Sustainability and Adequacy of Pensions in EU countries: Synthesis from a Cross-national Perspective

2. Setting the Context: The Sustainability Concerns

An essential starting point is to assess the varying extent of population ageing faced by EU countries. Figure 1 presents the old-age demographic dependency ratio (number of 65+ / number of 15-64), for the period 2008-2060. These results, extracted from the 2009 Ageing Report (European Commission 2009a), show that the old-age dependency ratio in EU states is expected to rise from 25.4% to 53.5% over the period 2008-2060. On average, the EU countries would move from having four working-age people for every person aged 65+ to a ratio of two to one. The EU of today already had the highest old-age dependency ratio in the world in 1950, and during the period 2000 to 2050 the largest increases are projected to take place in Japan (by close to 50%-points), China and the EU27 (by almost 30%-points).1
Note the list of countries on the left-hand side of the graph: the combination of rising longevity and low fertility and a resultant aggravation of the old age dependency ratio will leave Central and Eastern European (CEE) countries facing a particularly difficult demographic situation within EU countries. This will greatly impact on CEE countries’ ability to address the challenges of pension income adequacy and sustainability in the near future.

Figure 1: Population Ageing in EU countries, 2008-2060, as given by the old-age dependency ratio (Number of 65+/Number of 15-64)

Source: European Commission (2009a), data originally from Eurostat, EUROPOP2008.

By 2010, most EU countries have regained a positive growth. However, this recovery in growth has been accompanied by experiences of joblessness and a further deterioration of public finances. Figure 2 gives an account of unemployment rates across EU countries, during 2006, 2009 and 2010. Once again, it can be noted that five out of the seven countries with the highest unemployment rate belong to the CEE countries. Thus, it is likely that workers in CEE countries are more likely to have a disruptive working career, which will perversely affect their accumulation of pension rights. Also, the future challenges in sustaining economic growth and competiveness in CEE countries can be expected to be disproportionate in comparison to other Western European EU countries, largely because of their young market economy status.

Figure 2: Unemployment rate in %, 2006, 2009 and 2010

Source: European Economic Forecast – Spring 2010 (provisional version).

During 2009, undoubtedly, the key challenge across the World has been to counteract the recession. Consequently unprecedented fiscal and monetary policy measures were put in place, so as to stimulate economies and stabilize financial markets. Heavy public spending either in the form of large fiscal stimulus packages or in automatic stabilizers put enormous additional strain on public finances during 2009, and almost all European governments faced a significant deterioration in their public finances. Government deficits among EU states rose substantially, from an average of -1.4% of GDP in 2006 to -6.8% in 2009 (see Figure 3 below), leading to an accumulation of large government debts. These results raise further concerns regarding the sustainability of public finances in many EU states, which remains a live and ongoing issue in many EU countries.

Figure 3: Government deficit (-) / surplus (+) in EU countries, in terms of percentage of GDP, 2006 and 2009

Source: Eurostat 2010.

As discussed in detail in Zaidi and Rejniak (2010), the CEE countries faced additional sustainability challenges, attributed largely to their young market economy status. Having made the transition to the market economy during the 1990s, these countries have not had the benefit of prolonged periods of economic growth and also have gone through the political transition towards democratic institutions relatively recently.
The ultimate question therefore is how ageing populations and crisis will affect EU countries’ financial sustainability in the future. The gains in human longevity have indeed been a positive trend, particularly in CEE countries where life expectancy is lower than that in other EU countries. But, rising longevity combined with falling fertility has led to shrinking working age populations in many EU countries. An additional challenge for the CEE countries is emigration of a large number of workers to other EU countries. This paper, drawing from Zaidi (2010a), provides an analysis of the indicator of financial sustainability gap (namely: S2), devised by the European Commission’s Working Group on Ageing, with a focus on how population ageing contributes to the fiscal sustainability gap.
The S2 indicator approximates the gap (as % of GDP) that must be closed permanently in order to ensure that governments will be able to finance all future public budget obligations. The indicator provides a compact measure to approximate the size of risks to public finance sustainability when a long-term perspective is taken. The S2 indicator can be decomposed into two components so as to also point to the sources of the risks and appropriate policy response required.
• Firstly, there is the gap arising due to the starting fiscal position, referred to as the Initial Budgetary Position (IBP). The IBP will exert a negative pressure in many countries because of the deficit during 2009, largely due to the economic downturn experienced during 2008-2009.
• Secondly, there are the additional costs related to population ageing and expenditures on pensions, healthcare and long-term care. This component is referred to as the Long Term Changes (LTC). Note that the LTC results still rely on the employment and GDP growth assumptions of the pre-crisis period.
It needs to be emphasised here that the picture that emerges errs on the ‘optimistic’ side. This is because the bulk of the raw data used in the calculation of the S2 indicator was collected prior to the onset of the current economic crisis. It can be speculated that the revised projections would be, when adjusted in line with the current economic realities (in terms of government deficit and debt and (un)employment projections), providing us a perverse picture. It can also be argued that the crisis in the sustainability of public finance itself highlights the need to further refine the quality and the independence of the evidence base from which decisions are made: the more high-quality evidence is admitted to this debate as the accepted starting point for discussion on what to do next, the easier it becomes to formulate policy responses and persuade the public of the need for, and the consequences of change.

Figure 4: Sustainability gap (S2 indicator) across EU countries and the contribution of the Initial Budgetary Position (IBP), and the Long Term Changes (LTC), 2009

Source: Sustainability Report 2009, p. 35.

Results presented in Figure 4 show that, at the EU27 level, the total S2 gap is 6.5% of GDP. On average, the contribution of two components of S2 is almost the same: 3.2% for the IBP and 3.3% for the LTC. Wide variations across EU countries can also be observed, and they are divided into categories of high, medium and low risk. As many as 13 EU countries are being considered high risk countries. Among them, Ireland, Greece, the UK, Slovenia and Spain have a sustainability gap in excess of 10% of GDP. Latvia, Romania and Cyprus also do not fare well, at just below 10%.
Countries also differ remarkably in terms of sources of risks, i.e. contribution of the IBP and the LTC. Within the high risk countries, the contribution of the LTC is particularly high in Greece, Slovenia, Cyprus, Malta and the Netherlands and the contribution of the IBP is large in the UK, Latvia and Slovakia. Within the group of medium and low risk countries, Luxembourg and Finland and also Belgium and Germany stand out for a larger contribution of the LTC. As for the IBP contribution, Poland is most notable, but so too are France and Portugal.
The question is how have policy-makers been responding to these sustainability challenges? In many EU countries, the policy responses within the remit of labour market policies have been to enhance the employment rate of the working age population, especially for those who had been typically low employment groups (e.g. mothers with young children, older workers, and disabled persons with reduced work capabilities). Pension policy has sought to complement labour market policy moves, with greater incentives towards longer working careers, improvements in the coverage of public pension schemes for working age populations, the provision of suitable low-cost mechanisms to encourage private personal savings and, where possible, a scaling down of pension benefit provisions to improve affordability of public pension schemes. These reforms have contributed towards improvements in financial sustainability as well as ensuring a greater fairness between and within generations and men and women. Some pension reforms have also addressed pension income adequacy, especially those that improved the coverage and the indexation of minimum pensions. Nonetheless, it can be said that until recently the issue of adequacy has not been a priority in these reforms, and this paper provides a glimpse into how the current generations of workers are expected to fare with respect to their incomes when they retire On the basis of the information available, three possible ways can be adopted to examine the evolution of pension incomes of future retirees in EU countries:
1.    To examine changes in the benefit ratio that measures the evolution of pension expenditures per pensioner in relation to the wage per worker. The period under consideration for these analyses is between 2007 and 2060, and these results can be seen to be an approximation of the aggregate impact of the pension reforms across EU countries.
2.    To discuss what impact pension reforms are likely to have on pension income replacement for low, average and above average wage workers. These analyses, for those workers who enter into employment during 2006 and retire in 2046, show the cumulative effect of reforms that happened since the early 1990s, for stylised cases of workers who spent their full career working. These results can be seen to be an approximation of the impact of pension reforms on the structure of pension systems.
3. To analyse the changes expected in the average first pension as a proportion of the average wage; for the same period as used for the analysis of the benefit ratio, but using the case of stylised male workers on average wage through their working careers.
These three analysis streams provide insights into how pension incomes for future retirees are going to be affected, and the next three sections of this paper address them one by one.

1 These conclusions are drawn from the estimates based on the UN World Population: The 2008 Revision, as referred to in European Commission (2009a), p 48.

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