and for all by creating a true system of social security that protects workers both in old age and in the event of disability or death during their working life. 2. Is it true that the PSA system is unfair and only benefits rich workers? No. The opposite is true. The PSA system benefits all workers equally, because it establishes a direct connection between the savings effort for old age and the pension obtained as a result of that effort. Moreover, our proposal introduces a positive bias in favor of the poorer workers by providing a state-guaranteed minimum pension, funded by general tax revenues and not by the regressive tax on labor. In addition, it removes the discrimination against the poor inherent in the pay-as-you-go system, in that generally speaking the poor start work earlier in life and when they retire their life expectancy is lower than that of the rest of the population. In other words, under the state-run system a poor worker contributes for a longer period and receives benefits for a shorter period, whereas in a PSA system that situation is compensated by the fact that the longer period of contribution results in a better pension. 3. What happens to present pensioners and workers who do not want to transfer to the PSA system? In our proposal existing pensions are respected in their entirety. What is more, it guarantees to pensioners that their pensions will be updated in accordance with the increase in the cost of living (inflation). The proposal also gives workers currently included in the state-run system the option of continuing in that system and receiving the benefits they have been promised, or transferring to the new system of pension savings accounts, if they are under 45 years of age. We would stress that, according to all independent forecasts, the pay-as-you-go system will be unable of delivering its promised benefits and hence all serious proposals for the maintenance of the pay-as-you-go system recommend major reductions in the benefits. 4. What will happen to those workers who voluntarily decide to transfer to the PSA system? Transferring to the new system is voluntary for workers under 45 years of age. Workers over 30 who decide to change systems will be given a recognition bond. The state will pay this bond when the worker reaches retirement age or is otherwise entitled to receive a pension (e.g., in the event of disability). The pension of that worker will thus be financed by the sum of his contributions to the PSA system and the recogniton bond. 5. Is it true that to create a PSA system such as the one proposed in this study costs two and half times Spain's GDP? No. According to some studies, that would be the cost of capitalizing the current pay-as-you-go system (which incidentally reflects the extent of the insolvency of this system). But our proposal does not involve creating a fund to capitalize the commitments to be met by the pay-as-you-go system, but to move gradually from the existing system to one of individual, private pension savings accounts, by maximizing the use of internal sources of financing the transition. 6. How much will the transition from a pay-as-you-go system to a PSA system cost, and how can it be financed without a huge increase in the public deficit? The study proposes a gradual transition and a very cautious use of public resources. That will ensure that the transition entails a limited deficit to be financed by sources external to the reform. That deficit reaches its highest point (0.41 percent of GDP) in the fourth year, and thereafter decreases until in the eighth year a fiscal surplus is registered that will gradually increase to represent 5.4 percent of GDP in the year 2025. The primary sources of financing are a "bridge debt" (at market rates of interest) which is acquired by the state with the new pension funds created under the PSA system, and the transition tax, a temporary tax that replaces part of the present payroll tax and which in fact defers the reduction in the payroll tax for workers transferring to the new system. In the medium and long term the reform would produce a significant fiscal surplus, thus permitting the abolition of the transition tax--which would have a major positive impact on employment through the reduction of this tax on the hiring of workers--and the repayment of the "bridge debt" assumed by the state. 7. Can a PSA system go bankrupt? No. A PSA system is based on definite contributions and resultant benefits. Therefore by definition it cannot fail. The pension is automatically adjusted to the reality, whatever that may be. Precisely one of the major structural shortcomings of the pay-as-you-go system is that it promises certain levels of benefits the fulfilment of which is critically dependent on variables which no government can control, such as the birth rate or the life expectancy of the population. If those variables change in a way that adversely affects the maintenance of the pay-as-you-go system, as is happening in all the developed countries in what is known as the process of population ageing, governments have to reduce the promised benefits, which is tantamount to recognizing financial bankruptcy, the cost of that insolvency being borne by the future pensioners. 8. What guarantee is there that one of the companies administering the PSA system will not go bankrupt? The administration companies may go bankrupt, just like any other company in a competitive market. However, that in no way affects the workers' savings, which are in a pension fund that constitutes a separate legal and financial entity from the administration company. The system must be supervised by a government agency of the highest technical capacity and autonomy, to ensure that the regulatory framework is strictly respected by all the participants in the system. 9. What incentives does a worker have for transferring from a pay-as-you-go system to a PSA system? Better pensions, better service and the absence of the injustices and abuses that prevent him from enjoying the fruits of his efforts. In a PSA system, the worker's monthly contributions are deposited in an individual savings account which is his own property and which increases by the results of a diversified and safe portfolio of investments in the capital market. 10. What happens at the end of one's working life to the capital accumulated in the pension savings account? There are two options. One, to transform the capital into a life annuity with a life insurance company. The other, to leave the capital with the company that has administered the account for years and make scheduled monthly withdrawals (based on a formula incorporating the worker's life expectancy). In the latter option, if the pensioner dies, the balance of capital in his account becomes part of his estate. In both cases, the pension is subject to a state-guaranteed minimum. 11. What happens if a contributor to the PSA system becomes unemployed? It is not compulsory to make contributions to the pension savings account while one is unemployed. However, the savings continue to generate the earnings represented by the yield of the pension fund in which they are placed. If he wishes, once the worker finds another job he can make up for those periods during which he did not contribute to his account by making voluntary contributions over and above the minimum required by the system. 12. Can pension funds in a PSA system yield a negative return during certain periods? Yes. But the history of the capital markets shows that in the medium and long term, with a diversified portfolio reflecting an adequate risk-yield combination, positive rates of return in real terms (i.e., above inflation) of at least 4 percent per annum can be obtained. Negative returns can only occur during exceptional short periods. The Chilean system, which has now been in operation for 15 years, has yielded an average annual rate of return of 12.6 percent after discounting inflation (including a rate of 28 percent in one year and of minus 2.5 percent in another year). The essential point is that while capital markets by definition imply a certain element of risk, that risk can be suitably minimized, whereas the risk of the state-run, pay-as-you-go system stems both from political variables and from population variables, for which the worker has no protection whatsoever. |
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