The new sustainability factor of the public pension system in Spain

Rafael Doménech, Víctor Pérez-Díaz, 11 December 2013

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As in many other European countries, long-term trends in population growth and life expectancy in Spain make the current pay-as-you-go pension system unsustainable. A later baby boom and a recent immigration wave help explain why Spain has postponed the implementation of reforms already introduced in other European countries in the 1990s (see, for example, Chapter 1 of OECD 2012). A deep economic crisis has now revealed how dramatic the scenario really is. Whereas the number of pensioners will grow from nine million today to 15 million in 2050, the working-age population is expected to remain around the same (Instituto Nacional de Estadística 2012). A reform in 2011 that introduced parametric changes and a commitment to a sustainability factor by 2027 has not been sufficient (see De la Fuente and Doménech 2013, and the references therein). The second recession following the sovereign debt crisis made it clear that, as a result of the large increase in the unemployment rate (close to 27% in 2013), the expected deficit of Social Security would be equivalent to 1.5% of GDP – one-third of this being structural.

Responding to this challenge and to strong pressures from financial markets, the European Commission, and Spain’s European partners, the Spanish government mustered the resolve to design and introduce a sustainability factor for the pension system. In April 2013 it set up a Committee of Experts, which issued a report by early June defining a sustainability factor to be implemented beginning in 2014.

The sustainability factor as defined by the Committee of Experts

The sustainability factor proposed by the Committee consists of two adjusting components. The first is the Intergenerational Equity Factor for new retirement pensions. As in other European countries, this factor adjusts the initial pension according to a coefficient that is the result of dividing the life expectancy of those who have entered the system at a specific age at an earlier date by that of the new pensioners who enter retirement at the same age but at a later date. Figure 1 shows the 2014–2050 projection of this ratio of life expectancies at age 65. It is clear that the application of the Intergenerational Equity Factor would imply a downward adjustment in the calculation of the initial pension, with an average cut of 5% every ten years.

The second component is the Annual Growth Factor – a new indexation system to be applied each year to all pensions. As explained in the Annex, the revalorisation of pensions will be given by the difference between the nominal growth rate of social-security contributions and the growth rate of expenditures if pensions were not updated. The latter term is just the sum of the growth rate of the number of pensioners and the growth of the average pension due to replacement effects, as a result of the differences between the pensions of the new pensioners and of those leaving the system. In those situations in which the social-security system is not structurally balanced, the Annual Growth Factor also includes an additional term that corrects the cyclically-adjusted budget imbalances over time. All variables in the Annual Growth Factor are cyclically adjusted using centred moving averages of 11 years, implying the use of forecasts for six years.

Notice that, by construction, current pensions would improve their purchasing power if the real rate of growth of revenues (contributions) is greater than the sum of the growth in the number of pensions plus the replacement effect.

Figure 2 presents the four components of the Annual Growth Factor. According to the trend components estimated for 2014, the revalorisation of pensions for that year should be -2.57%.1

Figure 1. Intergenerational Equity Factor. Reference age: 65 years (2014=1)

Sources: Instituto Nacional de Estadística 2012 and Committee of Experts on the Sustainability Factor of the Public Pension System

Figure 2. Components of the Annual Growth Factor

Sources: Ministry of Employment and Social Security, Stability Programme 2013–2016 and own calculations.

The public debate and the social options open by the application of the factor

In September 2013 the government put forward its own variant of the sustainability factor, well within the range of the options recommended by the Committee.2 The debate, now open for trade unions, business associations, political parties, and the Parliament, seems in its final stage. It is taking place in full view of markets, other nations, European authorities, and international institutions – that is, in a context that seemingly suits the deliberative and experimentalist style increasingly characteristic of European governance (Sabel and Zeitlin 2012). This stage should end with a final decision in December 2013, so that reform would be in full force in 2014.

It seems likely that a close variant of the Government’s proposal will be adopted on the basis of its parliamentary majority, after an intense partisan debate. Obviously, there is no guarantee that this majority will last, and the next elections are due no later than November 2015. Since we are talking of a policy to ensure the long-term sustainability of public pensions, if some reasonable variant of that policy is to remain, we need to reflect upon the conditions for such a policy to stand the test of time.

The application of the sustainability factor increases dramatically the range of options for Spanish public policy on the matter. The factor solves one key problem – the financial sustainability of the system in the long run – but keeps open the debate for an ongoing process of pension reform and welfare policies. To begin with, under the new scenario, although the real average pension may grow in the coming decades, the ratio of the average pension to the average wage is likely to fall – and current forecasts suggest that the dependency ratio will increase considerably in the absence of structural reforms that lead to a large increase in the number of contributors.

Spanish society may choose between a combination of the following options to tackle the effects of the increase in the number of pensioners and attenuate the reduction in the ratio between the average pension and the average wage:

1. Increase the number of contributors by creating incentives for prolonging the active life of workers and through structural reforms that promote economic growth, reduce unemployment, and increase the labour force.
2. Increase social security contributions or provide the pension system with resources from other taxes.
3. Make provisions so that the pensions received from the public system are complemented with income from private savings.

Thus, the introduction of the sustainability factor should be the starting point of a debate on a wide range of policies, and changes in the pension system need to be seen in the context of a larger debate on the welfare system as a whole (old age care, health, education, and so on), to promote growth under conditions of increased global competition (Ringen 2007).

This brings us to the crucial role that the Committee assigned to the application of a rule of transparency to the public pension system. The rule is rooted in a commitment to democratic accountability, and should help foster an open debate between well-informed citizens and politicians who are willing to set aside partisan passions and overly tactical considerations. This is lacking in Spain. So, a variety of institutions halfway between civil society and the state (some variant of the Swedish Governmental Commissions, for instance) may be of some help in this regard. In fact, the Spanish Committee was made up mostly by experts with no party, business, or union links.

A commitment to an open and transparent public debate on pensions lies at the very heart of the proposal of the Committee. Citizens should become involved both in the debate and in the practical solutions of the problems of the system. The application of the sustainability factor in a transparent way should reveal on a yearly basis the impending disequilibria or the good health of the system. This requires that citizens get enough aggregate information, certified by an independent agency, on the elements that enter into the two formulas – life expectancy and other demographic factors; the number of contributors and the total amount of contributions; and the number of pensions and their total amount. At the same time, every pensioner (and each contributor) must receive information related to the pension (or an estimate of future pensions) that results from applying the sustainability factor.

References

De la Fuente, A and R Doménech (2013), “The financial impact of Spanish pension reform: A quick estimate”, Journal of Pension Economics and Finance, 12(1): 111–137.

Instituto Nacional de Estadística (2012), “Proyección de la población a largo plazo. Parámetros de evolución demográfica 2012–2051”. 

OECD (2012), OECD Pensions Outlook 2012.

Report by the Committee of Experts on the Sustainability Factor of the Public Pension System.

Ringen, S (2007), What Democracy Is For: On Freedom and Moral Government, Princeton: Princeton University Press.

Sabel, C F and J Zeitlin (2012), Experimentalist Governance in the European Union: Towards a New Architecture, Oxford: Oxford University Press.

Annex

The Annual Growth Factor (g) to be applied in t+1 in given by the following expression:

where gi is the nominal growth rate of revenues (I), gP the growth rate of the number of pensions, and gr the growth of the average pension due to replacement effects, as a result of the differences between the pensions of the new pensioners and of those leaving the system. G is total expenditure in contributory pensions. The coefficient α measures the speed at which cyclically adjusted budget imbalances are corrected.


1 In this example we assume that the Annual Growth Factor corrects every year 1/5 of the cyclically adjusted imbalance estimated for the social security system.

2 In the new law, the Intergenerational Equity Factor is called the Sustanaibility Factor, and will use life expectancy forecasts estimated by the National Institute of Social Security. These forecasts will be updated every five years. The Annual Growth Factor is called the Revalorisation Pension Index, which basically applies the indexation of the Annual Growth Factor with an upper (inflation plus 0.5 percentage points) and a lower limit (0.25 percentage points).

Topics: Europe's nations and regions, Welfare state and social Europe
Tags: accountability, democracy, pensions, Spain, Sustainability, transparency

Rafael Doménech

Chief Economist for Developed Economies, BBVA Research; and Professor of Economics, University of Valencia

Chairman, Analistas Socio-Politicos Research Center