January 27, 2005—In efforts to transform their institutions after the dissolution of Communism, Eastern European countries ended up at the forefront of pension reform in Europe. "It's really a revolution, when a majority of countries are changing their pension systems in a profound way," says Michal Rutkowski, a World Bank pensions specialist with extensive experience in Eastern Europe and Central Asia and Middle East and North Africa.  |  | | Rutkowski says a pension revolution is taking place in East Europe. | |
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Most countries that have joined or are slated to join the European Union have reformed their pension systems. The countries in question are Hungary, Latvia, Poland, Estonia, Bulgaria, and Croatia Bulgaria, Slovakia, Lithuania, Romania. Only Slovenia and the Czech Republic didn't do so. Moving away from the old pay-as-you-go (PAYG) system, which became strained and ultimately unsustainable due to changing demographics, these countries have diversified their pension schemes by improving the PAYG component and creating a new privatized module funded through capital markets. "Eastern European countries could afford to be quite radical in pension reform because they faced multiple challenges at the same time," says Rutkowski. Among other transitional challenges was movement to market economy and developing financial markets. Using capital markets to finance pensions is becoming more widely used around the world as means to secure funds for old age. A dozen Latin American countries have undertaken similar pension reforms over the last 20 years. Eastern European countries trimmed old PAYG systems and made them more transparent. Instead of pooling workers' contributions into one large pot of money to fund pensions of today's retirees, the new PAYG system tags contributions. A person's pension becomes the sum of yearly contributions plus the accumulated interest. This modification gives people a strong incentive to work longer. "Now if a worker retires at 64 instead of 63, he gets some 8 to 9% more return in his pension. In the old system the difference was only 1 to 2%," explains Rutkowski. In the old PAYG system, the pension was based on the worker's ending salary, not the lifetime of contributions. The countries also introduced a new privately-funded module in which workers' contributions are passed on to pension funds that invest the money in financial markets. These changes have made the overall pension system more fiscally sustainable. The system is also designed to adjust automatically to changing circumstances. "If life expectancy goes up there is no need to have a parliamentary debate to change the retirement age," he says. People will be more willing to work longer to accrue more in pension. | | Eastern European countries had a lot to learn from Western Europe during the EU accession process," says Rutkowski. But in terms of pension reform ECA countries are the leaders. Although all European countries have a similar demographic situation, Western Europe will be less likely to undertake reforms as radical as those of their East neighbors. "Western European countries will have to reform, but most of the changes will probably be within the PAYG pillar along the lines of the Swedish model," explains Rutkowski. These changes would allow Western European countries to have systems that automatically adjust to changing demographics. It would also encourage workers to participate in pensions system throughout their entire career. Current PAYG systems in Western Europe are very generous, especially in France and Germany, which means that these governments have a higher implicit debt. Implicit debt is the debt the government would have to pay to current workers when they retire based on promises already made. Since these countries have developed financial markets, they can't really expect to boost their financial markets by creating pension funds. "Funded elements would be much more marginal and voluntary unlike in Eastern Europe," concludes Rutkowski. Listen as Rutkowski outlines Europe's challenges. | |
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Inspiration for Reform Pension reform in Eastern Europe was inspired by reforms undertaken by Sweden and Latin America. Sweden made its PAYG system more transparent by clearly linking contributions and pensions. The reformed system mimics a privatized system in the sense that workers' contributions are noted and tracked. Upon retirement, the pension exclusively depends on the amount of contributions they paid in during lifetime and life expectancy based on the age of retirement. Latvia and Poland based their reforms on this principle. Latin America provided a model for a privately funded pension system, although there are key differences in how Eastern Europe adopted the principle. Unlike Latin America, which shifted from a reliance on PAYG to the worker funded system, private investments in Eastern Europe's pension scheme account for less than 10% of an individual's pension plan. Also, a larger portion of investment is in variable income instruments, such as shares, not government bonds. "In the beginning, it's understandable that most of the investment goes into government bonds. But, I would expect over time, that the investment in shares would go up, and it has been going up," says Rutkowski. New System Instills Confidence Nobody has retired in the new system as of yet. Its effects won't be visible for several years to come because only people under 50 are eligible to switch over to the new system. "It makes no sense for people older than 50 to switch over to the new system because they don't have enough working years left to be able to benefit," says Rutkowski. People seem to have embraced the reform. Among those who were given a choice between staying in the old system or moving to the new one, people largely chose the new one. "In Poland, for example, nine million people moved to the new system. In the 30 to 50 age range, three-fourths of people moved to the new system. It was age related. Younger people were more likely to choose the new system. Only those between 30 and 50 were offered the choice. Those under 30 had to be in the new system," says Rutkowski. |
