23 June 2004

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Tenets for pension reform in Malta

Family and Social Solidarity Minister Dolores Cristina recently delved into a number of issues related to pension reform – including the effects of population ageing on economic development, government revenue and expenditure, savings and investments, labour supply, and the EU’s open method of co-ordination as a guide to pension reform - at a recent Business Times/Radisson Business Breakfast. Following is her wide ranging address.

The system of retirement pensions in a country is expected to address the issue of income generation in old age in a manner which is economically efficient and sustainable, socially equitable, and transparent. There is a widespread notion that the system of pensions in Malta will fail to meet these objectives in the near future. This is because it operates on a Pay-As-You-Go (PAYG) system whereby pension benefits are financed out of contributions in concurrent periods. As the population is rapidly ageing, the system could face financial difficulties as contribution revenues will be insufficient to cover benefit expenditures. This would lead to a possible increase in contribution rates, effectively increasing costs of production in the economy, the lowering of pension benefits, with important consequences on social equity and on political stability, or higher fiscal deficits, which would threaten the long run sustainability of the economy and the achievement of commitments arising out of EU membership. It is to be further noted that the present system entails an in-built element of capping of pension benefits and contributions, which may hinder it from providing adequate pensions in future.

The effects of population ageing on economic development
The first half of this century will be characterised by the ageing population phenomenon, reflecting the persistent downward trends in birth and death rates over the past fifty years. To cite but one example, the share of elderly people in the overall population of the EU will double to 30 per cent by 2050. Similar trends are expected in the rest of the developed world.
Malta will also experience this demographic phenomenon. Before the 1940’s both birth rates and death rates were very high in our country. After the Second World War, however, death rates began to decline considerably, in part reflecting the large fall in infant mortality rates. Birth rates did not adjust at once to this last development, with the result that Malta’s population expanded sharply, leading to high unemployment levels and, in turn, to the last big emigration drives of the 1950’s and 1960’s. After this ‘Baby Boom’, however, the birth rate declined steadily, to such an extent that at present it stands at about a third of its level in 1950. At the same time, life expectancy started to improve as a result of increased economic prosperity and better access to health care.
Thus when in the early decades of this century, the Maltese ‘Baby Boom’ generation starts to reach retirement age, our country will have to support a larger proportion of elderly who will live longer than their predecessors. The number of persons aged over 60 is expected to rise by nearly 40,000 to 103,000 in 2020, representing a quarter of the Maltese population. Meanwhile, due to the decline in birth rates, the working-age population will drop slightly from its present level. According to these demographic projections, the support ratio – the number of persons of working age to the dependent population – is set to fall from just under four at present, to slightly above two, by 2020.
This process of population ageing is expected to have wide-ranging and long lasting economic effects, involving not just government revenue and expenditure, but also national saving and investment, as well as the labour market, and consequently economic development. Economic policy-makers must adopt appropriate fiscal, monetary, and supply-side measures to face the challenges posed by population ageing. This will no doubt involve making choices, some of which may have unpleasant consequences in the short run but which are essential for long term economic development.

Government revenue and expenditure
The main issue that comes to mind when mentioning population ageing is its impact on government finances. Most countries, including Malta, presently run pay-as-you-go pension systems whereby benefits to retirees are paid out of contributions from current workers. Population ageing will financially strain pay-as-you go systems by reducing the number of contributors relative to beneficiaries. In Italy and Germany, for instance, spending on the pay-as-you-go system as a share of GDP is expected to peak at around 16 percent by 2030. Ageing will also entail increased government expenditure on health, and especially on the care of the elderly.
The impact of increased social security commitments shouldered by government on public finances was already evident during the 1990s, even though the full effects of population ageing still lie some years ahead. Throughout the decade, expenditure on social security absorbed close to 30 per cent of Government revenues, and is now close to Lm200 million. Contributions received from employers, employees and the self-employed fall short of total social security expenditure by around Lm60 million, which corresponds to around two-thirds of the entire fiscal deficit. This, within the context of a fiscal position where government revenue falls short of structurally-ingrained expenditures that have acquired the character of fixed outlays, including wages and salaries and social security expenditure itself. While the efforts currently being undertaken to consolidate the fiscal position should bear fruits over the next few years, the ageing phenomenon will pose a major financing challenge to the Exchequer.
The consequent increase in demands on fiscal resources may produce three outcomes. Firstly, if no action is undertaken, there could be an increase in the fiscal deficit, fuelling a greater demand for imports, and thus leading to pressures on the balance of payments and the exchange rate. Secondly, there could be an increase in taxation, including national insurance contributions to avoid fiscal expansion, but possibly at the cost of placing further burdens on the economy’s productive base, thereby hurting competitiveness. Thirdly, there could be a reduction in other forms of government expenditure. This would be desirable if it eliminates waste, but should not compromise essential spending of a productive and investment nature, including that on education. Thus the ageing process will require the establishment of priorities in government expenditure and involve making hard choices between various worthy social objectives.

Saving and investment
Changes in the age distribution of the population are expected to affect a country’s rate of private consumption and saving. The ‘life-cycle hypothesis’ suggests that individuals aim to smoothen consumption over their lifetime, such that a person saves during the working career in order to finance consumption during retirement. A greater proportion of elderly people is thus expected to reduce national saving rates. OECD studies, in fact, point to a reduction in saving rates of between 5 and 12 percentage points of GNP over the period 1980 to 2025. Such a contraction would lead to a vicious circle, as higher interest rates would reduce investment, adversely affecting economic growth, and in turn the ability to finance social security commitments.
The consideration of future developments in saving is particularly relevant in the case of Malta, where notwithstanding that the ageing process is still far from its peak level, the gross national saving rate in 2003 stood at 15 per cent of GDP, down from 27 per cent of GDP in 1989. Household savings decline, as well as the financial burdens experienced in the process of budgetary consolidation, were great contributors. Whilst the decline in household savings (the latter development) may be a short-term reaction to the changes effected in the indirect tax system and possibly the factoring in of the liberalisation of the financial sector, it is also probably true that the prospect of a pay-as-you go State pension upon retirement decreases the motive for household saving.

Labour supply
The drop in fertility rates is expected to adversely affect the supply of labour and its quality. A smaller labour force would act as a drag to potential output growth, and impact negatively on competitiveness by tightening labour market conditions, leading to upward pressures on wages and inflation. An older work force is also likely to be less mobile and flexible, albeit more experienced.
The Maltese labour market is presently characterised by two major, somewhat related features – underground economic activity and the low participation of females in the labour force according to official statistics. Both of these factors are decreasing the effective formal labour supply, thus contributing to tighter labour market conditions. The possibility of undertaking underground economic activity may be leading to a misallocation of resources and lowering potential output, as underground production due to the small size of enterprises does not benefit from economies of scale. At the same time, a greater participation of females in the labour market may also remedy the drop in the working age population brought by lower fertility. Female participation at present stands at around 37 per cent, compared to nearly 80 per cent in the case of males. It is often contended that National Insurance contributions payable under the present pay-as-you-go scheme are perceived as a form of tax that is unrelated to eventual benefits received. It is best avoided either through work in the informal economy, or by abstaining from labour market participation.
The EU open method of co-ordination as a guide to pension reform
Population ageing may be seen as a negative supply shock on the economy, of which the effects on fiscal finances are but a manifestation. It is expected to hamper the economy’s productive base and its competitiveness.

The adverse effects of the reduction in output are expected to be compounded by higher consumption, which is expected to crowd out investment expenditure and exert pressures on inflation and the external balance of payments.
The desirable outcomes of policies intended to meet population ageing are obvious. They must produce an increase in productive capacity and output, stimulate saving and investment, thereby alleviating pressures on inflation, fiscal resources and the external account. Indeed, these aims should be pursued independently of population ageing, but are rendered even more urgent by the onset of the phenomenon. It is the way in which all this is to be put in practice that is often subject to contention.
Contentions often arise from the fact that it is not always appreciated that any course of action chosen, including a passive stance, involves sacrifices. On the other hand, reforms that should engender a win-win situation in the long run could perhaps impose sacrifices on a number of individuals in the short term. An informed debate should take full account of the costs and benefits involved in any course of action, and come to a reasonable conclusion therefrom.
In particular, the present welfare system needs to be re-considered in a way that protects the rights of the elderly to a decent standard of living, promotes saving and gives proper incentive for self-help while reducing the burden on government finances in the long term.
The EU Open Method of Co-ordination of pension systems is a framework within which Malta is already participating aimed at enhancing the provision of pension income throughout EU Member States in line with the objectives set in the Lisbon Agenda of March 2000. This approach emphasises three principal objectives to be attained by pension systems, namely, the adequacy of pensions, the sustainability of pensions, and the modernisation of pension systems.
The adequacy of pensions implies that the pension system should be able to prevent poverty in old age and, to the extent possible, allow the continuation of an unchanged standard of living throughout lifetime. Another important consideration in this regard is that of inter-generational equity, implying that different generations should expect to have a comparable standard of living in old age.
The sustainability of pension systems involves a number of facets, chief among which is the fact that its cost to public finances should not be excessive. Ideally, the pension system would be financially self-sustaining. In order to achieve this, it is essential to have a high level of employment and to encourage labour participation, particularly of women and older workers, to partially offset the effects of population ageing on the balance between the number of workers and the number of retired persons. The use of funded pensions is often viewed as a good approach to foster financial sustainability in the wake of population ageing. This is because under funded schemes, pension income would be paid out of past savings made by pensioners during their working lives. This could provide a better guarantee of sufficient funds to cover pension payments compared to the levying of contributions out of a declining work-force.
The modernisation of pension systems calls for pension systems to encourage flexibility in the labour market by permitting mobility between occupations and countries. It also implies the need for gender equality in pension systems. Transparency of the pension system is another essential requirement in this regard, implying that the system should be straightforward and easy to comprehend and actuarially fair. In other words, pensioners should get a reasonable rate of return in terms of pension income for the contributions that they had effected during their working lives. Pension systems should also be adaptable, in the sense that they should be flexible enough to cater for different needs and preferences of different individuals.
These are indeed the principles guiding the work of the Welfare Reform Commission and this Government in their approach to pension reform. It is augured that feasible solutions that are perceived to be equitable are derived in the shortest possible time so as to enable our country to maintain and improve its welfare system today and for future generations.

Copyright © Newsworks Ltd. Malta.
Editor: Saviour Balzan
The Malta Financial & Business Times, Newsworks Ltd, Vjal ir-Rihan, San Gwann
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