In 1998 LFMI carried out a Freedom House-sponsored project “Promoting a Viable Pension System in Lithuania.” Partners to the project were the Jaan Tonisson Institute (Estonia) and Janis Cakste Foundation for Promotion of Democracy (Latvia).
The purpose of the project was to promote pension reform in Lithuania by providing a conceptual framework for converting the fraying public pension scheme into a viable system conducive to economic growth and congruous with fully-funded pension insurance. To accomplish the goals of the project, LFMI undertook a series of research, policy advocacy and dissemination activities. LFMI conducted policy-oriented research on the existing pension system in Lithuania and identified its inherent flaws and deficiencies. LFMI prepared an overview of the current pension system in Lithuania, providing a comprehensive account of pension reforms conducted to date and exploring the need to replace the pension system. LFMI looked at early pensions and pension eligibility criteria, the new pension formula and an increase in the retirement age, and privileged pensions.
LFMI also carried out analysis of conditions and prerequisites for pension reform in Lithuania, explaining demographic pressures on the pension system, the effects of tax evasion, financial, tax-related, political, legal, technical and physiological conditions for pension reform as well as the existing macroeconomic environment.
The results of the project were utilised in LFMI’s policy advocacy efforts to promote the redesigning of Lithuania’s fraying public pension scheme.
The first phase of the project was designed to conduct policy-oriented research on the existing pension systems in the three countries, identifying their inherent defects and exploring conditions for reform. This following presents an abstract of a study on conditions for pension reform in Lithuania prepared by LFMI’s policy analysts, Audronė Morkūnienė, Remigijus Šimašius, and Rūta Vainienė.
No Prospects for the Current Pension System
Based on the pay-as-you-go principle, the Lithuanian pension system is unable to cope with the problems of financing retirement provision. The worsening demographic predicament is a major setback. The trend is also toward avoiding or reducing payments of social security contributions, which are widely regarded as a tax. Such attitudes are prompted by several considerations. To begin with, many people pay much higher contributions than is needed to finance their pensions. Second, people continue to pay social security contributions after they have qualified for pension (as in the case of working pensioners). Third, a ceiling is imposed on pension benefits rather than contributions: Those who earn more pay more, even though they do not receive higher benefits for their additional contributions. Finally, some insured fail to qualify for pensions despite the fact they had paid to social security (in the case of too short an insurance record).
Actuarial calculations suggest that if social insurance premiums were accumulated instead of being redistributed, financing of pensions of insured persons would require much lower contributions than those paid today (about 10 instead of 23.5 percent).
Financial conditions for pension reform
The development of the capital market is an essential factor in switching to a private pension system. The operation of private fully-funded pension funds is based on the investment of accumulated resources intended to preserve their value and accrue gains. The liquidity, magnitude and safety of the securities market are therefore key attributes of pension reform.
Assets safety is the biggest cause for concern for financial intermediaries. The functioning accounting standards do not require that customers’ assets be segregated from the company’s assets. Off-balance accounting has not evolved as yet to allow of effective segregation of assets.
The system of commercial banking presents another risk as most settlements are conducted through banks. Even if capital market intermediaries ensure the safety of customers’ assets, all assets are exposed to potential risk in banks.
Tax-related conditions for pension reform
The payment of personal income tax by those contributing to a private pension scheme should be deferred until pension benefits from pension funds are received. In other words, contributions payable to pension funds should be exempted from personal income tax and social security contributions.
It is anticipated that the tax burden will reach 35.4 percent in 1998. On average, one third of people’s income will be taken away for redistributive purposes. Social insurance contributions account for about 30 percent of this redistribution. If the tax burden does not decline, people are very unlikely to have enough money to ensure decent retirement provision.
Credible money is one key to a successful pension reform and a viable operation of pension funds. Monetary policy should be reliable and predictable. In early 1997 the Bank of Lithuania adopted a Monetary Policy Programme for 1997-1999 which projects unpegging litas from the US dollar. There is no mention of the principles of monetary policy after the year 2000.
The prospect of having a stable monetary policy and credible money for a period of two years is not sufficient in adopting a major pension reform and shifting to private pension insurance. It would be unreasonable to stake monetary policy on the introduction of a single European currency due to Lithuania’s uncertain prospects of accession. If the stability of national currency is not enshrined in law, emerging pension funds will have to take precautions against currency risk on their own.
Most elderly people in Lithuania are ignorant about private pension funds and the prospects of private retirement provision. So far, all hopes to receive pensions have been associated with social security and probably its improvement. Many people of younger age are fairly sceptical about the public pension scheme. Still, there is little interest in institutions that could help provide for retirement.
Article 52 of the Lithuanian Constitution states that “the state guarantees the right to old-age and disability pensions…” Thus, the Constitution does not allow the state to withdraw from the pension system. On the other hand, it does not specify what pensions should remain the domain of the state. Nor does it indicate under what conditions pensions are guaranteed.
At the present moment company law is not adapted to the operation of fully-funded pension funds. In addition to specific rules applicable to pension funds, there are problems relating to ambiguous division of authority between bodies within legal entities as well as unclear responsibility for fraudulent actions of these bodies. The institution of trust, on which many Western pension funds are based, is under-developed in Lithuania.
Technical conditions for pension reform
No technical barriers to pension reform exist. Private entities are capable of accomplishing the task which is now the responsibility of a public fund.
Fundamental prerequisites for pension reform are in place. Problems that must be solved in order to create a credible pension system have been identified. One of them is the need to secure the safety of assets both in banks and other financial intermediaries performing operations with pension fund resources. A budget reform aimed at lifting the tax burden for market participants must be an integral part of the reform. Stable money is another condition for a viable operation of fully-funded pension insurance. The accomplishment of these goals and a steady approach to reform also requires approval and support of political forces in Lithuania.