Pension Reform in Lithuania

No other word has come to define an entire decade of Central and Eastern European history like ‘reform’. Common sense suggests that poorly conceived or executed reform is worse than no reform at all, yet those enacted across the region since the fall of Communism have often been less than ideal.
Lithuania is no exception. Since regaining its independence in 1991, the country’s legislative process has often retracted, sidetracked, and for long periods entirely abstained from, reformist legislation. The rapid economic growth of the last two years (in 2003, GDP grew by nearly 10%), and the political leverage this offered for expensive structural reforms, only highlight the failure of the government to pursue such a course. It is sufficient to simply take a look at the situation of healthcare or education systems today.
Over the past year, the state-run healthcare system has begun to show signs of deterioration, and requires far-reaching reform. For example, while it is ostensibly state-financed, it currently constitutes up to 50% of some household’s monthly expenses. So far, the government has only proposed temporary, and ineffective, measures to curb these rising costs. However, its willingness to acquiesce to the demands of striking doctors, who are badly underpaid, usually only buys them a brief respite. Equally, when a hospital does not have the equipment necessary for a given surgical procedure, the patient simply has to raise the money independently, and usually obtains the procedure in Scandinavia. That Lithuania’s healthcare system is failing both doctors and patients is one of the country’s worst-kept secrets. Yet reform is consistently deferred despite the current economic conditions that would significantly ease its burden.
Unfortunately, the much tinkered-with education system has not brought much improvement to the old one. Despite having a very high proportion of university graduates, Lithuania lags behind much of Europe in productivity because the system has an inherent bias towards the quantity rather than the quality of its higher education. This has saturated the domestic labour market, and created a potential new threat to the economy by encouraging economic migration. The government however, has once again chosen a non-solution by simply increasing the amount of money it spends per pupil.
Similarly, changes in agriculture are limited to compliance with the EU’s Common Agricultural Policy (CAP). The important reforms of strategic budget planning and business deregulation are similarly in a legislative limbo. Admittedly, over the last three years, steps have been taken to recover individuals’ savings from the pre-independence period; however, the process is still far from a satisfactory conclusion.
One piece of major, though still relatively modest and cautious, reform nevertheless progressed significantly in 2004. Until the end of 2003, Lithuania relied on a simple redistributive mechanism to provide for its elderly. The traditional pay-as-you-go (PAYG) system, employed in many European countries, is based on a money transfer from workers to retirees. This system, otherwise known as the first pillar of the three pillar pension model, accounts for 90% of total pension income in the European Union countries. Despite its widespread use, however, the system is flawed in a number of ways. Firstly, it places sole responsibility for future pensions in the hands of the politicians. Second, it encourages early retirement while discouraging job mobility. Third, it places a high burden on labour, though it excludes the self-employed.
But most importantly, a PAYG pension system places an unsustainable strain on government social spending. Some EU countries are currently piling up liabilities on the scale of war debts. On current trends, nine EU countries will have accumulated gross debts of 150-300% of GDP by 2050, causing the eventual collapse of a system to which pensioners have diligently contributed throughout their working lives. However, many countries are beginning to experience the breakdown of their PAYG systems. While the current state pension constitutes 30-40% of the average salary, it is very difficult to maintain a normal standard of living below 70%. Fundamentally, the flaws in the system are encoded in simple demographics. The population of Europe is ageing at an ever increasing rate, and within 30 years, the ratio of over-65s to those aged 20-64 will double. This will create an irresolvable fiscal imbalance wherein a small number of providers will be unable to support a growing number of pensioners.
Acknowledging the inevitable, the Lithuanian Government began modelling what was to become a three-pillar pension reform in 2000. A second pillar was eventually added to the first pillar tax-roll contributions in January 2004, and a third pillar – voluntary savings – is being implemented in the New Year. While Lithuania was the last of the three Baltic States to undertake this reform, the pre-existence of the model elsewhere meant that its implementation occurred relatively smoothly. This is doubly impressive given the extremely short period of time – the package of laws were adopted in July 2003, and the first round of subscriptions completed by December – during which state institutions had to prepare by-laws, and the fund-managing companies had to both acquire licenses and carry out promotional campaigns. In fact, Lithuania’s transition has been much less troublesome than similar shifts in most European countries, despite the truncated timeframe.
The second pillar of the three pillar model (TPM) allows every socially insured employee to direct 2.5% of his earnings into a private pension fund (of his choosing) from January 1, 2004. This contribution rate will be increased annually (at the expense of the first pillar share) until it reaches 5.5% in 2007. All age groups of the employees are free to choose whether to participate in the second pillar and to start private saving in a pension fund or to stay completely dependent on the State Social Security Fund (Sodra).
The introduction of the second pillar does not incur any changes on those willing to remain within the PAYG system. Those taking part in the funded second-pillar system, however, now can accumulate funds that will remain the sole property of the individual, and can also choose the fund and manager who best suits them on a risk/return ratio.
Open to all
These reforms in Lithuania also allow all employees to participate in the second pillar, a provision unique within Europe. In most countries, workers have been discriminated against on the basis of age. The Lithuanian decision not to do so is both fair and economically well-reasoned. Participation benefits should depend on individual contributions, not imprecise age brackets. Equally, if the state disqualifies people from the second pillar, it would need to guarantee sufficient returns from the first pillar to provide for one’s old age. Such a guarantee would significantly increase the cost of the present pensions system, and distort the very rationale of the private solution.
Guaranteed returns and investment security can only be ensured through competition. The Lithuanian Law on the Pension System Reform is rather obliging in this respect – it allows participation of both financial intermediaries as well as life insurance companies, so fostering conditions for competition. Indeed, competition could be strengthened further if similar reforms were enacted at European Union level. For example, competition among pension funds would increase if an individual could save for their basic pension – second pillar – in any EU member state.
The funded pillar model has three obvious economic advantages. It boosts economic growth (extra savings lead to higher investment and thus faster growth); it provides an incentive to remain in the labour market longer; and it is a more efficient use of capital. Although these economic outcomes are secondary to the social purpose of pensions, they function as a supporting and advancing mechanism. The funded pillar model also motivates people to become actively involved in decisions about their pensions.
The main and essential shortcoming of the present reform, on the other hand, is the size of instalments that could be directed into the second pillar – they are too small to allow big returns on investments. As such, they may be limiting participation levels since the incentive to save remains insufficient. Further reform of the pension system must increase the size of these contributions to allow low- and middle-income workers to accumulate real wealth. However, one rarely noted advantage – or beneficial consequence – of the pension reform is the significant effect it has had on the amount of wage transactions in the informal sector. Official statistics suggest that 30% of Lithuanian wage earners receive additional wage payments under the table, and a recent survey of market participants suggests that as many as one in four minimum wage earners receive additional informal wages.[*] The introduction of the funded pillar model will encourage people to declare their true earnings.
This pension reform is a significant, albeit small, step towards a sustainable and financially sound national pension system. Certainly, the system has been adopted enthusiastically by fund management firms and ten companies are now offering their services. Public interest has been similarly impressive. As many as 48% of Lithuanians have chosen to participate in the new system, while in Latvia and Estonia, participation rates hovered around 6-7% during the first two years of the funded pillar model’s adoption. Fears about a dearth of competition among service providers and a lack of public participation have thus proved to be unfounded. Considering that participation is not obligatory, the number of participants is more than impressive: the results of the first two stages were not only better than those in neighbouring countries; they also far exceeded the Social Ministry’s most optimistic projections.
The danger is that the Government now will rest on its laurels. A reform of the reform will soon be needed to ensure the system’s long-term sustainability and the public’s willingness to participate in it, to facilitate the success of the third – voluntary savings – pillar, and most importantly, to encourage reform in other sectors of the public services.

[*] LFMI, A Survey of Lithuanian Economy, 2004-2005 (1)