ROMANIA: PENSIONS POLICY NOTENovember 11, 2008
ROMANIA: PENSIONS POLICY NOTE[1]
I.Background and Accomplishments
During the first decade of moving towards a market economy, the Romanian pension system underwent several ad-hoc adjustments intended to help cope with transition hardships. Many workers were granted early retirement, leading to a rapid increase in the number of pensioners and increases in pension expenditures. Pension system revenues fell due to restructuring of state enterprises and the increasing informality of labor markets. In an effort to counterbalance this drop, the payroll contribution rate was increased from 14.5% in 1990 to 35% in 2001, without taking into account the possible negative impacts of this policy on labor competitiveness and compliance. Despite the sizable increase in the contribution rate, the pension system started running a deficit in the mid 1990s that was projected to increase to unaffordable levels under the projected aging of the Romanian population.
Recognizing this challenge, the government designed and began implementing the first comprehensive reforms in 2001. Important changes included increasing retirement ages, and the introduction of a new point based benefit formula taking into account the entire work history of the employee, in order to strengthen the link between contributions and benefits. In 2004, a second wave of reforms was introduced under the Action Plan for the consolidation of the public pensions system, approved as part of the PAL program. The plan, which was only partially implemented until 2007, strove to: a) improve the structure of benefits by externalizing the non-contributory benefits to other sources of financing (e.g. moving farmers’ pensions and dependent child benefits to the state budget and sick leave benefits to the health insurance fund); b) restore system equity by recalculating the pension benefits of those retired before 2001, using the point based benefit formula; c) improve the benefits adjustment framework by switching from wage indexation to price indexation; and, d) reduce the cost of labor by lowering the contribution rate to 29.75% of payroll.
These actions, combined with better revenue collection performance and supported by steady economic growth, improved pension system financial performance sufficiently to achieve a fragile surplus of 0.3% in 2006 and 0.2% in 2007 (Table 1).
Table 1. Pension Fund Indicators (% of GDP)
2001 / 2002 / 2003 / 2004 / 2005 / 2006 / 2007Revenues* / 6.33 / 6.18 / 6.15 / 6.06 / 6.08 / 5.7 / 5.9
Expenditures / 7.2 / 7.0 / 6.5 / 6.8 / 6.3 / 5.4 / 5.7
Balance / -0.87 / -0.82 / -0.35 / -0.74 / -0.22 / 0.3 / 0.2
*MinusState Subsidy
Source: CNPAS
Had the Romanian pensions system continued to operate in line with the 2004 reforms, the projected medium and long-term fiscal balance would have probably been affordable even in the case of a indexation of benefits beyond inflation.[2]The simulations conducted by the Bank in 2006 (Figure 1), present the financial balance of the public pensions fund,using two different benefit indexation assumptions: (i) 150 percent indexation of benefits against inflation beginning with 2009 (Baseline 1); and (ii) full indexation of benefits against inflation beginning with 2009 (Baseline 2). Notably, in the short run, these projections were already confirmed by the reality of the last two years (2006 and 2007), when the above mentioned surplus was achieved.
Figure 1: Pension PAYG Balance Based on 2004 Reforms Using Different Indexation Assumptions
Source: World Bank PROST simulations 2006
The improved fiscal sustainability as a result of these measures came at the expense of pension benefits. As Figure 2 shows, the level of old age pensions relative tothe average wage was expected to fall over the projection period.
In 2006, the Government introduced a mandatory fully funded, defined contribution second pillar that became functional in May 2008. The second pillar allows workers to put a portion of their pension contribution into an individual, funded account with the worker at retirement receiving a reduced public pension plus an additional pension from the contributions and investment earnings in the funded account. The contribution rates to the funded pillar will gradually rise from 2% of wage in 2008 to 6% of wage in 2016. Currently, there are fourteen private pension funds operating in Romania with a total number of 4,409,755 registered participants. [3]
Figure 2: Benefit Rates Resulting from 2004 Reforms
Source: World Bank PROST simulations, 2006
II.Key Issues and Challenges
Despite progress in pension system reforms, the combination of recent increases in benefit levels, the aging of the population, and the absence of a rule for benefit indexation has once again brought the system’s long term financial sustainability into question. Under the current parameters of the pensions system, Romanian pension benefits compare very favorably to both world averages and many ECA countries. At the same time, the system’s high contribution levels are a disincentive to formal employment and the establishment of businesses within the formal sector. These issues are covered in greater detail below.
Sizable Increase in Pensions and Absence of a Rule for Benefit Indexation are Straining System Finances. In order to address declining benefits levels, Parliament in 2007 approved a generous pension increase program which led to the reversal of some of the above mentioned reforms. This program has been implemented in two phases: a) beginning in November 2007, the pension point value was increased to 37.5% of the average gross wage from a level of approximately 30% of average gross wage; and b) beginning in October 2008, the pension point value was further increased to 45% of the average gross wage.[4] Moreover, the recently approved increase of the number of pension points for retirees that work in hazardous conditions (work groups I and II as defined by pension legislation), also applicable to future retirees, will further worsen the pension system fiscal balance.
Figure 3 presents the resulting replacement rates as a percent of the average wage under three scenarios. The assumptions used under these scenarios are presented in Annex 2. In all three scenarios, the benefits from the second pillar are assumed to be indexed to inflation. As expected, replacement rates under the pension increases (Scenario 2) are higher than the replacement rates with inflation indexation of pensions (Scenario 1). Average replacement rates further improve with the increase in the number of points earned by workers in work groups 1 and 2(Scenario 3).
Figure 3:Average Replacement Rates of the Pension System under Different Scenarios
It should be noted that the replacement rates presented are gross replacement rates, meaning that they are calculated relative to gross wages and do not take into consideration the taxes and contributions paid by individuals. The average worker earning these wages makes contributions for pensions and for health insurance, and pays taxes out of his income, making the pension a much higher percentage of the take home salary of the average worker. Therefore, a net replacement rate that takes into consideration taxes and contributions paid is a better indicator for evaluating retirement income adequacy.
In order to allow for comparison of Romanian replacement rates with those of other countries in the region, stylized replacement rates were produced. Figure 4 presents the comparison of the net replacement rates for full career male workers in the time of retirement in Romania with net replacement rates in selected countries of Central, Eastern and Southern Europe along with ECA and World Averages. Pre-retirement income is expressed relative to the economy wide average wage. An examination of the net replacement rates indicates that net replacement rates provided by the Romanian pension system are higher than the ECA and World Averages and among the highest of the select countries presented. [5]
Once workers retire, their pensions are adjusted based on the indexation rules of the pension system. Therefore, indexation of benefits after retirement is an important factor in defining the level of benefits of existing retirees. The replacement rates presented below are for new retirees retiring in 2040 and hence do not include the impact of indexation. However, given that the current wage indexation rule in Romania is more generous than all the countries presented below (except Slovenia) and the benefits levels relative to wages will be maintained, the analysis above will not change the fact that replacement rates in Romania are more generous than most other countries.
Figure 4:Net Replacement Rates for Full Career Male Workers Retiring in 2040 under Stylized Assumptions
Source:Holzmann and Guven, 2008
Sizable increases in the pension point value (hence a generous indexation of benefits), will cause substantial financial deficits as early as 2009. These deficits are projected to accelerate and continue for the next 35 years before declining somewhat. If the current point value as percentage of average gross wage (45%) is maintained (a de facto return to full wage indexation of pensions), the fiscal deficit is projected to be 2.3% at the end of the projection horizon and will reach a level as high as 5.5% of GDP in 2040. Figure 5 presents the projected fiscal deficit that would be caused by the above mentioned pension increase program (Scenario 2), compared with the fiscal balance that could have been achieved if the 2004 reforms would have been maintained (Scenario1). The fiscal situation further deteriorates when the additional points awarded to workers in work groups 1 and 2 are taken into consideration (Scenario 3). Such a high deficit coupled with the possible negative effects of the international financial crisis may jeopardize ambitions for continued integration and income convergence with the EU.[6]
Figure 5: Fiscal Balance after Increases in Pensions
The absence of a stable pensions benefit indexation frameworkalso makes the pension system extremely vulnerable, inviting political pressure from rent-seeking groups. This increases the risk that the system will once more fall into a vicious cycle of ad-hoc, politically-accommodating decisions that could lead to its complete failure, especially since benefit determination rules themselves are overly flexible due to vaguely defined point values. The result is substantial and unnecessary uncertainty for all system participants, and for the country’s fiscal outlook.
High Contribution Rates SpurGrowth of Informal Employment. As previously mentioned, the contribution rate for the public pensions fund reached 35% in 2001. Although the contribution rate was then decreased to 29% in December 2007, it still remains high by international standards. Moreover, aggregate social insurance charges (pensions, health, unemployment, and work injury) count for almost 44.5% of gross average wages, making the Romanian workforce one of the most heavily taxed in Central and Eastern Europe. High payroll taxes increase non-wage labor costs and can have adverse consequences, contributing to high informal employment, and hence to low coverage of the public pension plan. Low public pension coverage, in turn,will leave many without access to pensions, increasing the risk of poverty in old-age.
Low Retirement Ages Increase Fiscal Pressures. The reforms introduced in 2001 gradually increase retirement ages from 55/60 to 60/65 for women and men respectively in 2014. For men, life expectancy at retirement is 13.5 years, making it difficult to increase the retirement age beyond the legislated gradual increase. For women, however, life expectancy in retirement is 20.9 years and will only go down to 20.6 years in 2014 when the retirement age reaches 60. Current retirement rules raise both the issue of gender equity, and are adding to the fiscal pressures on the pension system. As shown in Box 1, most OECD countries have equalized retirement ages between men and women, and many have increased the retirement age.
Box1: RETIREMENT AGES AND PENSION INDEXATION IN THE OECD COUNTRIESRetirement Ages in the OECD Countries
Most OECD countries have a standard retirement age of 65 for men. In Iceland, Norway and the United States, the retirement age is either 67 or it is being increased to this age. Denmark, Germany and UK are in the process of legislating increases.
Most OECD countries have equalized or in the process of equalizing retirement ages for men and women at age 65. These countries include Australia, Belgium, Canada, Denmark, Finland, Germany, Greece, Italy, Japan, Luxembourg, Netherlands, New Zealand, Portugal, Spain, Sweden, and UK. In Iceland, Norway and United States, retirement ages are equalized at 67 while in Ireland the retirement age is equalized at 66. (Annex 3)
Pension Indexation in the OECD Countries
Most OECD countries that have an earnings related first pillar pension scheme link the adjustment of pensions to prices. These countries include Belgium, Canada, France, Japan, Korea, Spain, Turkey, United Kingdom and United States. Some countries such as Finland, Hungary, Poland, SlovakRepublic, and Switzerlandhave adopted indexation to a mix of price and wage inflation, as pioneered by Switzerland. In some countries such as Germany, Netherlands, Luxembourg, and Norway, the adjustment is based on increases in wages.
Source: (Pensions at a Glance, OECD, 2007).
The Possibility of Generous Early Retirement Provides Incentive for Workers to Leave Formal Sector Employment. The level of benefits in case of early retirement is still high compared with the level of full pensions, and becomes an incentive for more and more people to retire early and to continue to work thereafter (often in the informal sector). The eligibility criteria for early retirement due to health reasons are very permissive and in the absence of a strong enforcement of the control mechanisms, the number of these retirees has increased significantly over the years, from 8.1% of the total number of pensioners in 1990, to19.0% in 2008.
Limited Administrative Capacity. Although a considerable amount of training has been provided to the staff of the institutions responsible for the design and administration of the pensions system, there are still areas where necessary expertise is missing. For example, the actuarial capacity of pension system administrators, which would enable them to prepare accurate projections of the fiscal implications of reforms is limited.
Need for Improved Information SystemsThe Government is currently developing and implementing several information technology and communications (ITC) systems, but their integration has not yet been achieved. The National House of Pensions has built-up (with the Bank’s support) a new ITC system designed to provide data and information management for individual worker contributions and for pensions benefits, but it does not yet incorporate all the legislative changes from the last three years. Although a module for recording and allocating individual contributions to the mandatory private pillar was developed, its utility is conditioned by the reconciliation of data on individual accounts of contributions collected by the Agency for Fiscal Administration (ANAF). Until ANAF implements its new ITC system, currently under development, the flow of contributions from CNPAS to the mandatory private and of relevant information will not be accurate.
- Inter-Sectoral Linkages
There are clear and important linkages between pension system policy, social assistance, labor markets, overall economic growth, and budgetary/fiscal constraints. Unless expenditures on pension benefits are brought under control, they are likely to place a significant and growing burden on government budgets. High contribution rates increase the cost of doing business and may push workers towards migration to other EU countries with a lower tax burden. Generous early retirement benefits and high contribution rates also push workers toward informal sector jobs, further exacerbating labor market shortages. Labor market shortages, in turn, can constrain growth, while fewer workers in formal sector jobs undercuts the financial sustainability of the pension system itself. A drop in those eligible for formal pension system coverage also leaves a growing number of Romanians vulnerable to slipping into poverty in their elder years, an issue that social assistance programs will need to address.
- Policy Options/Recommendations
The following actions could be undertaken to improve the efficiency of the pension system and to improve fiscal sustainability:
Increase Retirement Ages. Retirement ages for women could be increased to equalize women retirement ages with that of men, followed by increases in retirement ages for both men and women in line with changes in life expectancy.
Put in Place a Rule for Indexation of Benefits. The current law could be amended to ensure that full and transparent price indexation is implemented, rather than tying benefit adjustments to wage-adjusted points. In cases of high real wage growth, if pensions are indexed to inflation only, the living standards of pensioners lag too far behind that of workers. In order to address the impact of the declining value of pensions relative to wages, we recommend legislating the pension indexation such that it will include some component of wage growth if the wage growth exceeds a certain level, for example 10% or maybe 5%. This allows flexibility to accommodate the current high wage growth period without jeopardizing long-run fiscal sustainability.
The fiscal improvement as a result of indexing benefits to inflation and increasing the retirement age (Scenario 4) is presented in Figure 6. Retirement ages are increased such that the retirement age for women and men is equalized at 65 in 2014. After 2014, the retirement ages are increased based on changes in life expectancy until the retirement age reaches 68 in 2045 and is kept at 68 thereafter. The fiscal situation significantly improves in Scenario 4 compared to Scenario 3 that reflects the current situation.
Figure 6:Fiscal Balance of the Pension System under Different Scenarios
The replacement rates under different scenarios including Scenario 4 where benefits are indexed to inflation and retirement ages are equalized for men and women and increased based on life expectancy changes thereafter are presented in Figure 7. The replacement rates in Scenario 3 compared to Scenario 1 are quite similar. In fact, the replacement rates towards the end of the projection horizon are higher in Scenario 3 than in Scenario 1 although the deficit in Scenario 3 is lower than in Scenario 1 due to the increase in retirement age. It is important to note once again that these are gross replacement rates and that net replacement rates will be higher.