Reforming European Pensions: Urgent Action is Needed

European governments cannot afford to underestimate the challenge of the demographic transition currently taking place, according to Professor Tito Boeri of Bocconi University, Milan, and CEPR, speaking at a CEPR/Royal Economic Society discussion meeting on Thursday 3 February. In particular, he argued, public pension systems can no longer bear the full burden of providing pensions and efforts must be made to achieve a more balanced pension programme with a sufficiently large funded component. What is more, pension programmes should no longer encourage early retirement nor should they hamper labour mobility. And there needs to be greater competition in private pension provision.

Professor Boeri discerned four distinct trends feeding into the demographic ‘timebomb’:

•  In future years, there will be a large number of retirees relative to the working population.

• These retirees will live much longer than at present.

• The number of children is falling.

• Workers tend to retire at much younger ages than previous generations.

He went on to argue that:

Time has been lost.

The problem is not demographics per se, but demographics coupled with excessively generous pension systems - both in terms of eligibility rules and in terms of benefits paid out to retirees.

Inevitably someone will have to pay for the public pension burden. 

One option is to increase social security payroll taxes for current workers and firms, which would have negative effects on competitiveness and growth. An alternative is that future generations ‘foot the bill’ for current generations by continued government borrowing. Neither of these outcomes sounds appealing in an economy that intends to promote growth. A third option is that some pension promises are broken. Although such an outcome may endanger the credibility of pension programmes, credibility is also eroded by not taking action when everybody is aware that current arrangements are no longer sustainable. 

The credibility of pension programmes must be restored…

Compulsory contributions to pension systems that are not deemed sustainable can only be viewed by workers as extra taxes, rather than savings for old age, with negative effects on employment. 

…. and restoring credibility means taking a long-term perspective.

Public pension programmes, particularly if they are unfunded (current workers pay for current retirees), lack the flexibility to cope with the demographic transition. A serious risk is that pension reforms take a short-term perspective, because of political constraints. 

What to Reform?

Public pension systems can no longer bear the full burden of providing pensions.

Where necessary, efforts must be made to achieve a more balanced pension programme with a sufficiently large funded component. The major steps to be taken in this respect are:

• Promoting social partnership by involving workers, government and industry in the provision of income for retirement.
  

• Encouraging individual responsibility for retirement saving.
  

• Confining the role of public pension systems mainly to redistributing resources from the lifetime rich to the lifetime poor, and shifting to the other social partners the responsibility for full old-age insurance provision for workers. 

All this does not mean that pension funds and firms should pay the bill for the gaps in building up a pension, but simply that workers will have more freedom to decide on the best use of their money.

An ageing Europe needs to retain workers in the workforce when they reach the peak of their seniority: pension programmes should no longer encourage early retirement. 

Pension arrangements should not hamper labour mobility. Workers should be able to move freely across jobs. Hence long vesting periods should be avoided (rights to receive a benefit should be made readily available), and the build-up of pension rights should be protected while the transferability of pension rights both within a country and between countries should be guaranteed. Most of all, the taxation of pension funds should not be an obstacle to portability of pension rights.

Workers and firms can join forces and exploit ‘global’ market opportunities in order to provide higher standards of living to workers in their old age. It should be stressed that global investment is the key to achieving flexibility of pension programmes vis-à-vis demographic and political crises: this is exactly where unfunded pension systems fail. 

Global diversification of resources accumulated for retirement provision can be achieved only if there are no barriers to capital movements within the ‘prudent man’ framework. Prudential rules are actually inconsistent with national quotas in the allocation of the portfolio of pension funds. 

This also implies allowing greater competition in private pension provision. Hence there should be freedom of contract between sponsoring companies and pension funds and the avoidance of any automatic cost-increasing mechanism being imposed on pension funds (that is, automatic linking of benefits to wages, etc.).

How?

It cannot be denied that reforms have a cost. What is more, resistance to change naturally arises from the fear of being among the losers in the transition from the old system to the new one. Yet, all generations can benefit from a more balanced (that is, more funded) pension programme, if the costs and the benefits of pension reforms are shared. In particular, compensation mechanisms can and should be designed to avoid the middle generations bearing any extra burden caused by changes in the system. This would contribute to winning public support for reform.

Note for Editors: Tito Boeri was speaking at a public meeting on ‘Defusing the Pensions Timebomb: What are the Policy Options?’, organised by CEPR and the Royal Economic Society (RES), and supported by Morgan Stanley Dean Witter.

Boeri is Professor of Economics at Bocconi University in Milan; Director of the Rodolfo de Benedetti Foundation in Milan; a CEPR Research Fellow; and coordinator of a report on pensions commissioned by the European Round Table of Industrialists and due to be presented to Romano Prodi, President of the European Commission, on 14 February.

For Further Information: contact Tito Boeri on 00-39-02-5836-3323 (fax: 00-39-02-5836-3302; email: Boeri@uni-bocconi.it); or RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 0468-661095 (email: romesh@compuserve.com).