Pension Reforms in EU Member States: progress and Challenges

3. Strengthening Incentives to Extend Working Lives

Working longer is an explicit European target in the Lisbon context, both through the objective of increasing the employment rate of older workers (aged 55-64) to 50% and through the objective of an increase of 5 years in the effective age of exit from the labour market. Longer working lives result in more contribution years and fewer benefit years, thus contributing directly to the adequacy and sustainability of the pension system. Pension systems are an important part of labour market institutions through the provision of benefits. Therefore, it is of utmost importance that the incentive structure embedded in the pension system is supportive to employment. Over the last decade, the employment rate of older workers has increased, reversing a long declining trend. The employment rate of older workers (55-64 age brackets) has increased to 44% in 2006. But in spite of these recent increases, there is still a long way to go in order to reach the European target of 50% employment among older workers. These evolutions actually show significant discrepancies (Figure 2): the levels still differ and to a lesser extent so do the size of improvements. In any case compared to the huge declines (10 to 20 percentage points) observed earlier on, the improvements look small but as a signal of a changing trend they are important.

Figure 2: Employment rates of older workers in 2005 and evolution since 2000
Source: Labour Force Survey, annual averages.

In nearly all Member States, recent reforms have strengthened incentives to extend working lives (especially for statutory schemes), and reduced access to early retirement. Working longer is generally encouraged by pension supplements and leaving earlier discouraged by actuarial reductions. Furthermore greater flexibility is provided in the timing of retirement, for example combining employment and partial retirement. In addition access to disability, sickness and incapacity schemes are being reviewed to eliminate other paths to early exit. While in defined contribution schemes, effective incentives are inherently embedded, some defined benefit schemes may require adaptation of eligibility rules and pension parameters (such as age limits of access to early or specific schemes, bonus/malus coefficients, etc.).
Most Member States are currently reviewing or reforming the conditions for taking-up of pensions, notably by adapting statutory retirement ages (like for instance DE, DK or UK), by introducing more flexibility in the choice of the path from work to retirement3, and also by reviewing conditions for early exits from the labour market.
More flexibility in retirement age can be achieved through appropriate incentives to prolong working lives, but also through partial pension and possibilities of combining pensions with earnings. The strength of incentives to work longer appears as a key issue for the design of flexibility in retirement age. If incentives are too weak, this is an encouragement to retire earlier, and if incentives are too high, costs for public finances can be significant in the event of significant increase in average retirement age (notably as at higher ages, there is a risk of subsidising those who would have in any case postponed retirement). Besides, incentives should be strong enough for lower wages, both on efficiency (sustainability) and adequacy grounds. For the latter, reviewing the incentive structure should take place in respect of minimum income provision. But for lower ages (in particular before 60), the emphasis should be less on incentive structures than on restricting possibilities to exit the labour market before standard retirement age (except perhaps for special conditions, such as hazardous jobs).
Pension reforms give strong incentives to work longer and when well designed they reward doing so with adequate pensions. However there is a need to ensure that people can work effectively longer. Opening up employment opportunities for older workers through accelerating labour market reforms is essential. Pension systems can facilitate later retirement, but without suitable access for older workers to appropriate employment, they are unlikely to be particularly effective.
A key dimension of pension systems is that they relate not only to the current situation of older people but also to future developments, which are influenced by enacted reforms. In view of the potential high costs implied by the ageing of populations, most Member States are engaged in significant reforms of their pension systems, which will clearly impact on future pension benefits. Indeed, reforms are generally aimed at curbing the overall rise in pension expenditures, as expressed as a share of GDP.
To look at reform impacts from the perspective of an individual, the Social Protection Committee (SPC) has developed a highly theoretical instrument: theoretical replacement rates, calculated by Member States for 2005 and 2050 (see ISG report 20064). The work carried out highlights that reforms of statutory schemes will often lead to a decrease in replacement rates at given retirement ages, which also reflects the trend towards an increase in life expectancy at 60 or 65 (see 2007 Joint report on Social Protection and Social Inclusion, supporting documents, section 3.35).

Figure 3: Trends of replacement rates: effect of enacted reforms at a given retirement age (2005-2050)
Source: Stylised illustration from ISG results on gross replacement rates.

It should be noted that the evolution of replacement rates is assessed for given retirement ages and given contribution length, while most pension reforms actually plan an increase in at least one or both of these parameters. There are also calculations available — even more hypothetical – on private pension provision and the impact of working longer (graph 3): in an average Member State a combination of private pension savings that amounted to 5 percentage points over the working life and an increase in retirement age of two years would roughly maintain the 2005 replacement rate. This clearly highlights the risks for future adequacy of an insufficient increase of employment rates among 55-64.

4. Guaranteeing Minimum Retirement Income Provision and Solidarity

Besides general earnings related schemes, minimum income provisions for older people have an essential role in alleviating or reducing poverty risk amongst the elderly6. While many reforms can reduce the average level of pensions, Members States pay attention to guaranteeing a decent minimum to all. A number of Member States have made reforms to their minimum systems with the aim of: increasing levels of benefits; making access to benefits easier; or replacing existing benefits with new systems. This reflects the growing attention that minimum incomes have received in recent years alongside reforms that many Member States have undertaken to their general pension systems.
Broadly speaking minimum provisions can be divided into 3 types (though it should be noted that some systems combine an element of 2 or 3 of these broad categories) (i) minimum pensions within the earnings related pensions systems that rely on contributions throughout a working life. These often offer a strong degree of solidarity, and are generally available with a fairly low threshold of contributory years and are subsequently almost universal in their coverage (ii) flat rate benefits for all older people with residency for a certain period of time being the criteria for receipt (iii) separate social assistance benefits, that are usually paid to those who do not meet residence criteria and/or have made too few contributions to the general system and subsequently have little or no income in old age. These are often subject to some form of means-test and are paid to ensure that individuals have the basics for adequate living, at times the social assistance rate is higher for the elderly, and maybe referred to as a Minimum Pension, or minimum income. Besides, older people generally benefit from other types of benefits which make an important contribution to their living standards (in particular health care services, housing benefits).
In a number of Member States, the risk of poverty for people in retirement ages is currently higher than for the active population (graph 4). It should be noted that the poverty gap of older people (i.e. income closer to the poverty line) in all but a few Member States is narrower than the general population. This is in part due to the provisions of minimum incomes to the elderly on the whole being higher than similar provisions that are available for the general population (such as general social assistance). Older women and oldest people are particularly at risk of poverty, mainly reflecting past accruals and ongoing indexation of pensions. Nevertheless, one should note that needs may be different and these numbers do not take good account of in kind benefits and housing costs (imputed rents).

Figure 4: Risk of poverty for people aged 65+

Member States are trying to maintain or even improve basic income protection, while pension reforms also tend to reduce the level of replacement rates for a given career length and profile. Future developments in the role of minimum income provision for older people are difficult to assess, as in the coming decades contradicting trends will be at play: the maturation of pension schemes and increase in female workforce participation will continue; the effects of past unemployment levels and an increase in partial employment will begin to develop; and there will be the effect of recent reforms (that often translate as a decrease in benefit levels). Partially as a result of the indexation rules, including those influenced by automatic adjustment mechanisms, replacement rates of people will lag behind the general evolution of incomes to various extents and sometimes substantially.
Another issue is whether minimum pensions or minimum benefits are indexed differently from earnings-related pensions and whether this can have unintended effects on the income distribution among pensioners. Recent developments show that more and more countries have switched to price or close to price indexation both for earnings-related schemes and for minimum pension schemes. Increasing minimum incomes by price inflation can be argued for on the grounds that consumption needs of pensioners may be stable or even decline with age, and therefore retaining a price link is sufficient. However, this also ensures a worsening of the relative income situation of pensioners and particularly for those on the lowest incomes. This is also reflected in poverty levels of the oldest pensioners usually being greater than that of their younger cohorts (though here there are a number of other factors that contribute to this differential). Calculations of theoretical replacement rates by the ISG suggest that this effect can be substantial, as replacement rates for a standard career generally decrease by around 5 to 10 percentage points 10 years after retirement (Figure 5). Those with little or no access to the general pension system are likely to be even more harshly affected where reductions of 10% to a low income is less sustainable.

Figure 5: Theoretical replacement rates: effect of indexation 10 years after retirement (2005-2015)

2 SEC(2006)304
3 The SPC has adopted a study on flexibility in retirement provision in April 2007, that will shortly be available on the following web address:
6 See SPC study on minimum income provision for older people (2006).

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