A global perspective on Pension Systems

Author: MAPFRE Economics

Summary of the report’s conclusions:
MAPFRE Economics
A global perspective on Pension Systems
Madrid, Fundación MAPFRE, April 2021

Retirement pension systems are always exposed to great pressure to reform because of several factors that can be grouped into two large blocks: the first covers those related to the lack of sufficiency of pensions (to maintain a certain standard of living after retirement) and the second group includes those factors that have their cause in medium- and long-term sustainability problems.

Demographic factor

The block of factors related to pressure due to the lack of sustainability includes demography, especially for pension systems in which the distribution components (in which ongoing pensions are financed from the contributions of active workers) have a higher weight. A key indicator for assessing the degree of pressure that demographic dynamics exert on retirement pension systems is the “support ratio” or “workforce ratio per retiree”, which measures the number of working-age individuals for each individual who has reached retirement age.

Due its structure, the ratio of workforce for each retiree allows for various metrics. The most used metric has the workforce of the population between the twenty and the sixty-five years old. This is because they are the ages at which people in a position to work are entering and leaving the labor market on average (the 20–64/65+ “support ratio”).

The United Nations population databases provide estimates and forecasts by age group from 1950 to 2100 for a total of 201 countries. Based on these, Chart 1 presents a demographic pressure index on retirement pension systems considering two elements:

• The situation of the workforce with respect to the population over 65 years of age in 2020 (the 20–64/65+ “support ratio”).
• The average annual percentage of expected decline over the next thirty years of that indicator (2020–2050).

 

pensiones gráfica 1 articulo 7

As can be seen, the Southern Europe region and, in general, Western Europe are showing the greatest demographic pressure. This is mainly because these regions have the lowest ratio of people in the workforce who have reached retirement age, which is around 3 working-age individuals per person over 65 on average. This ratio, according to the latest United Nations forecasts, will continue to deteriorate in the coming decades to fall below 2 in 2050 and around 1.5 by the end of the century. In contrast, the regions of Western, Central and Sub-Saharan Africa have the lowest rate of population pressure, followed by the South Asian region. In terms of breakdown by country, Japan has the highest demographic pressure.

It should be noted that, for the time being, these forecasts do not yet take into account the effect of the mortality caused by the COVID-19 pandemic. However, given the virus fatality rates observed to date, deviations that will significantly alleviate the demographic pressure on pension systems derived from these forecasts are not expected.

Pressure Index for reforming Retirement Pension Systems (IPSPJ)

Although demography is fundamental, it is not the only factor influencing pressure on pension reform. There are other factors that play an important role when it comes to proposing reforms and the pressure there is for them to be approved.
The synthetic index, entitled the “Pressure Index for reforming Retirement Pension Systems (IPSPJ)”, developed by MAPFRE Economics, seeks to measure that pressure based on six indicators. Three of them are related to the pressure that the lack of sufficiency of the pensions exerts on the public authorities to take action to reform them and the other three factors are related to their lack of sustainability (see Table 1).

pensiones tabla 1 articulo 7

The current direction of the retirement pension system reforms

After analyzing in-depth the reforms implemented in eleven pension systems over recent decades (which cover the spectrum of the main models that are often taken as a reference when considering reforms), the most common parameters on which the reforms focus are shown below:

  • Contribution rates.
  • Ordinary retirement age. It is currently the quintessential reform parametric since it enables the problems of budgetary sustainability of the distribution components to be addressed without altering the replacement rates. This increases the retirement age to align it with longer life expectancy and even in other areas in order to cope with the deformation of the constrictive population pyramids that arise from the phenomenon known as the baby boom until absorption of this phenomenon is completed and the pyramids become stationary.
  • Parameters that come into play when the ordinary retirement age is changed. These parameters affect the pension amount in cases of early and/or deferred retirement and pension compatibility with active work. The penalty percentages in the case of early retirements, as well as the percentages of incentives for deferred retirement or compatibility with active work (and the obligation or not to continue paying contributions in that period) are also relevant parameters when it comes to making reforms.
  • Incomplete careers. In relation to working life, other parameters of great importance are the years of contribution necessary to access the contributory pension and the years necessary to accrue the entire pension that corresponds to the regulatory base. This is in addition to the percentage of penalty for each year remaining year of contribution required to reach the minimum (pension in incomplete careers = regulatory base * percentage of penalty).
  • Regulatory or average base of the updated (“pensionable salary”) contribution bases. The number of years considered in the calculation of the average is a parameter that can have a great influence on the final amount of the pension and is always subject to review in the various reforms that we have analyzed in the systems that use it. The salary-updating mechanism to correct the effect of inflation is also of great importance. Some systems only consider a part of the pensionable salary when calculating the average, usually the higher salaries in order to reduce early retirement incentives. The regulatory bases connect with the contribution bases, which depend on the salary, as well as the maximum and minimum limits applicable to the contribution bases at any time.
  • Direct application of replacement rates to regulatory bases. This is applied in some pension systems with different percentages for different tranches, as is the case in the United States system. It is also applied by applying them in part to the average salary of all workers to calculate the pension as is the case in South Korea, giving it a redistributive character.
  • Pension limits. Use of maximums and/or minimums (and the complement to minimums) and indicators used for regular updating.
  • Revaluation of pensions. The parameters commonly used are the Consumer Price Index (CPI) and, to a lesser extent, other parameters such as the change in salaries, GDP growth and, in some cases, indicators related to the sustainability of the system (see chart, income and social security expenses), among others. There is a trend of introducing adjustment mechanisms in which the indexation to the indicators that measure the loss of purchasing power (the consumer price index, the salary trend index or a combination of both) is combined with other indicators related to the sustainability of the system. However, it is not a general practice, it is not done automatically and sometimes a part of the pension considered a vital minimum is left out of the adjustment. This is often linked to a greater or lesser extent to the evolution of salaries.
  • Life expectancy. Adjustment mechanisms for improvements in life expectancy for people who reach retirement age that may only affect (if introduced) new pensioners or all retired individuals.
  • Point systems. Parameters for calculating the purchase price and the value of the accumulated points for retirement (as is the case with pension systems in Germany and France).
  • Parameters related to notional accounts. It is an instrument for adapting the amount of benefits under the first pillar to the contributions made during working life (as is the case with the Swedish system). This is particularly true with the parameters related to the annual revaluation applied to the amounts entered in the notional accounts, as well as the revaluation percentages, interest rates and biometric tables used in calculating the portion of the pension from the notional accounts.
  • Fragmentation of the first pillar. Splitting the first pillar of the pension systems into components to which different calculation and revaluation parameters are applied (as is the case with pension systems in the United Kingdom and Japan). The first component is often referred to as a “flat rate benefit”, applying different update mechanisms (see the “Triple Lock” chart in the UK).
  • Strengthening the pillars that are complementary to the compulsory tax system (pillar 1) by improving the taxation of pension contributions promoted by companies and other employers for their workers (pillar 2) and individuals (pillar 3), seeking to achieve a greater balance between the three pillars.
  • Linking severance pay with pension systems as is the case in South Korea.

Other reforms related to the management of pension systems

It should also be noted that all the reforms analyzed have taken additional measures to redistribute the risks arising from the operation of their systems, to a greater or lesser extent, among the various parties. They have introduced public control mechanisms to prevent mismanagement of risks due to inadequate functioning of the system that may lead to situations where people who reach retirement age suffer consequences in the form of lower replacement rates.

The development of these mechanisms is important and the latest reforms tend to involve to a greater extent public institutions that are given greater supervisory powers. The measures analyzed include, but are not limited to:

  • Measures aimed at improving collection mechanisms, fraud control and the management bodies (collection and benefits), in order to reduce the levels of misuse of protection and non-compliance with the obligation to pay contributions.
  • Reforms aimed at eliminating or reducing the existence of special regimes to very justified cases of particularly grievous activities (see the chart on mining), which introduce complexity into the system, difficulties in its control and management, and lead to the coexistence of different groups of pensioners with widely varying, and socially disruptive, replacement rates.
  • Outsourcing requirements of funds for the coverage of pension commitments by companies with their workers, such as the Dutch and Spanish system. However, this is not a widespread practice, as there are still systems in which the funds supporting the commitments are allowed to be kept within the company’s balance sheet, such as in Japan, South Korea, the United States, among others, unless the outsourcing thereof is agreed upon, usually through collective bargaining.
  • Public control over competition and commissions charged by private entities managing capitalization funds, by creating public entities that participate in the system, as in the cases of the United Kingdom, Sweden and Chile.
  • The creation of public compensation mechanisms for workers who have suffered a loss in their rights because of the irregular operation of the parties involved in the system, as is the case in the United States.
  • The assumption by public institutions of some of the elements of the greatest risk and that have the greatest impact on retired individuals (such as life annuities), such that the coverage of demographic risks, both idiosyncratic, aggregate and systematic, rests on a public enterprise, in the case of the Swedish system.

The comprehensive analysis of the exogenous factors and risks affecting retirement pension systems, public policy measures, IPSPJ structure, and the in-depth study of systems in the United States, Brazil, Chile, Sweden, United Kingdom, Germany, the Netherlands, France, Spain, Japan and South Korea can be found in the “A global perspective on pension systems” report, prepared by MAPFRE Economics and available at the following link:

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