Pensions and Demography in the European Union

1.- Introduction

The population ageing in Europe is increasing dramatically and future projections by 2050 are astonishing. There are four demographic factors that are responsible for this increase. However, it is necessary to emphasize that these factors have a different magnitude in each EU country. The first factor is that fertility rates are below the rate required to stabilize the population. Secondly, there would be an increasing old-age dependency ratio which would affect detrimentally GDP growth and, consequently, would pressure the public pensions spending. Third, life expectancy at birth is expected to rise for both males and females by 2050. And fourth, the annual migration inflows are expected to decrease from 1.3 million in 2004 to 800,000 people by 2015. [1]
Thus, the European population by 2050 would be reduced and much older. The great key economic impact would be felt in the decrease of the working population which will shrink sharply to 16%. Even though there would be a temporarily increase of the employment rate of the EU 25 from 63% in 2004 to 67% in 2010[2]; it will not be enough to counteract the weight of the demographic change.
In this paper we are going to analyze the effect this demographic change brings to the public pensions systems of most of the European governments. Thus, we will present several measures these governments may considered as future options to tackle the ongoing problem derived from the growing older population. Among these alternatives it may be found a progressive move from an unfunded pension scheme towards a funded one together with the transition deficit that comes tied with it. And four other political options intended to avoid that transition deficit, by maintaining the established PAYG system.
In the last part of the text we will present the particular case of Spain and analyze its national pension system. We will show the proposed future projection of the public budget concerning pensions and, finally we will present measures to avoid the worse.

2.- Impact of the Ageing Population on Social Security and Public Finances.

Although the situation in the different member states may be different, the increasing ageing of the European population may lead to pressures on public spending. From the period 2004-2010 it is expected a rising in public expenditures related with age factors that will represent an increase of 10%.[3] This pressure status will start to be felt from 2010 onwards and more dramatically between 2020 and 2040. This pressure would be strongly felt in pensions, services and health for the elderly.
The risk of unsustainable public finance in many countries of the EU alerts the future equilibrium of the system in general. “Allowing public spending linked to ageing to create budget deficits would lead to an intolerable spiral of debt”.[4] This situation would be detrimental for the overall economic growth and the functioning of the single currency, and would lead to a consideration in depth of the system of pensions and the social benefits which would, consequently, have a negative impact on the welfare of the older population.
That is why there is a necessity to act now and not to delay the reforms, so that every generation, including the baby-boomers, would participate as well in the process of change. The EU governments did not remain inactive and started several reforms in the areas of pensions, employment, health and education systems. However, the emphasis these reforms add is a transference of responsibility from the government and corporations to the population itself. The role that the individuals will have to play regarding to the pension they will enjoy in the future will be determined, somehow, by personal choices such as savings and deciding when to retire from work.
The increasing ageing of the European population would also mean more public spending in long-term care and health care. In this aspect, the new technologies may be relevant in helping to adapt healthcare services and to improve a preventive treatment for chronic diseases. We are enjoying nowadays the highest life expectancy rates than ever. If this improvement in longevity could be combined with healthier life style and without disability, the public spending regarding the old population would be reduced to the half.[5]

3.- Guaranteeing Sustainable Public Finances in Europe

In the great majority of the member states there is a problem with the sustainability of public finance under present policies. In order to get a consolidate budget, there must be joint efforts to raise the participation of the population in the labor market. This is the way to increase the government returns and deal with expenditures due to ageing without having to increase the tax rate.
There have been made retirement reforms that will alleviate, somehow, the actual imbalance in the pension system, however, some countries may need additional reform. Among these we may find keeping ageing population active in the labor market for longer, raising the age of retirement, providing benefits to those who want to stay at work after the retirement age and offering the possibility to increase their income by means of an additional pension, all this obtained at the same time than an equilibrium is found between individuals contributions and benefits.
There are also appearing new initiatives to develop private savings and funded systems. In this sense it is of relevant importance to develop “efficiently functioning financial markets and to create stable and secure conditions for individuals to save and invest”.[6] There should also be enhanced the possibility for individuals to decide about the income they want to enjoy during their retirement age, by developing private savings and capital. There should be promoted, as well, an increasing knowledge of the
population in financial matters and its information to give them the tools to adapt to the future changing circumstances.
We are going to present now some possible solutions to escape from the problem of ageing population in the pension system in Europe.

3.1- Shifting from PAYG to funded systems

“Because of demographic imbalances, unfunded state pension schemes are unlikely to be sustainable, unless the real growth rate in pensions is severely constrained or the effective working life is increased substantially.”[7] In contrast, the profits available in the capital market makes more probable to obtain the wished pension scheme through funded systems.

The majority of state pension schemes are PAYG, that is, the one based on the contribution of the working population. In order to have the PAYG system balanced, there should be enough people in the labor market to pay for the pensions of those who are retired. In fact, this system is justified by the growth of the working population and productivity. However, the picture in Europe is changing dramatically. Europe’s population growth is diminishing vertiginously. In addition, life expectancy is getting rates never seen before due to the advances in medical technology. In this demographic time bombing, the real dilemma is, who is going to pay the pensioners if there is no younger working population to pay taxes?

Up to now, the United Kingdom is the only major country that has tried to reduce its pension costs. However, other European countries are raising the share of state pension’s costs as a proportion of GDP, as for example, Italy which is rising by 61% and more than doubling in the case of Portugal. There has been made estimates about the future liabilities of the pension systems, based on “present values of promise future pension payments and expected future contributions”.[8] If these liabilities were considered as part of the national debt, no country of the European Union would meet the Maastricht criteria of having less than 60% of GDP national debt.[9]

All this factors lead us to the conclusion that unfunded pension schemes are not feasible in any major country in the European Union. They would be viable only if the real growth rate were zero in the long run. It could also be practicable if there were an increase in the age of retirement, however this would be useless in a system in which people go on retirement even earlier of the established age.

As the state unfunded system PAYG seems to be unfeasible, the governments have no other alternative than to transfer the burden to funded pensions schemes that are more likely to be in the private sector rather than in the public one. In the long horizon, funded pension schemes seem to provide more efficient results than the unfunded ones. This is because they can provide higher profits by investing in other economies in the world which are experiencing rapid economic growth, instead than in Europe.

There is another reason for funded schemes to be superior to unfunded ones and it is because of the “dynamic efficiency”[10] of the economy. This is so, because saving through a pension fund favors the process of capital accumulation and, consequently influences in the increasing productivity of employees in the labor market. However, there exists a risk of converting this situation in counterproductive by getting the economy to be “dynamic inefficient” and thus, making it unsustainable in the long horizon. This is so because the accumulation of capital is so high that people start saving less and consuming more.

The funded pension system, although it may seem a plausible solution to the current increasing demographic problem, it is not a perfect cure to the disease. The funded pension system may provide the illusion of security because of the absence of political risks, as ministers may change their plans and move the right of pension funds to other areas in need. There are other added types of risks about the increase of contributions due to unemployment, illness, disability or death in the working place during the life time and also uncertainties derived from the insecurity of asset returns as the pension fund accumulation rises. These kinds of risks are very difficult to be transferred to private companies. As Diamond states, the mandatory unfunded systems are the ones that can deal with these risks collectively[11], but, as we affirmed before, the time bombing brings certain risks that the funded systems do not suffer. A last negative aspect of the funded pension systems is that, may be they are not feasible for poor workers, because the state unfunded services provide them with the minimum welfare benefit that the private funded sector cannot.

3.1.1- The Transition Deficit

Even though it may be recognized that a change from a PAYG to a funded pension system is desirable there is a major problem to solve: the transition from one scheme to the other. The point is that, although there was a change to a funded system, there would be still pensioners from the previous system to cover.

As those pensions are paid by the active workers, it could not be like that any longer as the workers contributions should be invested in a fund. So, to remedy this contributive gap, that is called transition deficit, there have to be levied extra taxation or by the “recognition funds” by the government, that is a “form of deferred taxation that formally `recognizes´ the unfunded liabilities of the state PAYG system”.[12] The resulting effect would be that the transition generation would have to pay double taxation: direct contributions to invest in their own fund and an extra tax to cover the pension of the retirees covered by the old PAYG state model.

Thus, there raises the question if the switch from unfunded to funded pension system is Pareto improving or not. The main aspect is if the transition generation would be rewarded according to the disadvantage they would have in comparison to previous generations enjoying the unfunded pension provision. That is why some critics would consider more profitable other measures to deal with the population ageing and the pension system rather than altering the established pension scheme.

Among the other political options we may find measures to maintain stable or increasing the working population, one of the main tools for the PAYG pension system to be viable. The government can achieve this by means of counteracting population ageing, rising the established age of retirement or reducing public pension benefits. We will cover this topic in the next section.

3.2- Other Policy Options

Due to the dramatic unprecedented increase of the old population European governments see a need to reform the current pension systems; otherwise, the increase of the accumulation debt would be detrimental to the European economies in general. In the past, they tended to raise public pension tax rates to cover the rising costs of maintaining public pension benefits. However, this is not longer viable as the contributions paid by the workers are already at very high levels and now, the objectives they want to cover are the ones allowing to a reduction in the budgetary expenditures. Another reason for the pressing situation in dealing with the problem is due to the legislative precedence needed to get present results and also to give time to the workers and retirees to adapt to the new policies.

We are going to go through four policy options intended to “reduce or end the growth of public pension expenditures”.[13] These options are divided into four groups depending on the four factors that determine public pension disbursement.

3.2.1- Counteract Population Ageing

To control or reverse the increasing older population in the future is one of the main measures to counteract a future weakening of the monetary balance of the public pension schemes. We may find two demographic ways to help a rising in the European population.

3.2.1.1- Encourage higher fertility

“United Nations projects population declines between 2000 and 2050 in Germany (from 82 to 79 million), and Italy (from 58 to 45 million)”.[14] If the fertility rates are increased, that would lead to an average of younger groups in society, thus declining at the same time the old-age dependency ratio of the old population per employee. There have been made projections from 2000 to 2050 by the UN[15] to estimate the impact on public expenditures if there were added half a birth per woman. As it was supposed, that increase of population by adding half a child per woman would lead to a lowering in the pension expenditures ratio. What these projections enhance is that with higher fertility rates the costs of public pensions would be reduced significantly for each country.

3.2.1.2- Permit more immigration

According to studies made by the UN in 2001[16], the average age of the immigrant population in Europe is lower than the European population. So, an increase in immigration would lead to a rejuvenation of the average of the European population and a decline of the old-age dependency ratio. In the same projections study presented before, they estimated an increase in the net migration rate by 2.5 net migrants per 1000 inhabitants.[17] As a result of this addition of 2.5 per 1000 of the projection, the public expenditures would be reduced considerably in comparison with the reference projection.

So, an increase in both the fertility and immigration rates would have a positive reduction in government expenditure due to the increase of young population to bear the burden of the pension systems.


3.2.2- Increase Labor Force Participation

A second political option aiming to increase the employment rates in Europe would not be by adding new born or immigrant population, but by encouraging already existing European population to participate more eagerly in the labor market. The female sector of the European population is the one that represents the bigger gap in the labor market. In Italy, for example, there is a big gap between male and female employment. The male ratio is 0.70 whereas the female one is 0.40 leading to one of the lowest employment rates in the European Union.[18] Any means to increase the employment ratio would be favorable to a reduction in the ratio between the pensioner and the worker. The employment increase would lead to “reduce the pensioner ratio by raising the number of workers above the minimum age of pension eligibility”.[19]

3.2.3- Raise the Age of Retirement

There has been a trend in the last decades in which the age of retirement was decreasing. There were two main factors for this to be like that. The first one is that the pension systems are more charitable than ever and there is only a slightly difference between the retiree and worker income. The second factor is that there are not enough incentives for the old working population to remain at work instead of retiring at the established age. Even though they keep on working they still will have to pay the same amount of taxes as before and that will not have a positive effect in their future pension income.
“An increase in the age at retirement reduces the pensioner/worker ratio by simultaneously reducing the number of retirees and raising the number of workers”.[20] We can get to this statement if we make a future projection increasing in five years the extra time at the labor market of a worker in contrast as it is now. The estimates of the UN report show an overall decline of the public expenditure ratio in OECD countries. Therefore, there should be proposed policies to facilitate older workers to stay at work by means of tax-exemption benefits, or by increasing the retirement age.

3.2.4- Reduce Public Pension Benefits

The level of public pension benefits varies from country to country. However, most countries have earning-related pensions, that is, pensions whose value depend on the period worked (number of years) and on the level of past wages adjusted for inflation.
The pension tax is treated differently in each country, depending on its adjustments, regulations and cuts of the type of population they want to target. Any reduction in the pension system benefit would be of relevant importance for the overall public expenditure reduction. If this attempt to balance expenditures with contributions does not work, there are another two options: to increase contributive tax or accept a deficit and accumulate debt. However, none of them are attractive for governments. The first one, because the great majority of countries already experience high tax rates and an increase would not be welcomed by the voting population. Even in United Kingdom, where the tax rate is not so high would not be wise to apply such measure.
In order to expect a decline of 10% in the public pensions expenditures there should be a combination of the aforementioned policies, that is, there should be an increase of 0.27 births per woman, increase of 1.8 net migrants per 1000 population, increase of employment of 9% and an increase of 1.6 years in the mean age of retirement.[21]
The most possible option adopted by EU countries would be to avoid the large public expenditures projected by means of a combination of several or perhaps all the measures, depending on the country. There should be levied taxes in some countries apart from adopting those policies.

4.- The Case of Spain

The demographic change that is and will be affecting Europe in the short and long horizon, is and will also have an impact in Spain. Spain’s evolution regarding to the reduction of young groups and increase of old groups in society is noticeable as it is shown in the table from the Central Statistical Office. The start of the decline in the 1980’s was mainly due to the transition from the dictatorship to democracy in which it begun to be allowed the use of contraceptive measures forbidden during Franco’s regime. The increase of the old group, however is mainly due to the generous pension benefits together with the increase of life expectancy.

[22]

Following, we are going to analyze the Pension system in Spain, budgetary constraints due to population ageing and the possible options to reduce a future public debt.

4.1- General Framework of the Pension System

The Spanish pension system is based on “public earnings-related schemes that cover the almost entire population (both employees and self-employed)”.[23] There were reforms in the pension system in the years 1997 and 2001, both influencing the three pillars of the Spanish system. There exists a social wage provided by autonomous regions to act as a safety net to those people unable to get other source of income. Other benefits are given to other people with necessities and long-term unemployed people.
The first pillar, which is mandatory and it is established by the state, consists of different stipulations. There is a basic universal provision based on non-contributory pension and a “Guaranteed Minimum Contributory Pension (GMCP)”[24] intended to those pensioners with low pension income. There is also the pension related to past earnings, forming the second part of the first pillar, that is maintained by contributions of the workers. As in the majority of the European countries the system is administered in basis of the PAYG method. The calculation of the pension income is made following certain parameters: the income is calculated according to the one obtained in the last 15 years in the labor market or the full pension is conceded if the worker contributed at least 35 years and retires with 65 years old. According to the 2001 reform, there is a possibility to keep on working after the retirement age by means of part-time contracts. Under certain conditions it is allowed early retirement at the age of 61.
The second pillar, consist of additional funded pension provisions; however, they are not well-known by the Spanish population. In the year 2003 the government and social partners signed an agreement to make mandatory this complementary system but their efforts do not encouraged enough people to opt for the supplementary alternative.
[25]
The third pillar, it is private and consists on voluntary “accumulation for old-age to pension funds or insurance companies”. [26] The retiree obtains benefits from this system by means of lump-sum or regular payments intended to cover invalidity, retirement, or any other scarcity detrimental for survival.

4.2- Projected Public Expenditures

The increase of the old population in Spain is mainly the cause of the negative projections estimated until the year 2050. The future projections of the Spanish old-dependency ratio is suppose to rise from 25% to 66% (from 2004-2050), what would suppose the highest increase in comparison with other member states of the European Union. This situation would lead to an economic growth expectation of decrease from 3% in the period 2004-2010 to 2% in the period 2011-2030 and a 0.6% from 2031 until 2050 [27].
The projected overall public expenditures related to age are going to be higher than the average of the EU, specifically, there would be an increase on pensions and health-care which will be higher than the average expectation of the European countries; however, long-term expenditures increase is not going to surpass the EU average.
The Spanish public finances have gone soundly in the past few years, with a surplus of 1.1% of GDP corresponding to the year 2005. However, this surplus is expected to continue until the year 2008 in which it will be reducing gradually until the figure of 6% of GDP.[28] Even though the government counts with that surplus, in the long run, the ageing of the Spanish population would have a negative effect on the government budget, estimated to surpass the average of the EU, due to the projected spending on pensions. However, Spain is considered by the European Commission as a medium-risk country regarding the sustainability of its public finances.

4.3- How to escape?

The current situation of the social security in Spain follows what was established in the Pact of Toledo in 1995, in which they considered the need to continue with the improvement of certain pensions such as the ones of widowers, enforcing the sense of equity and adding new factors of contribution and proportionality. They are dealing also with the problem of the pre-retirement by which an old worker -but not in retirement age- is forced to leave by the company he/she is working for with the consequent negative effect on the pension he/she is going to receive later on as a retiree. Another aspect they are discussing is the question of early retirement, by which only those workers who have accredited contributions before January 1 1967 can retire at the age of 61, otherwise they will have to wait until the age of 65.
However, the Spanish government sees a need to continue with the reform of the pension system to attain, through the social dialogue, the goals set by the European Union. In order to stabilize the projected future deficit there has to be made the following alterations:
a) Promoting measures to incentive the permanence of workers in the labor market, as this would mean longer contributions and shorter pension benefits to pay.
b) Improve the already existent partial retirement measure to facilitate a gradual transition from the active to passive status of the worker, at the same time that contributing in the labor market.
c) Refrain early retirement among those who are not at the established age of retirement.
d) Facilitate women integration in the labor market by means of measures that reconcile private and working life.
e) Implement measures that allow a stricter calculation of the pension system based on equity and other factors of proportionality as well as to increase the base period that is determined by the 15 years prior to retirement.
f) Consider the increase of smaller pensions, those which are at the minimum level, especially those of the surviving spouses.
g) “Progressing in the separation of financing sources so that the amount of the
complements for minimum pensions have greater financing through the State General Budgeting, which will allow improvement of outcomes at the contributory level and aid in the maintenance in the coming years of the Social Security System surplus”.[29]
h) Continuing the accumulation of the Reserve Fund that started in the year 2000, guaranteeing the balance of the system that pays costs for future negative projections.
i) The government should provide incentives to those companies/employees contracting, voluntarily, a supplementary funded pension scheme, to enhance their popularity and encourage other people/companies to adopt them.

5.- Conclusions

In these changing demographic times the majority of countries of the European Union will have to face pressures in their public expenditures. As the fact that the growing older population will exist in the future it should be enhanced and implemented measures to reverse the trend or consider the possibility of changing from an unfunded pension system to a funded one, even though the latter would include the consequent transition deficit. There is no more time to waste but to act accordingly in the legislative level, at the EU and national level to start changing the rules as there is a need to adapt to the changes.

In the particular case of Spain, the demographic factor would influence the public budget significantly, that is why the government should consider the proposed options to deal with the problem efficiently without affecting negatively on the respective future working and retiree generations.





















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Population and Development Review, Vol. 30, No. 1. (Mar., 2004), pp. 1-23.

European Commission, Communication on The demographic future of Europe – from challenge to opportunity, 2006 http://ec.europa.eu/employment_social/news/2006/oct/demography_en.pdf

European Commission. Directorate- General for Economic and Financial Affairs. The Long-term Sustainability of Public Finances in the European Union, 2006 http://ec.europa.eu/economy_finance/publications/european_economy/2006/ee406_en.pdf
Ministerio de Trabajo y Asuntos Sociales, secretaría de Estado de la Seguridad Social. The Pension System in Spain. 2001. Pp. 12. www.urban.org/pdfs/eu_event_spain.pdf

Natali, David. Spain, The Pension System. Service Public Fédéral Sécurité Sociale, 2004. www.ose.be/files/mocpension/SpainOMC.pdf

[1] European Commission. Directorate- General for Economic and Financial Affairs. The Long-term Sustainability of Public Finances in the European Union, 2006. Pp. 23. http://ec.europa.eu/economy_finance/publications/european_economy/2006/ee406_en.pdf
[2] European Commission. Pp. 23.
[3] European Commission, Communication on The demographic future of Europe – from challenge to opportunity, 2006 http://ec.europa.eu/employment_social/news/2006/oct/demography_en.pdf pg 6.

[4] European Commission, Communication on The demographic future of Europe – from challenge to opportunity, 2006 http://ec.europa.eu/employment_social/news/2006/oct/demography_en.pdf pg 6.
[5] European Commission, Communication on The demographic future of Europe – from challenge to opportunity, 2006 http://ec.europa.eu/employment_social/news/2006/oct/demography_en.pdf pg 7

[6] European Commission, Communication on The demographic future of Europe – from challenge to opportunity, 2006 http://ec.europa.eu/employment_social/news/2006/oct/demography_en.pdf pg 12
[7] Blake, David. Does It Matter What Type of Pension Scheme You Have? The Economic Journal, Vol. 110, No. 461, Features. (Feb., 2000), pp. F46

[8] Blake, David. Pp. F48
[9] Blake, David. Pp. F48
[10] Blake, David. Does It Matter What Type of Pension Scheme You Have? The Economic Journal, Vol. 110, No. 461, Features. (Feb., 2000), Pp. F51.
[11] Blake, David. Does It Matter What Type of Pension Scheme You Have? The Economic Journal, Vol. 110, No. 461, Features. (Feb., 2000), Pp. F52.
[12] Blake, David. Pp. F52.
[13] Bongaarts, John. Population Aging and the Rising Cost of Public Pensions. Population and Development Review, Vol. 30, No. 1. (Mar., 2004), pp. 14.
[14] Bongaarts, John. Population Aging and the Rising Cost of Public Pensions. Population and Development Review, Vol. 30, No. 1. (Mar., 2004), Pp. 15.
[15] Bongaarts, John. Pp. 14.
[16] Bongaarts, John. pp. 14.
[17] Bongaarts, John. Pp. 15.
[18] Bongaarts, John. Population Aging and the Rising Cost of Public Pensions. Population and Development Review, Vol. 30, No. 1. (Mar., 2004), Pp. 17.
[19] Bongaarts, John. Pp. 16.
[20] Bongaarts, John. Pp. 17.
[21] Bongaarts, John. Population Aging and the Rising Cost of Public Pensions. Population and Development Review, Vol. 30, No. 1. (Mar., 2004), Pp. 19.
[22] Ministerio de Trabajo y Asuntos Sociales, secretaría de Estado de la Seguridad Social. The Pension System in Spain. 2001. Pp. 12. www.urban.org/pdfs/eu_event_spain.pdf pp.9
[23] Natali, David. Spain, The Pension System. Service Public Fédéral Sécurité Sociale, 2004. www.ose.be/files/mocpension/SpainOMC.pdf pp. 1
[24] Natali, David. Pp. 1
[25] Natali, David. Pp. 2
[26] Natali, David. Spain, The Pension System. Service Public Fédéral Sécurité Sociale, 2004. www.ose.be/files/mocpension/SpainOMC.pdf pp. 1
[27] European Commission. Directorate- General for Economic and Financial Affairs. The Long-term Sustainability of Public Finances in the European Union, 2006. Pp. 112. http://ec.europa.eu/economy_finance/publications/european_economy/2006/ee406_en.pdf
[28] European commission. Pp. 112.
[29] Ministerio de Trabajo y Asuntos Sociales, secretaría de Estado de la Seguridad Social. The Pension System in Spain. 2001. Pp. 12. www.urban.org/pdfs/eu_event_spain.pdf