The economics of pension reform

A smart 16-year-old student asked me whether it would be possible for him not to pay the national insurance contribution when he starts working. He feels that paying the national insurance for an uncertain or insufficient government pension would not be an optimal strategy. He prefers to save the equivalent of the national insurance contribution and invest in a personal private pension plan.

My answer was that it is not possible for young workers not to pay the national insurance contribution for two main reasons. The first is that a significant part of the national insurance contribution goes to finance the public national health system where current health costs have to be financed out of present government income. The second is that the pensions given to the retired people have also to be financed out of the current government revenue.

The two-thirds pension system adopted in Malta in 1979 is a pay-as-you-go system, where the working young finance the retired old. There is an implicit social contract in this system whereby the current young are committed to support the current old, just as the current old supported the previous old when they were young. This implicit social contract is very important in our present system of pensions and is the crucial element that needs to be addressed in any attempt of pension reform.

The change from the current pay-as-you-go system to a fully funded system is difficult due to the double financial burden that would be imposed on the young and middle aged workers. It would be impossible to expect that current workers over 50 would save enough in a private pension plan to have an adequate pension at retirement. Hence, these workers will have to remain on the current government system.

Young workers under 35 years and the middle aged workers, 35 to 50 years, still have enough working time to save an adequate sum in a private pension plan for their own retirement.

They however still have to contribute the national insurance part to finance the current pensions and the forthcoming pensions of the workers aged 50 years and over. Hence, the dilemma to move from the current social pension to a fully funded private pension scheme. The double burden might not be acceptable to the present middle aged and young workers.

The real economic burden for future pensions can be seen through a simple example. In the current year, five workers support one retired person. If each worker produces 100 loaves of bread, the total 500 loaves have to be divided between six people. Each person therefore receives 83 loaves of bread.

In 2025, every three workers will have to support one retired person. If in 22 years' time, each worker still produces 100 loaves of bread, the 300 loaves will have to be shared between four persons, providing 75 loaves each. This results in a decline of 10 per cent in the standard of living of each worker and each retired person in 2025. For every person to receive the current 83 loaves of bread, a total of 332 loaves will have to be produced by the three workers (111 each). This means an increase in productivity of 11 per cent by each worker.

Hence, over the next 22-year period, an increase in productivity of 11 per cent is necessary (an average of half of one per cent per year) just to keep every worker and retired person on the same standard of living enjoyed in the current year. A significant part of economic growth and increase in real output will have to go to finance the well-being of the increase in the number of retired persons.

To finance an increase in the standard of living of everyone, an increase in productivity of more than 11 per cent is necessary over the next 22 years. Consequently, the pension problem is fundamentally one of economic growth and increase in worker productivity.

Certain characteristics under the current pay-as-you-go system compound the problems within the existing pension structure.

The current pension is not linked to the number of years that a worker pays the national insurance contribution. A worker receives the same pension whether he/she paid 10, 20 or 40 years of national insurance contributions.

The pension received is based on the highest salary of the best three years in the last decade of one's working life. It is not linked to the total of national insurance contributions paid and accumulated with interest, inside the system.

Moreover, the life expectancy at birth has increased to 76 years for males and 80 years for females. This means that the pension system has to finance on average 15 years of pensions for males and 20 years of pensions for females under the current retiring age of 61 for men (public officers 60 years) and 60 for women.

An important advantage of private pension plans is that they allow the flexibility of choosing one's retiring age and the choice of the size of the pension at retirement.

A worker might choose to save 10 per cent of his income for 40 years and retire at 61; another might be willing to save 15 per cent of his salary and retire earlier at 56; while another might desire to save less, say eight per cent of his income, and retire later at 65.

An implicit problem in the current government two-thirds pension is that there is a maximum pension (Lm4,400 per annum) which is the equivalent of the two-thirds income ceiling of Lm6,700, on which the highest national insurance contribution is deducted.

The maximum pension of Lm4,400 might have been a respectable pension 20 years ago. Inflation, however, has progressively eroded the purchasing power of this maximum fixed sum.

More importantly, future inflation will push everybody's income higher and higher until many workers will be receiving a salary which has exceeded the maximum ceiling of Lm6,700 for pension purposes.

This means that unless the maximum government ceiling is also adjusted for inflation, many workers will find that 20 years from now, the purchasing power of the highest pension will imply a significant drop in their living standards.

The current male retiring age of 61 and the current male life expectancy at birth of 76 mean that if a worker starts work at 21 years he will contribute 40 years of work and national insurance to receive, on average, 15 years of two-thirds pension.

This means 2.66 years of work for every year of pension received. The proposal to increase the working age for males to 65 years will imply 44 years of work for an average expected 11 years of pension. The ratio now becomes four years of work for every one year of pension, a ratio which may be more desirable from a macro perspective. The retiring age can be progressively increased by six months every year. This will mean that it will take eight years, from 2004 to 2011, for the retiring age to reach 65 years.

For women, the current work-pension ratio is even more startling. If a female worker starts work at 20 years and retires at 60, she works for 40 years and is expected to receive 20 years of pension since the life expectancy at birth for females has risen to 80 years.

This implies a ratio of four years of work for every two years of pension or simply the very low ratio of two years of work for every one year of pension. If retirement age for females is also increased to 65, females will work 45 years to receive an average expected 15 years of pension. The ratio will then improve to three years of work for every one year of pension.

Another underlying problem of the population age structure related to pensions is the low level of fertility currently prevalent in Malta. A population needs a fertility rate of 2.1 live births per marriage to remain constant. The current Maltese fertility rate of 1.46 means that the Maltese population will reach a plateau in 2020 of 393,700 and then start to decline thereafter to reach 333,800 by 2050.

An official government policy to induce young married couples to have more children is difficult to propose and maintain. An alternative to more children to stabilise the population is to allow more young immigrants to settle in Malta. This will settle the overall population size issue and stabilise the young-old relationship ratio.

The fundamental pension problem however remains one of economic growth and faster creation of well-paying jobs. The emerging educated young desire and expect well-paying jobs in Malta. Unless they find them, the young, as from May 1, 2004, will have the option of emigrating and seeking high paying jobs in any country in the European Union.

They will search for better pay abroad, a higher standard of living and higher savings for larger pensions for retirement. Working abroad will effectively imply a legal way for these smart Maltese students to work but not to pay the national insurance contributions in Malta.

The creation of well-paying jobs in the Maltese economy will remain necessary to maintain the educated young in Malta and to create the required financial flows to support the increasing number of retired old.

(First published in the Maltese Jesuit publication Orbis, Volume 2:4, winter 2004, pp. 8-10.)