III Introduction of a Three-Pillar Pension System (2024)

Table 3.1.

The Baltic States: Demographic Projections and Theoretical Burden of the Pay-As-You-Go Pension System

Source: U.S. Census Bureau, International Data Base; and IMF staff projections.

¹Gross wage and salary income, inclusive of social tax.

²Assumed.

Introduction of a Three-Pillar System: Pros and Cons

Proponents of a move to a three-pillar system claim a number of potential gains from the introduction of a fully funded scheme. Such a plan is expected, inter alia, to provide higher levels of retirement income, enhance the efficiency of the economy, and increase transparency of the pension system.

Higher average returns on savings for retirement. It was anticipated that the move to an FF pension would help address the demographic challenges, as an FF system was expected to provide a higher rate of return than a PAYG plan. The rate of return on the FF system would, in the long run, depend on the economy-wide interest rate, or marginal productivity of capital, and—assuming that the pension scheme allows investment abroad—foreign interest rates. The implicit return in the PAYG system, on the other hand, depends on the growth of the labour force and average wages. Given the projected demographic trends, the former was expected to be significantly larger.22

It should be noted though, that over the long run the rate of return on capital also depends, in part, on demographic trends, so that simply moving to a fully funded scheme does not allow a country to “escape” demographics (Box 3.2).23 A fully funded system may, however, be able to better handle the adverse domestic demographic trends of a country, provided that the mandatory private pension funds are allowed to invest internationally, and that the world’s demographic trends are more favorable than those of the home country.

Increased national savings rates. A switch to the FF pillar could stimulate savings above their current levels, raising output and potentially contributing in a solution to the demographic problem. Assuming that the government finances the ensuing first pillar deficit primarily through increased taxes or reduced expenditures, rather than via increased borrowing, private savings outside the second pillar might decline somewhat, but the net effect is expected to be a rise in national savings in both the short and long term (see Section IV). Nevertheless, the impact of these higher savings on domestic output may be marginal in small open economies such as the Baltics with ready access to international capital markets and large capital inflows.

Capital market development. It has been claimed that the rising investment needs of pension funds, together with the competitive setup of the privately managed funds, would eventually lead to deeper, more liquid and more competitive national capital markets. However, in the context of small open economies, such as the Baltics, it is questionable whether relying on domestic capital markets is necessary, or even an appropriate use of resources.24

The expected accession of the Baltic countries to the European Union and the European Central Bank (ECB) over the next five or so years serves to underline this point.

Closer links between contributions and benefits reduce labour market distortions. It has been argued that, under an FF system, contributions may be viewed not as taxes, but rather as individual savings, so that labour market efficiency will increase in at least two ways. First, with retirement benefits dependent on lifetime contributions, the shift to an FF system might be expected to contribute to a shift of labour from the informal to the formal sector.25 Second, as taxes are reduced, the overall supply of labour should also increase and the efficiency of the mix of productive inputs improve. However, this positive effect may not fully materialize. The second pillar is made mandatory because it is believed that individuals would otherwise undersave; at least some portion of the FF contribution may therefore be viewed as a tax, distorting optimal (short-run) behavior. The Chilean experience (Box 3.3) is consistent with this view.

Greater transparency and reduced political risks. The traditional PAYG system—as a defined benefit plan—is relatively inflexible in that it can be politically and legally quite difficult to reduce pension levels as the tax base declines and the fiscal burden increases. For example, as noted above, the Latvian government’s attempt to cover the shortfall in the pension fund in mid-1999 by cutting eligibility for benefits led to a political crisis, which ultimately forced the government to scale back its plans. An FF pension system, however, allows benefits to adjust automatically when rates of return on accumulated assets change, taking the potential conflict between generations out of the political arena. However, it is possible that lower than expected returns on an FF pension scheme would generate political demands for action to increase retirement income through the budget.

Critics have raised a number of concerns related to FF schemes, focused largely on the transition costs of a move from a PAYG to an FF system. In addition, critics have placed doubt on the claims regarding increased economy-wide efficiency put forth by advocates of the three-pillar system. Rather than favoring an FF pension, PAYG proponents offer a number of recommendations to preserve the current systems, including raising retirement ages and reducing some benefits to bring the system’s parameters up-to-date with rising life expectancy. Others have presented alternatives to the pension reform, which differ in at least some aspects from the World Bank’s three-pillar model (see Box 3.4). Those who favor keeping the present system broadly unchanged argue that, in any case, an FF scheme is already available to anybody who wants to save voluntarily and appropriate tax legislation should be used to stimulate savings in the voluntary FF pillar. Among their specific criticisms of the three-pillar system are the following:

The move to a fully funded scheme would come at a significant cost for transition generations. While some portion of payroll tax revenue would be shifted to the FF pillar, current retirees (and older workers retiring under the old pension) would still need to have their benefits paid by current workers. In essence, the current working generation would be required both to support the current retirees and prefund a large part of its own retirement. This transition cost results from the fact that the first generation under a PAYG system receives a pension without having to contribute. The “last” generation—that is, the transition generation—has to pay for the first generation’s pension and for its own pension as the “chain-letter” is broken. Given that the present working generation in the Baltics has already carried the burden of adjustment to a market-based economy, one could argue that this generation should not be additionally burdened with a pension reform. Nevertheless, the demographic picture suggests that there is currently a window of opportunity that would allow these transition costs to be shared by a large working-age cohort.

The efficiency gains of a pension reform replacing the PAYG with an FF system are ambiguous. For example, while the reform may raise efficiency by eliminating the pure tax component of PAYG contributions, it also would tend to reduce efficiency to the extent that it requires increased general taxation to pay for transition costs or for the interest payments on the higher explicit government debt. Further, it may not be necessary to reform the pension system to pursue particular economic objectives such as higher national saving; other measures, such as a move from direct to indirect taxes, could help achieve the same goals.

The benefits of higher average returns on contributions to the fully funded system come at the cost of exposing pensioners to higher investment risks. This is a potential major drawback since the primary objective of a pension system is to provide old-age security for workers, (As indicated in Table 3.2, replacement rates can vary dramatically with only moderate changes in average rates of return on FF investments.) The risks of the fully funded system can be particularly high in transition economies, given the low level of development of capital markets in these countries, especially if investments abroad by pension funds are limited by law (see below). Beyond normal investment risks, private pension funds could fall victim to fraud, in particular when financial sector regulation is still improving. Further. PAYG systems, with their benefits independent from the business cycle, can provide an element of insurance for the economy as a whole; PAYG proponents point to the depression of the 1930s as an example in which an FF system would have failed and led to even bigger economic contraction.

Private pension funds often generate high administrative costs—including for marketing—that are reflected in sizable administrative fees and charges. The share of social security contributions that goes to cover the insurance premia and the costs of running private pension funds in the countries that have introduced FF schemes total up to 4 percent of the fund’s value annually. Such charges can have a large impact on the rate of return on pension investments. Similarly, in the absence of developed annuity markets, the higher returns of the second pillar relative to the PAYG implied returns may be eaten away by high discount rates for purchasing an annuity at retirement.

Options for Fully Funded Pillars in the Baltic Countries

All three countries have made substantial progress in moving to a three-pillar pension system. First, each has passed legislation establishing the legal basis for operating the third, voluntary IT pillar, and this pillar is already in place in Latvia and Estonia. Second, in the mid-1990s all three countries, with assistance from the World Bank and other international advisors, developed detailed projections for the financing needs and operation of the mandatory FF pillar. However, progress in the actual creation of this pillar has been slow. Latvia, the most advanced in developing the second pillar, signed into law the main legislation defining the basic parameters of the second pillar in February 2000, and the mandatory FF pillar will start accepting contributions beginning July 2001. Estonia is also making progress in developing its second-pillar legislation and expects implementation to begin in 2001–02 as well. (Simulation results for different pension reform scenarios in Estonia are presented in the Appendix.) Lithuania, so far, has been moving more slowly than the other two Baltic states, although in April 2000 parliament approved a resolution asking the government to prepare a concept paper for reform of the old-age pension scheme beginning in 2002, along similar lines as its Baltic neighbors.

As the three countries move forward in implementing the three-tier system, they face a number of key decisions regarding the design of the fully funded pillar which will be crucial in determining the ultimate success of the reform. The following discussion examines the trade-offs involved in these decisions.

Size of the Pillars

The Baltic countries face the fundamental question of how to split payroll taxes between the first two pillars of the system. Most proponents of three-pillar systems would argue that a first pillar that is larger than necessary to provide a minimum safety net would be inefficient. However, the larger the first pillar remains, the lower the government’s transition costs and the smaller the adverse impact on the transition generation.

Therefore, the size of the first pillar will depend to a considerable extent on the available sources of financing. It was in this context, in fact, that the Latvian government decided to limit contributions to the second tier scheme to 2 percent of salary, during the years 2001–06, gradually rising to no less than 4 percent in 2007, and to 10 percent from 2010 onwards.26 In Estonia, the debate has focused on increasing the 20 percent social tax by 2 percentage points for participants of the FF pillar, while diverting 4 percent from the current social tax. This would ensure proper funding for the PAYG pillar, which would receive the remaining 16 percentage points of the social tax. While such limits on the size of the second pillar reduce the transition cost—in Estonia this cost is projected at about ½ percent of GDP—so do they limit potential benefits of the reform.27

Financing the Transition to a Fully Funded System

The transitional deficit can be financed through either fiscal adjustment—some combination of higher taxes and reduced government spending—or increased debt. The first option—which, in effect, requires the prefunding of the current generation’s pensions—would be expected in the long run to lead to higher savings. In fact, this effect can be seen as a primary benefit from the move to a three-pillar pension system (see Section IV). However, this option is likely to be met with political resistance from the transitional generation that is being forced to “pay twice” for pensions. Financing at least a portion of the deficit via borrowing (or, alternatively, using privatization receipts which otherwise would have been used to pay off existing debt) would help share the cost of transition between the present and future generations. However, financing via borrowing would not help tackle the demographic shift. While some of this borrowing may, in practice, come from surpluses generated in the private pension accounts over the medium term, taxes will have to increase to finance interest payments on the higher explicit debt. This higher taxation imposes a permanent efficiency cost offsetting, at least in part, the potential efficiency gains from the shift of labour from informal to the formal sector. Further, the accumulation of substantial explicit public sector debt could have an impact on confidence in the domestic economy, as reflected, for example, in the risk premium on foreign borrowing.

Participation in the Second Pillar

There are various possibilities regarding who should be included in the new system, and the extent to which individuals can choose to participate or not. At one extreme, some countries, such as Bolivia. Kazakhstan, and Mexico, have opted for a complete and mandatory shift from the old PAYG into the FF system. In most cases, however, the reforms provide for some level of choice especially to the middle-aged workers who have already accumulated substantial pension rights under the PAYG system.28 The decision on who joins the FF pillar has strong bearings on the transition costs. For example, allowing only labour market entrants into the second pillar spreads out the transition costs over current and future generations to a maximum, thereby reducing the costs in any given year of the reform. However, in the absence of appropriate reforms to the first pillar, this would simply delay addressing the long-term solvency issue, at which the FF scheme is aimed.

In Latvia, the second tier scheme will be mandatory for all employees under 30 years old. Individuals subject to the state pension insurance and who are age 30 to 49 when the Law takes effect in 2001 may affiliate with the FF scheme on a voluntary basis. For Estonia, it appears that participation in the second pillar could be mandatory for those under the age of 35 and optional for older workers. Under the current proposal, PAYG pensions would not be reduced significantly for those opting for the FF pillar, suggesting that a majority of Estonia workers will switch from the PAYG to the FF plan. A more careful design of incentives seems warranted to limit potential transition costs.

Administration of the Fully Funded System

An FF system can either be administered by a special class of licensed institutions (institutional pension funds), or can take the form of a special class of accounts or securities (individual pension accounts) that can be held with (or issued) by most licensed financial intermediaries. In a number of countries, the mandatory FF pillar is operated on the basis of individual pension accounts, administered by a single government-controlled or supervised provident fund. In more competitive environments, the FF pillar is operated by a number of specially licensed pension funds.29 The most competitive environment is offered by systems where individual pension accounts can be opened with almost any financial intermediary, such as banking institutions, mutual funds (unit trusts), insurance companies, brokerages, and, conceivably, stock exchanges, or nonfinancial institutions.

The three Baltic countries still lack detailed regulations of the future second pillar. Estonia intends to allow 3–5 private pension funds to manage the investments of the second pillar, while the individual records would be monitored by a non-profit institution that could be financed by the treasury. In Latvia, it has been decided that the State Treasury will manage the accumulated resources in the mandatory pillar until January 1, 2003, but the institutional design beyond that date remains unclear. This may be sensible in the short run given the initial small size of the second pillar, as fixed administrative costs could be prohibitive with competing private firms. However, a move away from this setup would be needed over the medium-term to fully realize the expected benefits of an FF system. In particular, allowing the treasury to maintain control over pension resources would provide a potential captive source of government financing.30 Both Estonia and Latvia are moving toward unified financial sector supervision, under which regulation of private pension funds would be incorporated.

Regulations on Investments Under the Second Pillar

Most countries impose investment guidelines for pension institutions. Some countries impose strict quantitative and qualitative restrictions while others require managers to follow prudent behavior. The former approach, common in continental Europe, has often been used to direct pension capital to specific types of investment, in particular domestic bonds issued by public institutions and domestic corporations. The latter approach, adopted by the United States, has forced managers to develop internal prudential rules, and is often credited with forcing U.S. managers to diversify outside the United Stales and into more varied investment instruments.

In this context, one of the key issues facing the Baltics is whether pension funds (or individual pension accounts) should be allowed to invest abroad. Allowing such investments would provide the opportunity to reduce portfolio risk and increase returns via diversification and would allow funds to hedge against country-specific shocks and risks. In this way, FF pensions can contribute to a solution to the demographic problem facing the Baltics. Further, investing abroad precludes pension funds from acquiring excessive market power in local capital markets and limits the extent to which pension funds become a source of “captive resources” for the government. Investment abroad is often prohibited, or limited, in part to maximize the potential impact of reform on the development of the domestic capital market. However, in the Baltics—small open economies fully integrated into world capital markets—this would appear to be a dubious objective. The Estonian authorities expect that the bulk of savings would be invested outside the country. Latvia has yet to make a decision on this point, but legislation for the third pillar limits investments abroad to 15 percent.

Operation Costs

Several options could help in lowering the administrative costs of a compulsory second pillar. One possibility would be an employer-based second pillar similar to that in Switzerland, in which sponsors have a choice of in-house management, banks or insurance companies for the management of the pension plan (Queisser, 1999). Another option would be a centralized public institution, perhaps under the umbrella of the existing social security institution, with asset management provided through competing investment managers. Under such a model, the public institution would be able to negotiate asset management fees for all affiliates, while workers would still have a choice between investment portfolios; this option is currently being explored in the management of the Southeast Asian provident funds. A third option would have pensions invested in a broad international stock market index, which would imply extremely low administrative costs (Kotlikoff, 1999).

Risk Protection for Second Pillar Pensions

Institutional pension funds may offer some form of a guaranteed minimum rate of return on investments, underwritten by the government or a specially created insurance fund. While governments have generally not provided formal guarantees for possible second pillar losses, they may well end up bailing out failed private funds. In some cases (for example, Chile and Peru) risks are moderated by compensating the poorest performing pension funds out of the earnings of all pension funds. However, such guarantees should be avoided, as they can generate serious problems of moral hazard by encouraging overly risky investment decisions and raise administrative costs.

Beneficiaries of FF pensions may have several options for using their accumulated savings upon retirement. In the least restrictive regimes, individuals may have absolute freedom to withdraw all funds at a single time, spread the withdrawals as they wish, or simply pass on the funds to their heirs. Alternatively, beneficiaries may be given an option to withdraw some share of their saving in the FF account at any time after reaching a certain age, but require the purchase of an annuity with the remaining share, in order to ensure adequate retirement income and limit subsequent recourse to public assistance (Walliser, 1999). In more restrictive regimes, government regulations may require the purchase of specific annuities sold by licensed institutions; given the lack of developed annuity markets, such products may provide low rates of return to retirees (and high rents to the licensed institutions).

Tax Treatment of Pension Contributions and Benefits

Tax codes typically offer incentives to investors in both the mandatory and voluntary pension pillars. Tax benefits can be offered when investments are made, as earnings on invested savings accumulate, or at withdrawal. Specifically, income spent on periodic investments into the pension system can be deductible from taxable income for income tax purposes, or the pension capital can be allowed to accumulate tax-free until withdrawal, or the accumulated capital in the pension account can be withdrawn at retirement free of income taxes. The front-loaded incentives have an immediate and transparent budgetary cost and provide the most tangible immediate benefit to savers. The back-loaded incentives have a future and more uncertain fiscal cost, provide the highest potential benefit to savers who expect to have high retirement income, and may be seen as less credible by the public, who may not trust that future generations of politicians will honor these tax commitments. However, the back-loaded tax incentives are easier to administer because savers simply do not owe any taxes on the accumulated savings. Tax incentives may also be targeted to specific groups or purposes. For example, tax-free pension investments or withdrawals may be restricted to lower income groups, or access to pension savings before retirement could be limited to financing of health care or education expenses. This may be justified on the grounds that housing or educational expenditure in most instances offer an opportunity to diversify savings into nonfinancial assets or increase future earning potential. However, introducing such provisions complicates tax administration and can lead to significant revenue loss for the government.