pension reform

The Government Starts Building a Financial Pyramid

Sandro Urushadze
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The government of Georgia has put forward an initiative for pension reform. Its high popularity rating gives it the possibility to take such an important decision for the country without providing any explanation to society or holding any public debate on the issue. It plans to establish a model under which mandatory individual contributions will form the pillar of the pension system. "The source of pensions to be issued to citizens will be accumulated through the pension contributions made by them," reads the government program "For a Strong, Democratic, United Georgia." This means that to finance the increased pension liabilities, the government will introduce a system of pay as you go (PAYG). "The accumulative pension system will apply to every citizen of Georgia," said the Minister of Labor, Health Care and Social Affairs of Georgia a couple of days ago.

Today, our population easily trusts promises issued by the ministry, but society must necessarily be informed about the expected results of the government pension plan and the existing political alternatives.
The "new" pension scheme proposed by the government is in fact a relic of a well forgotten past. After the breakup of the Soviet Union, Georgia inherited the very same PAYG system from that country; shortly thereafter, however, it had no other option but to switch to a universal, independent contribution pension model. At that time, this was the only solution to cover pension liabilities and, at the same time, avoid an increase in tax rates and an expected budget crisis.

Today, the country faces the same dilemma. An accumulative pension plan means the same as it did 15 years ago: high tax rates and debts that the government borrows from pensioners to cover its pension expenditures. By the way, two years ago the Finance Ministry also devised such a plan that envisaged establishing a state pension fund which would be financed from mandatory pension contributions. Back then, however, that proposal was rejected as being incompatible with the social and economic climate of the country.

Introducing an accumulative pension model under decreased taxes pursues the aim of funding increased social costs. In 2014, the budget of the Health Care Ministry will be increased to almost three billion GEL, with the lion's share of that intended to cover the increased pensions. The amount earmarked for pensions in the 2014 budget is calculated to cover the already increased pension, worth 150 GEL a month, which means that no further rise in pensions is planned.

Unfortunately, like many other government promises, the model for accumulative pensions is out of touch with the current economic and social context of Georgia. With this promise, the government is creating a new illusion that looks very much like a financial pyramid.

The Health Care Ministry tries to win the hearts of current voters whilst the Finance Ministry tries to finance the budget deficit with increased taxes. As regards current taxpayers, when they reach retirement age and the time for the delivery on the issued promise arrives, a large segment of current politicians will no longer hold their current positions. By that time, our pensions will not depend on the sums contributed by taxpayers over many years, or upon the number of years they have worked, but will again hinge upon those 150 persons sitting in parliament at that time.

Today, approximately 800,000 people in Georgia are employed in the formal sector and pay income tax. It is these people who will be required to pay a new social tax, whereas the remaining 3.5 million citizens, i.e. 80 percent of the entire population, will not be affected by this system and nothing will change for them.

Why has it become necessary to change the existing pension model? What model does Georgia have today? Is a mandatory PAYG pension scheme better? Are there other alternatives? These are the issues of which society must be well informed about in order to objectively assess the new proposal from the ministry.

The existing pension environment

Pensions in Georgia are universal; they do not depend on contributions. They are issued in equal amounts to everyone who meets the requirements for citizenship and permanent residence and has reached the legal retirement age (60 for women and 65 for men). The issuance of pensions are not conditional on any other criterion, for example, the minimum number of years worked in the formal sector or an individual's financial standing.

Pensions financed from general taxes ensure that people of retirement age have a regular income – the system thus pursues the aim of sparing them from poverty.

Pensions are not automatically indexed to the rate of inflation, but they periodically increase (the last increase took place on 1 September) and, moreover, they do so at an even higher rate than the nominal Gross Domestic Product (GDP) does (10 times faster during the past decade).

The size of the old age pension comes to almost one fifth of the average salary.

The population of Georgia is aging, something caused by decreased birth rates and increased life expectancy.

Old age pensioners comprise 18% of the population (the average of OSCE countries is 15%) and, according to existing forecasts, this indicator will reach 25% by 2025. The indicator showing the dependence of pensioners on employed people is high (1.4 pensioners per employee); as is the indicator of people employed in the informal sector (>65%), which means doubled pressure on the existing and future pension system.

The share of pension expenditures exceeds 3% of GDP. Since all social costs are covered from general budget revenues and no liabilities are left uncovered by the state, Georgia has not accumulated the so-called hidden pension debt.

According to the most recent data from the World Bank, the poverty indicator for Georgia in 2007 was at 23.6% whilst the indicator of extreme poverty stood at 9.3%. Pensions, along with targeted social assistance, are an effective instrument for reducing poverty.

Options for pension reform

There is no ready-made recipe for tackling problems in the pension system. Here I will provide an outline of the key characteristics of different pension models existing worldwide to illuminate those factors that should be taken into account when considering pension reform.

Germany's way – a contributions-based PAYG system

Under the PAYG system, current employees pay the pensions of the current pensioners. Payment is mandatory for each and every employee. This creates a problem when the total number of pensioners rises relative to the total number of employees and the indicators of economic growth are not sufficient to cover the deficit. In such a case, the state has to finance the deficit. This increases the pension debt and threatens the economy with fiscal instability.

Given that contributions to the pension fund are mandatory for all employees, the current generation will have to pay twice in order to finance the pensions of the current pensioners and their own when they retire in the future. Thus, current employees will have to carry the additional burden of increased costs. By various estimates, it will become necessary to increase the current rate of income tax by at least 50%.

To balance pension costs with contributions, the system has to collect more payments from existing employees and, due to the lack of a direct link between the tax and the final benefit, the pension contribution will thus acquire the meaning of an increased tax. All this will push up unemployment and encourage illegal/informal activity.

The formal sector, which employs 65% of total employed people will, naturally, be unwilling to co-finance pension contributions of their employees and thus motivations for informal activity will only increase.

The PAYG system does not create any assets that can be used as investments. At the same time, this system requires additional administrative costs for performing such tasks as registering pension scheme participants and calculating contributions and outlays.

Today, the hidden pension debt of leading European countries exceeds the GDP of those countries many times over. To avoid financial catastrophe, the majority of EU countries that operate accumulative pension systems have responded to fiscal problems in their pension systems by constant parametric and systemic reforms. However, the examples of Greece, Ireland and many other countries prove that this often does not work.

For example, Germany plans to raise the retirement age from 65 to 67 (for comparison, in Georgia it is 60 for women and 65 for men). It also intends to increase the pension contribution to 20% beginning in 2020, and to 22% from 2030 (for comparison, in Georgia this indicator is 0%). It is noteworthy that Germany spends 11.4% of its GDP on pension outlays, while the similar average indicator of OSCE countries stands at 7.2% (for comparison, in Georgia it is at 3%).

Chile's way – private pension accounts

On 4 November 1981, Chile introduced a revolutionary and novel approach to pensions as a result of its social security reforms. The novelty provided every employee with the choice of paying 10% of their salary into a private pension account rather than contributing to the state's pension system. Chile was the first country that switched from a PAYG system to a funded pension scheme.

Funded pensions are financed from private contributions that employees pay into their personal pension accounts. Under the funded model, the size of a future pension depends on the total amount of contributions a future pensioner makes and the size of return a pensioner receives for his/her contributions being used as investments.

The funded system is a fairer pension scheme because the benefits received depend on the total contribution. Funded systems better respond to the challenges related to the aging of the population, even more so as it has lower liabilities. This model does not adversely affect the labor market. It encourages private savings and contributes to the development of the capital market. This model also decreases the risk of the pension system being politicized.

The funded pension model does not create state liabilities, but shifts investment risk onto employees.

After the reform in Chile more than 10 countries opted for a funded pension system and scrapped the PAYG system. Armenia is one of the most recent examples of a country having done so. Georgia also has the experience of reforming the PAYG system it inherited from the Soviet Union.

In general, there are lots of examples of countries reforming PAYG systems into funded systems; however, one cannot find any example of a country reinstating a PAYG system. Unfortunately, as a result of the government's thoughtless plan, Georgia may well become the first such country.

New Zealand's way – universal pensions

New Zealand belongs to the category of those countries that rejected the establishment of a mandatory payment-based pension system. Like Georgia, New Zealand also operates a universal basic pension system for the elderly and it sees no need to erect another mandatory pension pillar.

The government finances pensions of all people aged 65 or older. The annual size of a pension stands at 18,954 USD and the pension costs are financed from general taxes.

Along with a universal pension scheme, a private accumulative scheme is also operative. Participants in this scheme choose the size of their contribution, from either 2%, 4% or 8% of their salaries. Employers are obliged to co-finance this to the amount of 2%.

Nine countries and one big city pay universal pensions on the basis of only citizenship, place of residence and age. These are: New Zealand, Namibia, Botswana, Bolivia, Nepal, Samoa, Brunei, Kosovo, Mauritania, and Mexico City. The universal pension system applies indiscriminately to elderly citizens. As Georgia is among these countries, its "assistance oriented" model is certainly not unique, as some experts claim.

What should we do?

The pension system of Georgia faces serious challenges: the economy has come to a standstill, the demographic structure is deteriorating, the size of the informal sector is large, the ratio of pension beneficiaries to taxpayers is low, political pressure is strong and the expectations of the population about a further increase in pensions are high. In response, the government plans to restore the PAYG system, but has not properly evaluated those risks threatening the country's financial system.

There is no evidence today that the PAYG system is the best option for Georgia. It is, therefore, necessary to consider all other options. Society must be kept informed about expected changes to the pension system and pension-related expectations must not become a subject of political speculation.

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