Pension System Reform
Croatia Policy Notes 2016 Restoring stability, reviving growth and creating jobs
Pension System Reform Key Message Croatia’s pension system has seen significant change since the introduction of a multi-pillar design in 1998. While performance of the second pension pillar has been adequate, ad-hoc interventions in recent years in the first, pay-as-you-go (PAYG) pension pillar have led to larger expenditures than expected and became less affordable going forward. In addition to concerns about future adequacy, the system overall faces substantial equity and fiscal challenges, because of low labor activity and coverage. Without further reforms, Croatia’s pension system will remain fiscally and socially unsustainable in the long run. Key Actions
Tighten early retirement windows, raise retirement age faster, and stimulate elderly activity.
Equalize the eligibility to the supplement of 27 percent for PAYG-only and multi-pillar pensioners.
Converge privileged pensions to general PAYG rules faster.
Award PAYG pension credit only for paid contributions.
Consolidate the fiscal space for financing the second pillar transition cost.
Where Croatia Stands Now Reforming Croatia’s pension system is a critical priority in view of the projected rapid population aging. Croatia’s population pyramid is inverting and thinning, with an aging and shrinking population and a resulting increase in the demographic dependency ratio (Figure 1). In anticipation of demographic change, Croatia launched reforms of its pension system in 1998 by changing the pay-as-you-go (PAYG) system parameters and in 2002 introducing a second, mandatory fully funded pillar. However, pension reform remains an unfinished agenda. Numerous interventions in the pension system between 2001 and 2007 1 created additional fiscal pressures, induced large differences in pension benefits paid to consecutive cohorts, and delayed the planned increase of the contribution rate for the second pillar from 5 percent to 10 percent over five years2. Ad-hoc interventions in the pension system continued during the recent financial crisis. In 2010 the retirement age for women was 1
Including pension supplements of 1999 and 2001 for certain cohorts, the 2004 repayment of “pensioners’ debt,” restoring wage indexation in 2005, and a 2007 pension supplement of 27 percent on total PAYG pension for PAYG-only retirees, but not for PAYG benefit of the multipillar participants.
Croatia Policy Notes | Pension System Reform
raised to 65 (in 3-month increments, until 2030) and early retirement age to 60, but with reduced penalty. Figure 1. Croatia’s population is shrinking and aging
Source: UN Population Prospects
A number of distortive changes were also introduced in the pension system in 2013 and 2014: a penalty-free retirement with 40 years of service (decrements for service below 40 years of service were slightly increased) and a more generous (wage growth dominant) pension indexation pattern for both PAYG pensions and second pillar annuities3. The PAYG pension for 2
Initial pension reform package in 1998 envisaged initial contribution rate to the second pillar of 5%, rising to 10% over five years. However, in the law this schedule was formulated less strictly with „at least 5% to be paid into the second pillar“. 3 Given the uncertainty and lack of matching assets, such an indexation pattern is uncommon in the second
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multi-pillar participants (both basic and points parts) was increased in proportion to the PAYG share of the contribution (currently 75 percent), as a compensation for not raising second pillar contribution rate above 5 percent. Inability to finance larger transition cost will transform into higher future PAYG expenditures. Closing the second pillar savings for employees with extended service periods (hazardous and arduous occupations), nationalizing their second pillar accounts and restoring their PAYG-only benefit yielded a temporary fiscal relief in 2014 but added to the future PAYG deficit and implicit pension debt. At the same time, there were several positive measures taken: the retirement age was increased to 67 (with a full transition by 2038), privileged pensions were reduced and rationalized, while a new functionally-based disability assessment methodology and new integral disability assessment infrastructure has been introduced. The inflow of new disability pensioners has been significantly slowed and relative pension expenditures curtailed. Ad-hoc interventions in the pension system have led to larger PAYG expenditures than expected and locked contribution rate to the second pillar at 5 percent. Instead of an expected continuous decline of PAYG expenditures, providing fiscal space for financing transition costs of increasing the portion of contribution rates going to the second pillar, the actual PAYG expenditures remained high (Figure 2). As a consequence, second pillar contribution rate remained at 5 percent while its transition cost continued to fuel into the pension system deficit. Figure 2. Expected Expenditures to
and Actual Pension GDP, 2000-2014
Source: Pension Reform Working Group and World Bank calculations.
Second pillar performance has been positive and close to public expectations. The pillar. As a consequence, initial second pillar annuities could be reduced by 20 percent or more. 4 The real rate of return on second pillar accounts, commonly quoted and expected by the analysts was 3 percent.
Croatia Policy Notes | Pension System Reform
annualized rate of return on second pillar accounts since inception in 2014 has been at 5.9 percent - 2.4 percentage points above nominal wage growth, and almost 4 percentage points above consumer price inflation (CPI) 4. Second pillar accumulation in 2015 reached HRK 72 billion (22 percent of GDP). However, more than 70 percent of funds are invested in public debt, with fund management fees, although low by international standards, set relatively high for such passive portfolio5. Distortions and ad hoc measures have worsened Croatia’s pension system sustainability. The largest distortion in the system is the 27-percent supplement that PAYG only participants get for all years of service and those in second pillar only for the pre-2002 service: Benefit structure PAYG-only pensioners Multipillar pensioners
Service before 2002 Points + 27% Points + 27%
Service after 2002 Points + 27% 75% of points + II pillar annuity
With higher PAYG benefit for second pillar participants (both basic and points part), introduced in 2013, the gap is somewhat narrowed and average replacement rate stabilizes in the long run, but the gap still remains (Figure 3). Second pillar annuity compensates for the reduced PAYG benefit, but not for the 27percent supplement. Participants that had the choice to voluntary join the second pillar in 2002 (those aged 40–50) have been given the opportunity to opt back to PAYG-only at retirement. Opting back gives them full pension benefit including the 27-percent supplement to post-2002 PAYG pension. This unfair choice makes the decision easy (and currently automatically executed by the authorities unless an individual indicates otherwise): in 2015 less than 1 percent of the pensioners (i.e. those with large second pillar accumulations and short service periods) chose the multipillar benefit. As Figure 3 shows, without the adjustment, combined multi-pillar pension would remain below the PAYG-only pension for the next decade or two, i.e. prolong into the retirement of mandatory participants without the opt-out option, which may provoke reversal appeals. As indicated earlier, measures implemented in 2013 and 2014 have further worsened the system’s 5
In 2014 life-cycle portfolios were introduced, but the effective floors for investing in public debt were not reduced. 95 percent of funds remain in balanced portfolios with heavy exposure to public debt.
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fiscal sustainability (Figure 3), and reduced fiscal space for action. Figure 3. Projected Replacement Rate and PAYG Deficit in Croatia
are largely financed by selling debt second pillar pension funds. Second pillar annuities would thus be financed predominantly by future generations’ interest payment instead of from higher activity rates stemming from productive and diversified second pillar investment.
How Croatia can Pension System
PAYG deficit 2.0%
1.0%
0.0% 2012
2017
2022
2027
2032
2037
2042
2047
2052
2057
2062
2067
2072
-1.0%
-2.0%
-3.0%
-4.0%
-5.0%
-6.0%
PAYG deficit before 2013 measures
PAYG deficit after 2013 measures
-7.0%
Source: World Bank team calculations, PROST model
Croatia’s pension system still faces substantial coverage and adequacy challenges. Compared to EU, Croatia has the lowest labor force participation rates (of 15-64 cohorts - 59.6 vs. 71.9 percent for the EU28), second lowest average service period (31.1 years vs. 35 years for the EU28), and among the lowest exit age from work in the EU (1.2 years below EU for both men and women)6. Croatia already pays the lowest relative pension in EU, which, without further reforms, is likely to deteriorate further. Recent PAYG measures improved future adequacy but not as much as would higher second pillar contribution rate. Croatia’s second pension pillar requires fiscal support as well as policy and outcome monitoring. In the long run, the second pillar is expected to provide a higher value-forcontributions than the PAYG pillar. With equal PAYG conditions and the same contribution rate, the multi-pillar replacement rate would yield up to 10 p.p higher replacement rate. However, the second pillar requires a double-dip into current tax and contribution payers’ income – to pay PAYG pensions and to fill the gap of diverting a part of pension contributions (presently 5 percent) to the second pillar accounts. Transition costs currently stand at 1.5 percent of GDP, and
Strengthen
its
Several simultaneous reforms could improve system equity and adequacy. The key systemic issue to be addressed is whether to extend the 27 percent supplement to all beneficiaries or to abolish it for current beneficiaries. With 27 percent supplement extended to all (proportional to service in the PAYG pillar) or abolished for all, for most individuals the multipillar pension would exceed the PAYG-only one. Opting-out, if needed, would then be made a fair choice. Abolishing it is both politically and socially difficult. Extending it generates more PAYG expenditures, rising in parallel with retiring second pillar cohorts. In addition to already narrowed fiscal space with redefinition of pension for second pillar participants and other 2013-14 measures, extending the supplement would cause the PAYG deficit to remain at 4 percent of GDP. A set of policies to strengthen the PAYG system, addressing both fiscal and equity aspects could provide the needed fiscal space. The list includes i) abolishing early retirement or reducing it to 1-2 years prior to retirement age (with a bridging system for hazardous occupations), ii) abolishing or faster convergence of privileged pensions to PAYG rules, iii) faster increase in legal retirement age, iv) awarding pension credits only for contributions, v) introducing wage valorization of initial pensions and CPI indexation of pensions in payment, and vi) reducing minimum pension per year of service or means testing it. Abolishing or reducing the second pillar would bring short-term fiscal relief but exponentially raise the long run pension liabilities and implicit debt. Multi-pillar pension reform was designed as a reform for the future, a contribution of the current generation to lower burden for the future generations. At the launch of the second pillar it was emphasized that it would require fiscal support in the form of a fiscal surplus or a small sustainable deficit and debt. Instead, public spending exploded, added to both deficit and public debt, postponing the second pillar’s diversification towards more productive investment and abroad. Among the countries recognizing the inability of the current generation
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EU: The 2015 Aging Report: Economic and Budgetary Projections for 28 EU States 2013-2060.
Croatia Policy Notes | Pension System Reform
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to curtail fiscal deficits for longer run benefits, only two (Argentina and Hungary) annulled the reform by abolishing second pension pillar. A larger group of countries, including Poland, Estonia, Latvia, Lithuania, Bulgaria, Romania, and Slovak Republic, have striven through the fiscal crisis by temporary freezing or reducing second pillar contribution rate, and/or allowing some degree of voluntary participation in the system. Unless truly temporary, such relief measures carry serious long-run risks. Prolonged reduction or freeze of second pillar contribution rate bites into future adequacy and worsens the elderly poverty prospects. Similarly, those that opt-out from the second pillar are more likely to appear as social assistance beneficiaries in the future.
How the World Bank Group Can Help The World Bank has supported pension reform in Croatia from its beginning through analyses, investment projects, policy adjustment operations, and advisory services. In the last five years, the World Bank produced a Pension Policy Note (2011), simulation model of Croatian pension system (so-called PROST pension model delivered to counterparts in 2011 and 2012), policy reports on severance pay in the
context of the pension system (2013) and the extended service period (2013), as well as supported the pension policy reforms through Development Policy Loans (2011-13). Further World Bank support to pension policy in Croatia could include analyzing and evaluating policy options and assisting the counterparts to efficiently implement them. Croatia has prepared its pension system forecasts together with other EU countries. EU’s 2015 Aging Report findings for Croatia are similar to the World Bank’s. The status quo projection for Croatia indicates long-run social inadequacy despite fiscal sustainability, but does not address or evaluate policy options and implementation patterns in both PAYG and funded pension pillars, as well as on the labor market side. The World Bank could facilitate such an integrated pension, social and labor market reform review and assist in implementing policies emerging from it. Reimbursable Advisory Services (RAS) may include policy and financial analyses, modeling (PROST), preparing reports such as the Active Aging Report (the World Bank prepared a similar report for several EU Member States) or other type of active engagement.
This Policy Note was produced by the World Bank to inform policy debate in Croatia. This note was prepared by Zoran Anusic, Senior Economist. The findings, interpretations, and conclusions expressed herein do not necessarily reflect the views of the Board of Executive Directors of the World Bank or the Governments they represent. For any questions regarding this note, please contact Vanja Frajtic, Communications Associate, (vfrajtic@worldbank.org). THE WORLD BANK OFFICE ZAGREB http://www.worldbank.org/en/country/Croatia
Croatia Policy Notes | Pension System Reform
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