To provide a satisfactory benefit for citizens, countries such as the United States as well as most in the European Union (EU) have linked pension benefits to the rising cost of living. Now, facing severe fiscal constraints, countries are cutting social security spending.
The measures include altering or abolishing the index link, as has happened in Portugal, Greece, Italy and Lithuania. This stripping of the pension-index link can be likened to financial repression, market mechanisms used by governments to reduce debts (see
Taxation by stealth). The problem with ‘retirement repression’ is that it may bring fiscal relief, but could come at significant social cost. People retiring today could wake up in 10 years’ time and realize that benefits no longer cover the costs of living – and it is too late to do anything about it. RENEGING ON PROMISES
Governments and retirees feel the heat as pension benefits threaten to melt away. © Trunk Archive
Indexing serves as insurance to protect retirees from changing economic circumstances. If no adjustment exists, even at low inflation rates, retirees can face a tremendous decline in living standards. For example, the average life-expectancies of 65-year-old citizens of the European Union (EU-27) amounts to 20.7 years for women and 17.2 for men. An annual increase in consumer prices of 3% without indexing means a real purchasing-power loss of 46% for women and 39% for men through the average retirement.
From a budget viewpoint, eliminating pension indexation works like compound interest in reverse. It enables the state to lower pension obligations over time, leading to lower retirement spending. In Italy, scrapping indexation has resulted in a reduction in 2012 of €3.2 billion ($4.19 billion). In 2014, according to the
, the annual saved amount is projected to be € 10.5 billion ($13.7 billion). Such measures help governments gain control of spiraling pension obligations. That is why it was part of many pension reform programs to regain fiscal sustainability. It also shares the burden between generations. Not all costs are placed on the shoulders of the young – today’s retirees also share part of the load, which is why some countries, such as Germany, have applied even more severe measures to pensions, including ‘sustainability factors.’ IMF Country Report No. 12/167, July 2012
Shifting the indexation rule can also threaten the adequacy of a pension. The choice of the index benchmark is crucial to sustaining adequate retirement income. A peg towards prices protects retirees against the loss of purchasing power as benefits change with the costs of living. Indexation to wages results in benefit changes in terms of living standards. This protects the retirees’ relative income level.
In general, wage inflation is assumed to be higher and pension systems that link pensions to earnings are seen as more generous. Most EU countries have shifted their policy to price indexation or at least to a combination of wages and prices. By pegging retiree benefits to the consumer price index (CPI), the relative income of retirees decreases over time, increasing their risk of poverty and social exclusion.
, the theoretical replacement rate of retirees who will have spent 10 years in retirement in 22 member states will fall by at least 5% and in some cases by more than 10%. Poland is the most extreme example, with a benefit drop of 15%. Pension Adequacy in the European Union 2010-2050
The effect is most dramatic if the minimum pension is pegged only to consumer prices. John Piggott, director of the ARC Centre of Excellence in Population Ageing Research (CEPAR) from the University of New South Wales in Australia, noted in a recent interview with PROJECT M.
“First-pillar pensions declined dramatically in the UK because they were price-indexed and not wage-indexed. You could see that coming a long time ago. This runs counter to any notion of long-term guarantees of adequacy in the sense of providing people with enough to get by.”
Wage indexation of pension benefits can provide a rising absolute level of retirement income. However, in some situations, it can also be an inadequacy trap. In peripheral European countries with wage-indexed and partly wage- indexed benefits, the current debt crisis and the pressure it places on unit labor costs could lead to declining living standards for retirees as overall living standards decline.
Other political measures also threaten the adequacy of wage-indexed pensions. Several countries that rely on wage indexation, notably Germany and Sweden, where there was intense discussion about the financial sustainability of the pension system and the burden sharing between generations, have introduced ‘sustainability measures’ that ensure pension indexation lags behind wages.
Between 2001 and 2011, state pensions adjustments in western Germany were consistently below annual inflation. The link between consumer prices and state pensions was decoupled with the introduction of the
Riester-Rente and ‘sustainability’ factors. According to Deutsche Rentenversicherung statistics, in the past 10 years, German retirees saw real purchasing power decline by 8% as measured against official CPI. So, both wage-indexed and partly wage-indexed retirement systems can be prone to retirement repression. Yet, although inadequate in the longer term, a consistent indexation – whether against CPI or wages – is fairer than no indexation at all.
Unless indexed, benefits can become inadequate to sustain retirees above the poverty line. In Italy, as only the minimum pension is now indexed to prices, more and more pensioners will be pushed down to a benefit level that amounts to a social allowance. The government is betting that changes to second- and third-pillar pension provisions (occupational and private provision) will make up the shortfall, but is struggling to create robust systems and tax incentives to do this
There is a compelling, critical fiscal need for countries to temper their ‘pension promise.’ However, to do so without adequately informing citizens or equipping them to make up the shortfall could result in significant social unrest in years to come. Instead of furtively cutting benefits in the future, there are measures that can promote financial sustainability and adequate retirement income today.
To sustain adequacy throughout retirement, the initial pension payment could be lowered and coupled with adequate indexing rules. If this basic mechanism for the adequacy of retirement income is explained to citizens while they’re still working, they can react by working longer and saving more. Lowering initial benefits would reveal the effect of the austerity measure immediately and begin to promote a more financially sustainable pension system.
Currently, 25-50% of people retire before the statutory retirement age. As each additional year worked yields a pension bonus of 26% of retirement income, lower initial benefit payments could incentivize people to work longer. This would promote the financial sustainability of the pension system by increasing the size of the labor force, which means more people contribute longer to the state pension while decreasing the number of people receiving a state pension as well as the length of time they receive it.