Pension Reform. What Is to Be Reformed?

Debates on pension reform started in Lithuania back in 1994. Today we have 2002, but the debates are still going on. In April 2001 the Government of Lithuania approved a draft law on pension reform, providing for the introduction of mandatory fully-funded pension insurance and giving people an opportunity to save for retirement through pension funds. Before that, major political parties in Lithuania reached a consensus on this issue. President Valdas Adamkus on many occasions urged decision makers to launch the reform without delay. The World Bank pledged to provide financial and technical assistance for the reform to be implemented. Unfortunately, the bill got stuck in parliament. Finally, after long considerations and heated debates the ruling Social-democratic coalition declined the bill. A decision was made to revise the bill and to start the reform by introducing voluntary rather than mandatory fully-funded pension insurance. Mandatory insurance, the argument was, would be too expensive for the country.
The Lithuanian Free Market Institute has participated in developing a legal basis for pension reform since the very beginning. The Institute crafted the first draft law on pension funds and helped to create a legal framework for supervision of pension funds and a plan for establishing a three-pillar pension system. An extensive media campaign has been conducted to explain the need and merits of pension reform. The article refutes the Lithuanian Social Democrats’ arguments against pension reform.

Pension reform has been discussed widely and thoroughly. Promises to start it have been many in number. It is small wonder that the object of, and the arguments for, reform have been somewhat forgotten. It is common knowledge that the current pay-as-you-go pension system is fraying because it is not viable financially. Social security contributions are large, while pension benefits are relatively small. This ratio is deteriorating due to Lithuania’s adverse demographic trends. In addition to that, the current social security programme is based on redistribution, so there is a constant risk that political decisions to increase benefits will destroy the system’s financial balance.
Being financially unworkable, the social security programme does not provide any incentives to participate in it and is being eschewed on a wide scale. This is not only aggravating the current predicament of the social security budget. It is demoralizing society as people are required to surrender their money to a scheme that does not bring expected returns.
Lithuania is not the only country to face this problem. Pay-as-you-go pension systems are a headache for all nations with the same heritage. Even Germany – the architect of a pay-as-you-go pension scheme – has after long debates decided to narrow it by establishing mandatory fully-funded insurance.
The social domain is not regulated at the EU level, but there are voices to pass legislation that would lay down fundamental principles of a pension system. Such proposals sound natural for several reasons. First, the European society is aging. Second, the financing of pay-as-you-go pension programmes is placing a heavy burden on European nations. Finally, the systems are a drag on European companies’ competitiveness on global markets. The United States, for example, places a greater weight on private retirement savings plans (albeit not great enough in the opinion of the American society) and so is treading on Europe’s heel in this area just as in others.
Let’s do something to do nothing
One may conclude that Lithuania, being on the periphery of these worldwide developments, has not realized yet the magnitude of problems that the pension system is causing. Or, one may say, the difficulties that the reform will pose are understood much better than today’s problems.
Naturally, every reform requires a great deal of resources – ideas, people and money – to change what has been normal, familiar and customary for many years. In every system, regardless of the degree of its usefulness to the society, there are people who are content with status quo and do not want any change.
The more complex and extensive a reform is, the more difficult it is to make a transition from the old to a new system. This is particularly true for the current pay-as-you-go pension programme. Both preserving the programme and dismantling it are impossible without losses. Any reform that is going to affect people directly causes a great deal of concern and therefore requires enormous efforts to explain to the society the need for, and the contents of, the changes to come.
Of course, the lot of reformers is not something to be jealous of. But it is the mission of politicians to create a legal environment or to change it so that people could create prosperity today, tomorrow and for many years to come.
Not so long ago all political parties in Lithuania expressed their support for pension reform. They said they would go along with a reform if the White Book explicitly described it as transferring a fraction of the current social security contributions to personal accounts in private pension funds. This was expected to strengthen the pension system, to reduce redistribution and to increase people’s incentives to participate in the programme.
Today Lithuanian Social Democrats insist that the reform should start with introducing voluntary pension insurance. This proposition is tantamount to saying that people will be allowed not only to spend the money that is left after paying taxes and social security contributions but also to save for retirement!…
But this does not mean or require any reform! By proposing this, politicians are only giving a yet another instruction for people where they should spend their money. If that is the changes that are to be adopted, the real culprit of the current predicament and the need for reform – Social Security – would remain intact. It would continue to encumber the labour market, to jeopardise the country’s finances and to cripple people’s understanding about insurance.
The Lithuanian Free Market Institute has long called upon decision makers to entrust at least a fraction of the social sphere to the market in order to give some vitality for this fraying sector and some hope for Lithuania’s future tax payers. Obviously, this reform is not going to be an easy one. It requires a sound model, a scrupulous action plan, an extensive public information campaign and political will and commitment. Today we are stuck right at the beginning – the proposed model is close to being rejected.
Coercion will not bring efficiency
The main problem with the proposed pension reform is that people will have to continue to participate in the current social security programme anyway. They will not be able to decide for themselves whether to pay social security contributions or, say, to keep gold in the cellar or deposits in banks or to buy real estate or simply to spend money today at the expense of their future income. It is claimed that people should be compelled to provide for retirement and that they should necessarily do it through social security. Thus the choice remains only within the pension system itself.
Today the system affords no choice whatsoever: everyone must pay social security contributions. Under the proposed reform model, part of the population (aged 30 to 50) would have an opportunity to direct a fraction of their social security contributions (five percent) to the new system (a pension fund of their own choice), while individuals over 50 years of age would have to remain in the old pay-as-you-go programme.
However, if the aim is to reduce people’s liabilities as much as possible and to increase freedom of choice and individual responsibility for one’s own future, it is necessary to allow all age groups to choose whether to stay in the current social security system or to pay the five percent of their social security contributions to fully-funded pension insurance. This would not increase the uncertainty surrounding the reform. Given that a large fraction of the population would have a right to choose under the proposed model, calculation of the costs of the reform would have to be based on forecasts regarding the number of participants in the new system anyway.
The Social Democrats use the notion of dividing the population into age groups in pointing out plans to introduce mandatory insurance. However, the proposed reform model does not mean mandatory insurance. The envisaged insurance, to be compulsory for people under 30 years of age, would be used within the boundaries of the current mandatory social security contributions. Under the scheme proposed by LFMI, pension insurance would not be obligatory to any age group. Those who wish to remain in the mandatory programme without fully-funded insurance would be able to do that, while others would be allowed to accrue part of their social security contributions in private pension funds.
A solution will dictate a means
Another factor increasing the uncertainty of the reform is that not s single pension fund has been established as yet in spite of the fact the Law on Pension Funds is in place. It is small wonder. Many more people wanted to participate in pension funds when the pension reform was started than today. Therefore the question as to what should come first – pension funds or a pension reform that would create a market for pension funds – is a chicken and egg situation. If the reform were implemented, it would provide a powerful incentive for pension funds to appear on the market. On the other hand, pension funds would diminish the uncertainty of the reform and facilitate the transition.
A pension reform is a lengthy process. The time gap between the adoption and the enforcement of pension reform legislation would leave enough time for the market to react to the news and for pension funds to spring up (provided lawmakers removed the existing unjustified restrictions on pension funds’ investments). The risk that the time will be too short for pension funds to establish can be minimised as well. To do that, it is necessary to allow people to direct the five percent of their social security contributions not only to pension funds but also to fully-funded life insurance in insurance companies, a service that is already being used.
All roads lead to the treasury
A lack of money is invariably the final and deciding argument the Social Democrats use to cut off any discussion about the reform. This argument is used by anyone in power to confront proposals for long-term reforms. There is never free money in the state budget, just like in a private individual’s pocket. For individuals, it is always easier and more pleasant to spend money on a new car or a holiday or any other tangible thing. This is understandable and justifiable because it is their own money that they spend. Administrators of taxpayers’ money are also keen on spending it to achieve a fast and material effect, so they face a constant temptation to use the money for the benefit of individual groups rather than all citizens.
For example, they choose to grant special pensions for a few rather than raising pensions for all. They dole out various allowances, e.g., transport concessions, for selected groups rather than increasing benefits for all receivers. The desire to achieve fast results leads them to spend the money for today’s beneficiaries rather than investing it so as to benefit other generations as well. Today the authorities are ready to find resources to establish a new state telecommunications operator or to subsidise housing loans but not for pension reform.
A research conducted by The Economist (February 16-22, 2002) shows that the damage that the replacement of the current pay-as-you-go pension programme and reform-related risks may do will be smaller than the harm that will be caused by doing nothing. Therefore the Social Democrats’ position, albeit absolutely natural and even reasonable in the rhetoric of a political party, cannot be justified because it is injuring the Lithuanian people.