How decisions taken in 2007 continue to shape the pension reform narrative

Last Updated on Thursday, 15 June, 2023 at 2:44 pm by Andre Camilleri

The 2004 pension reform group’s terms of reference focused on achieving a sustainable and adequate pension for future generations. In setting up the framework for reform, the group sought to address several strategic questions. The decisions made to these questions continue to shape the narrative of pension reform today. I shall focus on three.

First. What should the goals of reform be? These were easy to identify at their essence: to avert the collapse of the pension system by rendering it solvent and sustainable and by providing an adequate pension to future generations. As mentioned in previous articles, pension adequacy for future generations was expected to collapse to 16% by 2050 with the PAYG bankrupt.

Second. How would the reforms be implemented? Were they to be implemented and introduced within a short period (vide the reforms in France) or were they to be phased and introduced incrementally, enabling them to be absorbed smoothly without major social shocks? If the latter, how would the reforms be phased in terms of their impacts on retirees, people nearing retirement and future generations?

Third. Which population cohort among those already in the labour market would be defined as “future” generations?

To a large extent, the responses to these questions were intertwined and required compromises and trade-offs.

The reformers determined that future generations would receive pension adequacy equal to that enjoyed by retirees and persons who would be retiring by 2020 – and in doing so, ensuring that the system can sustain such adequacy in terms of a pension deficit as a percentage of the GDP. This was the minimum objective that the reformers sought to balance adequacy and sustainability for future generations. Adequacy is technically defined by the average pension replacement rate (APPR), the relationship between the average pension income and the average wage. For retirees and persons retiring between 2004 and 2020, this was projected to be 54%. To achieve this 54% adequacy rate reforms, measures were directed towards boosting adequacy while securing sustainability. Two countervailing forces are working against each other.

The reforms towards sustainability consisted of tough changes to the architecture of the PAYG: an increase in the retirement age from 61 to 65 years, increases in contribution accumulation from 30 to 40 years and changing the pension income calculation formula to the best 10 out of 40 years, among others. On the adequacy side, the most important reform was the need to ensure that both the maximum pension threshold on which the 2/3rd pension is calculated and the pension income are both annually adjusted so that pension income, and hence adequacy, increase over time. It is pertinent to remember that between 1979 and 2004, the maximum pension threshold, which in 1979 was pegged to the President’s salary, increased only once from €13,980 to €15,720 while wages generally and the President’s salary respectively increased many times over.

The solution in this regard was to graft onto the PAYG an indexation mechanism. There are three main options: pegged to retail inflation, pegged to wage inflation and a hybrid. In the modelling carried out, an indexation mechanism pegged to retail inflation alone boosted the adequacy rate for future pensioners to 35% – below the World Bank minimum adequacy level of 40% and far less than the 54% minimum stated objective we had set. An indexation mechanism pegged to wage inflation alone rendered the system unsustainable. The modelling showed a sustainable indexation mechanism would be a hybrid of 70% wage and 30% retail inflation. However, the problem with this indexation is that pension adequacy only boosted the APPR to 45%. This would render future generations 9% poorer than their counterparts retiring by 2020. The problem facing the reformers was that the minimum stated adequacy goal for future pensioners would not be achieved with parametric changes to the PAYG alone. The question, therefore, was: how to bridge this 9% gap between future generations and current pensioners?

The solution opted for at the time was that the 9% gap would be bridged through a mandatory second pension. This decision, one could say, positioned what the reformers would define as “future generations”, how the reforms would be phased and how different cohorts of persons would be impacted. Determining who should be exempted from the negative aspects of the reform (the parametric changes but also contributing to a mandatory second pension) was the easiest of all. We believed there should be no changes to the social contract of persons close to retirement. The line was drawn at 55 years of age from when the government implements, if at all, the recommendations proposed. Indeed concerning this cohort of persons, two positive measures were introduced: a mechanism to have the maximum pension increased annually by retail inflation and removing the cap on pension income if they continued to be active in employment post-retirement.

The definition of who would be defined as a future generation stemmed from two considerations. The first was how long it would take a person to accumulate a fund to bridge the 9% adequacy gap. The second was to ensure a sufficient buffer for an accumulated fund to recover in a financial shock. The period identified was 20 years – through employees and employers each paying a contribution rate of 4% that is reached over 10 years. This meant that given that we recommended that the statutory retirement age for future generations would be increased to 65 years, then future generations of persons would be those who would be 45 years and younger when the reforms were introduced: that is, all of the negative parametric changes to the PAYG, a 4% annual contribution to a second mandatory pension and an indexation mechanism of 70% wage inflation: 30% retail inflation. We further proposed that the reform would impact in-betweens, that is persons aged between 46 to 54 years depending on how close they were to these two poles: less so if closer to 55 and more so if closer to 55 years.

We presented the recommendations to the government in 2005. The government enacted the reforms in 2007 and the demarcation line of what constituted a future generation was set: 20 years from 2007 being people born on and after 1962. The problem, however, is that the government cherry-picked the reforms. Faced with harsh criticism from all and sundry, the government immediately made it clear that it would not embrace a mandatory second pension. In doing so, the government made the worst of two worlds: future generations would still be significantly poorer compared to their counterparts retiring in 2020 and difficult to explain to those born in 1961 why the 70% wage inflation: 30% retail inflation indexation was also not applied to them.

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