The impact of the Financial Crisis on Pension Systems - Vladimír Špidla

SPEECH of MR Vladimír Špidla, Member of the European Commission, with responsibility for Employment, Social Affairs and Equal Opportunities

The impact of the Financial Crisis on Pension Systems

Conference on Pension Reform and the Financial Crisis
Bratislava, 4 May 2009

Thank you for the opportunity to speak at this conference.
The Commission considers well functioning pension systems the core of EU social policies. The Commission pays great attention to the impact the present crisis might
have on our pension systems and on the welfare of our older citizens who more than
many others are dependent on well functioning social protection.
The financial crisis and the wider economic impacts stemming from it make this
conference so timely. These events are forcing us to look at funded pensions and
indeed on pension systems in general. What we have seen up to now suggests that
the crisis in Europe has had less serious impacts on pension funds than on other
types of financial institutions and than on funded pension systems in other parts of
the world. In general, especially for those already retired or about to retire today,
European pension systems have so far been quite resilient. Nevertheless, for some
people who are dependent on private pensions we know that there will be serious
impacts on their retirement income, notably those with defined contribution
schemes.

Decline in confidence
There has been a decline in confidence in funded pension schemes. For instance,
in a recent survey of Dutch pension fund members, only 44% of people had
confidence in pension funds, down from 64% just three years ago. We can expect
maybe even stronger drops in confidence elsewhere, including in statutory funded
pension schemes set up in many Central and Eastern European Countries over the
last ten years. The radical drop in the book value of pension fund investments
caused by the financial crisis will inevitably have a psychological impact on
contributors to such funds, even if they are not due to access their pension for many
years.
Learning lessons from the crisis will be important if confidence is to be restored. I
should also say that it is still early days for assessing the full consequences of the
crisis for pension systems. But I think the evidence before us is strong enough for
me to point to some of the things we have discovered and from which we need to
learn.

EU role
Before I do that, I should make clear that the design of pension schemes and social
security systems is basically the responsibility of Member States. However, there
are some EU legal framework rules that apply to pensions such as those concerning
equal opportunity and anti-discrimination. Occupational pension schemes are also
regulated at EU level. And there is protection of workers against the insolvency of
employers as sponsors of occupational pension funds.
More generally we in the Commission monitor pension systems with a view to the
European level pension objectives, systems need to provide adequate benefits in a
sustainable manner. Pension systems, their structure and composition differ widely
across the Union. Yet, whether public or private, pay-as-you-go or funded what
matters is the ability of pension systems to deliver on those objectives.
Through the Open Method of Coordination the Commission enables Member States
to

1. Share best practice and policy advice,
2. Utilise the reference framework of objectives and indicators for monitoring
progress, on the basis of National Strategic Reports on pension's reform.
3. Gather legitimacy for the national reform effort.

3
As part of this we have recently published the Joint Report on Social Protection and
Social Inclusion 2009 -which among a wealth of information also highlights some of
the key challenges facing Member States' pension systems.
The report shows that Member States in the future - just as today - will provide the
biggest part of retirement income from State Pension systems where benefits are
financed by the current contributions.

Lessons and responses - PAYG
Of course these State schemes are not immune to the economic crisis, as they are
directly linked to public finances. Fewer people in work paying contributions,
increased national debt and lower or negative growth all place strain on the long
term sustainability of pay-as-you-go schemes. And pension systems were already
facing long term pressure from the demographic shift. In simple other words, we
expect that instead of roughly four people of working age for each person over 65
today there will be just 2 people in 2050.
Of course it is not just this ratio that matters, but how many people of working age
are actually working. Perhaps the least painful way of adjusting to ageing societies
is if more people work more and longer before they retire. So it is vital to ensure we don't repeat the mistakes of the past and use early retirement to cope with
unemployment in the downturn. We need to preserve and built on the positive
progress in increasing employment rates for older people which has been raised
from 37% in 2001 to 45% in 2007. As demonstrated by various Member States the
necessary adjustments to State pay-as-you-go schemes in response to a longer
lasting downturn or to the impacts of ageing populations can be made gradually and
in a manner that distributes the burden of adjustment equally – following the
solidarity principle.
Presently, funded pension only play a significant role in the pensions in payment in
a few Member States such as the UK, Ireland, the Netherlands, Sweden, and
Denmark where they – except for Denmark – still tend to be organised in so called
Defined Benefit Schemes.

Lessons and responses – Funded Defined Benefit
These funded pension schemes have suffered visibly from the impact of the
financial crisis. Defined Benefit pension funds, where sponsors take the investment
risk, in principle shield their members from financial market turmoil. Yet, in
situations with large drops in the market value of the investments backing liabilities
adjustments to restore the funding balance and to keep these schemes viable for
the long term cannot be shouldered only by sponsors. Most of these countries have
therefore included some shock absorbers in scheme designs which by way of
collective negotiations or immediate regulation allow schemes to restore funding
balances through adjustments to contributions, benefits and/or eligibility ages.
As social partners currently discuss measures such as low or zero indexation,
increases in contributions or gradual increases in retirement age collective
negotiations in most of these countries lead to solutions not dissimilar to those
adopted in pay-as-you-go schemes. The countries with problems are those which
like Ireland did not have sufficient protections for scheme members and capable
shock absorbers in place before the crisis struck.

Lessons and responses – Funded Defined Contribution

4
I would like to now turn to the funded Defined Contribution pension schemes.
Although typically they are not yet that important for those retiring today, funded
defined contribution schemes in general are becoming more important every day.
Perhaps the most interesting of the DC schemes are the mandatory defined
schemes which seek to partly replace some existing State pay-as-you-go provision.
The Social Protection Committee reported on the size of the expected changes a
few months before the financial crisis. According to this Slovak pensioners in 2046
will be getting slightly over two fifths of their overall pension from the statutory DC scheme. Among Member States that have introduced mandatory funded schemes
only Latvia and Poland plan to a give similarly large role in pension income provisionto DC schemes.

With such a size of the future retirement income coming from these systems the
lessons from the crisis are highly relevant – let me stress a few:
The Joint Report emphasised the need to mitigate risk in defined contribution
pensions, particularly for those people approaching retirement. And the report called
for appropriate solutions for the pay-out phase which is still to be determined in a
number of countries with mandatory schemes.
It also stressed that Member States should give careful consideration to the
proportion of overall pension income expected to come from defined contribution
schemes and whether they would be sufficiently appropriate for all groups in the
population.. This is often NOT the case for less well off people and for those with
shorter or atypical employment careers. People in this situation would typically be
better served by pay-as-you-go schemes as they would not be able to accrue
sufficient benefits or absorb the inherent risks.
In relation to the capacity to bear risk, the question is also whether a mandatory
scheme should not foresee provisions that protect against too much volatility? One
typical solution could be to guarantee the principal and some minimal rate of return.
Another consists in lowering the investment risk as people get closer to the
retirement age. Not all mandatory schemes contain such options at the moment.
The choice between investment strategies with different potential rates of return and
levels of risks leads to questions around the accuracy of information. Where - as
schemes were introduced - there was choice between continuing in pay-as-you-go
State schemes or moving part of the contributions to the new funded scheme,
people often opted for the DC schemes even if it was questionable whether this was
indeed the best solution for them. And when it came to the choice of pension funds
and investment strategies, evidence suggests that many people went for riskier
options than would have been justified given their earning capacity and the length of
their working life.

These choices were driven by the information people received at the time. Rates of
returns observed in the past and the positive growth expectations for Central and
Eastern European Countries obviously played a role. But so did the fact that nobody
told people that a sudden decline in asset values could occur.
Hence, access to unbiased information is of key importance and not only in DC
schemes. If non-partisan organisations such as consumer protection NGOs were
providing additional information it could help people to make the right choices.
Introducing limited risk default options designed to be a reasonable choice for most
people would likewise help.
When discussing these schemes we should not forget that they were introduced to
smooth the transition to an older population. Paying some contributions into funded
schemes whilst continuing to pay pensioners in the existing pay-as-you-go scheme
means more cost now and less cost later for public finances. This can help to bring

5
forward some of the costs of the demographic change and so smooth the longer
term impacts.
But funded mandatory private schemes represent just one of the ways in which a
smoothing of costs can be organised. Establishing reserve funds within the public
pension schemes can also allow for prefunding and so can occupational DB
schemes. Alternatively, Member States can also reduce public debt, so as to have
financial room for manoeuvre when ageing sets in full at a later date.
In any case prefunding means transition costs (paying for present and future
pensioners at the same time) and imply a bigger burden today. Obviously, assuming
such extra costs were also predicated on rapid growth rates in the countries
concerned. And we can see that in several of the countries with mandatory private
funded schemes authorities now think that the fiscal burden is too high and
contributions to the funded parts should be reduced. Similarly in some countries
with reserve funds the build up has been halted and funds reduced by partial
withdrawals.
While I understand that public authorities see the need to adjust DC the mandatory
private funded schemes in several aspects mentioned one should not forget that
pension systems need stability over the long term if they are to have the necessary
credibility among citizens. Hence transparency and long-term planning are
important.

Let me conclude with two more general comments:
1. Using funded pensions means exposing future pensioners to the outcomes in
financial markets. For those countries that have opted for this model the question
seems to be. (1) how to control the risk for the individual (2) how to give people a
realistic idea about what can be gained and (3) how to include in these schemes
only those income and career profiles for whom it can be an appropriate solution.
There are countries in Europe (e.g. Netherlands), and outside our continent, where
funded pensions play an important role today, and from where lessons can be
learnt. The Commission will play its part in instigating policy dialogue, encouraging
best practice exchange and supporting Member States in considering the difficult
issues they face. This could include looking at whether the regulatory framework
needs to be further adjusted and if so at what level.
2. The most important action in this respect seems to me to put the financial
markets back in order – important for the economy in general but crucial for funded
pensions. This is a key priority for the Commission - and following the de Larosière
Report, the Commission will propose action to regulate and supervise financial
markets – re-establishing a market in which funded pension schemes can operate.
And most importantly – to deliver adequate and sustainable pensions requires first
and foremost restarting the real economy. Hence a successful recovery strategy will
not only revive the European economy but also lay the ground for sustainable and
adequate pension systems.