Conditions and Prerequisites for Pension Reform in Lithuania
Factors that determine the course of a reform are manifold. The transition to a private fully-funded pension system will depend on the development of the capital market and the whole economy, the current state of the social safety net as well as political and psychological attitudes in society. On the other hand, the introduction of fully-funded pensions will have a profound impact on the economy and society.
Just like Western and other Central and Eastern European countries, Lithuania is facing the problem of a greying society. Worsening demographic trends are a major setback. The number of working individuals is falling, while the ranks of pensioners have been increasing since 1973. As compared to 17.7 percent in 1973, pensioners now account for over 20 percent of the country's population. Out of every thousand working-aged citizens in 1985, 315 individuals were of pensionable age. This figure rose to 333 in 1989 and to 357 in 1995. In 1996 it peaked at 415. Despite the 1995 pension reform, the number of pension recipients rose steadily from 39.2 percent of working-aged individuals in 1993 to 39.7 percent in 1994 to 40.4 percent in 1995 to 41.5 percent in 1996. A particularly sharp increase was reported in the number of recipients of disability and victims' pensions.
The birth rate started to fall in 1990, reaching the lowest level in the country's history in 1994. Lithuania is now undergoing a period of natural decrease. The mortality rate of working-aged individuals (especially men of 30 to 35 years of age) has increased due to an increase in disease and injuries, but the life expectancy of pension-aged individuals remains almost unchanged. People who reach 60 years of age live on average another 21 years, which is a fairly long period of receiving pension benefits.
This demographic predicament makes the pay-as-you-go pension system particularly vulnerable. In light of such trends the system has no prospects of development and is bound to go broke. Unlike a pay-as-you-go scheme, a fully-funded system operating on a defined-contributions principle is impervious to demographic pressure. A fully-funded system does not involve redistribution, and the funding of individual pensions depends on the level of contributions paid by the individuals.
Wide-spread tax evasion adds to the drop in the number of people insured under state social insurance. The ratio of the insured to working-aged population slumped from 83 percent in 1991 to 74 percent in 1992 to 65 percent in 1993 and to 61 percent in 1994. In 1995 and 1996 it increased slightly to 63 and 64 percent respectively. In such circumstances people contributing to the social insurance system are carrying an increasingly heavy burden of supporting pensioners. The number of working individuals supporting one pensioner has been on the downward trend since 1991. It was 2.1 in 1991, 1.91 in 1992, 1.66 in 1993, 1.54 in 1994, and 1.51 in 1995. As compared to 1976, when three working individuals supported one pensioner, presently three working individuals support two pensioners, and this figure continues to rise.
Since 1991 the number of insured fell by 400,000 from 1,764.3 thous. to 1,352.2 thous. Some of those who dropped out lost jobs. Yet, only slightly more than 100,000 of unemployed are registered with the labour exchange. Others have joined the shadow sector and ceased to pay social insurance contributions and other taxes. Still others do not qualify for social insurance by law. Only about half of sole proprietorship owners (40,000 out of 90,000) contribute to the social insurance system. About 180,000 owners of two to three hectares of land are not eligible for social insurance benefits. Out of 50,000 farmers, only 1,000 are insured. Although the above data are not precise, they suggest that only a negligible share of the 400,000 individuals who quit the ranks of the insured have returned to the social security system. Under such circumstances an increase in the number of the insured is unlikely. On the other hand, the drop seems to be stabilising. Furthermore, the rate of employment (the share of working individuals in the total number of working-aged people) in Lithuania is high relative to Western European countries. It is therefore unlikely that the level of employment will rise in the absence of major improvements in the business environment.
The heaviest burden of social insurance contributions falls on the employer, as the social insurance fund is financed mainly by enterprises. Reduced compliance of state-run industrial enterprises and companies supported by the state is a major concern. Private entities also tend to avoid social insurance payments. Previously, the biggest share of social security contributions was collected from large state-owned enterprises. The restoration of independence was followed by breakdown of economic arrangements with the former Soviet Union. In addition to that, the ownership of many state-run enterprises has not been transferred to private hands, resulting in their poor financial shape. Many of the enterprises are insolvent, some are on the verge of bankruptcy. The employees are on forced leave, receiving minimum wages. A range of social guarantees prescribed by labour legislation inhibit liquidation or sale of such entities. Social insurance contributions paid by these enterprises are very low. In many cases they are computed but not transferred. The financing of almost all budgetary institutions falls short of the required level, which frustrates payments to the social insurance fund. In 1996 the arrears to the social insurance budget rose by 18 percent.
Lithuania is carrying out an extensive privatisation programme which has already divested 66 percent of all enterprises. High social insurance contributions increase labour costs. To maintain competitiveness, enterprises are forced to conceal real wages and the number of employees. The amount of social insurance contributions is thus further reduced. Given that only labour contracts place people under an obligation to pay social insurance contributions, the conclusion of labour contracts is avoided on a large scale. In 1991 people working under labour contracts constituted 94.9 percent of all insured. This figure dropped to 92 percent in 1996. To avoid the payment of social security contributions, enterprises conclude other than labour contracts (e.g. commission contracts regulated by the Civil Code), even though jobs are of a permanent nature. Employees, in turn, prefer higher take-home pays to more social security guarantees.
The 1995 pension reform did not eliminate redistribution and therefore failed to link social security contributions made to pension benefits earned. This linkage would be feasible only if individual contributions were accumulated and administered separately.
The development of the capital market plays a major role in switching to a private pension system. The operation of private fully-funded pension funds is based on the investment of accumulated resources seeking to preserve their value and accrue gains. For this reason the liquidity, capitalisation and security of the securities market are essential preconditions of pension reform.
The foundations of the securities market were built in 1992 when necessary legislation was adopted and institutions founded. The latter include the National Stock Exchange, the Securities Commission and the National Depository. Lithuania's securities market is based on the French model. Shares are dematerialised and accounted by the Central Depository. The depository performs the functions of clearing and safekeeping of funds.
The securities market is developing rapidly. In the first session, which was held on September 14, 1993, nineteen issuers and twenty two issues were registered. Nineteen financial brokerage firms had a right to trade. As of January 1, 1998, 609 issuers and 665 issues were registered. At the present moment the stock exchange's Official Trading List contains seven blue-chip issues that meet strict market capitalisation, shareholding and profitability requirements. The Current List comprises 58 issues. The other 600 or so issues are categorised as Unlisted Issues. On January 1, 1998, 347 issues had market value. During the four years of existence the capitalisation of securities at face value accounted by the Central Depository totalled 16.584 billion litas, or 44.4 percent of GDP. Over 1997, capitalisation rose by 12 percent. Capitalisation of the T-bill market increased by a striking 70 percent.
Only licensed brokerage firms are allowed to trade on the stock exchange. The Securities Commission is the supervisory institution. It establishes capital and other requirements for brokerage firms. As of January 1, 1998 forty seven brokerage firms have a right to trade in securities, of which ten are brokerage departments of banks, 10 A-category and 27 B-category firms.
Upon the receipt of a permit from the Securities Commission, banks, brokerage firms and banks' daughter branches may provide depository services. Depositories must segregate the property transferred to them for safekeeping from their own assets.
No investment funds exist in Lithuania. This is due mainly to differences in tax rules applicable to the taxation of capital gains received by firms and individuals. These differences discourage investment through investment funds.
In 1994 the government started to issue T-bills. In March 1998 the total T-bill turnover reached 14.8 million litas. The capitalisation of the T-bill market was 1,561 million litas. The T-bill LITIN index was 1,398.8.
Assets safety is the biggest cause for concern for financial intermediaries. According to the functioning accounting standards, customers' assets are not required to be segregated from the firm's assets. Off-balance accounting has not evolved as yet to allow of effective segregation of assets. The system of commercial banking presents another major risk, as most settlements are conducted through banks. Even if capital market intermediaries secure the safety of customers' assets, all assets run a risk in banks. Separating customers' assets in capital market intermediation firms will therefore not solve the problem. It is essential to introduce reserved accounts in commercial banks. This would make it possible to replace traditional mechanisms of state supervision designed to secure the safety of the financial sector with more effective market-based measures of risk management.
Readiness for pension reform involves two aspects. For one thing, a tax conception of private pension funds is needed. Second, it is essential to look at whether the tax burden (or the level of redistribution) allows people to pay pension contributions. Decision makers in Lithuania agree that the payment of personal income tax should be deferred until pension benefits from pension funds are received. This means that contributions to pension funds should be exempted from personal income tax. Presently the ceiling of tax-exempt income is a subject of debates. If the principle of tax deferring is to be implemented consistently, all contributions to a pension fund paid by an individual should be exempted from personal income tax without limiting the sum or regulating to whose account these contributions are paid. This provision is instrumental if the aim is to avoid double taxation and to defer the payment of income tax. In addition to that, all payments to pension funds should be exempted from social insurance contributions. At the present moment, this issue is surrounded by a great deal of controversy.
It is anticipated that the tax burden will reach 35.4 percent in 1998. This means that people give away on average one third of their incomes for redistributive purposes. Social insurance contributions account for about 30 percent of redistribution. People are very unlikely to have enough means to secure retirement provision and a decent living if the tax burden does not decline. Lithuania has embarked on a budget policy reform that could be a proper measure to authorise a declining tax burden. Yet, the budget reform is confined to replacing the principles and form of budget formation by switching from functional to program budgeting. The budget reform is not intended to reduce the tax burden. Still, there is a general understanding that public spending should be tamed, and attempts are being made to identify ways to do it. Proposals have been voiced to set a maximum level of budget outlays relative to GDP or in absolute terms. At this point the government does not seem to be ready to adopt such a decision.
In terms of GDP, the Lithuanian economy began to grow in 1995 when GDP rose by 3.3 percent. The rate of growth reached 4.7 percent in 1996 and 5.6 percent in 1997. The estimated GDP growth in 1998 is 6 percent.
Credible money is one key to a successful pension reform and a viable operation of pension funds. A monetary policy should be stable and reliable. On April 1, 1994 Lithuania installed a currency board which pegged litas to the US dollar at a permanently fixed exchange rate of four litas for one US dollar. Under the currency board arrangement, currency in circulation was backed a hundred percent with foreign currency and gold reserves. Rule-bound monetary policy put inflation under control, forcing it down from 37.5 percent in 1995 to 13.1 in 1996 to 8.4 percent in 1997. The currency board arrangement brought about a marked decline in and levelling of interest and exchange rates. Moreover, it shielded monetary policy from political pressure.
In early 1997 the Bank of Lithuania (BoL) adopted a monetary policy program for 1997-1999. According to the program, the currency board is to be phased out and "classical" central bank functions are to be restored. The program is to be implemented in three phases. During phase I, which ended in early 1998, the Bank of Lithuania introduced open market operations, repo transactions, time deposit auctions, and overnight lending. These measures are used to influence interest rates as well as to accommodate commercial banks by providing liquidity loans and the possibilities of using free funds. Phase II will involve amending the Litas Credibility Law, supplementing backing of currency in circulation with securities, rediscounted bills of exchange, loans, etc., lifting reserve requirements, and establishing backing that is needed to "maintain currency stability." During phase III the litas will be linked to euro or euro plus a basket of currencies. Monetary policy after the year 2000 is not discussed.
It is obvious that a two-year prospect of a stable monetary policy and credible money is not sufficient in adopting pension reform and shifting to private pension insurance. Introduction of a uniform currency is uncertin due to Lithuania's uncertain prospects of accession. If the stability of national currency is not established by law, emerging pension funds will have to take precautions against currency risk themselves. This may prove too difficult for pension funds if laws establish strict requirements for investment portfolio diversification disallowing to hedge currency exchange risk. The need to secure against currency exchange risk is likely to engender supply of derivative securities.
Most political forces, including the Homeland Union - Conservative party, the Centre Union and the Liberal Union, have come out in favour of pension funds. The introduction of pension funds has been put high on the government's agenda. The largest lobbyist employers' groups support the process too. Trade unions have been rather passive.
Current pensioners and the elderly segments of populations may be resistance to the initiatives to phase out state social insurance. Given that pensioners represent one of the most active electoral groups, it is very likely that their opinion will carry much weight in adopting policy changes.
There is no clear vision of a future pension system and private pension funds per se. Nor is there a consensus on whether pension funds should supplement the public pension scheme or replace it. The sensitive nature of the pension issue obstructs the formulation of a clear position on trimming or replacing social security. Yet, it should be noted that there is no real pressure to raise social security benefits at the cost of increased contributions.
In Lithuania the policy making process on pension reform is influenced by the World Bank who provide continuous recommendations and plan to contemplate loan provision based on what principles of the pension fund law and what environement of pension funds will be established.
State officials and agencies have no specific opinion on the issue as they are not involved in the policy making process on a large scale. The Securities Commission and the State Board for Insurance Affairs are the most actively involved institutions. The two of them advocate fully-funded pension funds. In addition to that, the board is in favour of segregating the provision of pension annuities.
Most elderly people in Lithuania are ignorant about private pension funds and the prospects of private retirement provision. All hopes to receive pensions are associated with social security and its improvement. Many people of younger age are fairly sceptical about state pension entitlements. Still, there is little interest in institutions that could help provide for retirement. Only active young and middle-aged individuals are ready to assume responsibility for retirement provision. Yet, the awareness that people themselves rather than the state should care about their pensions would be a great psychological shock.
Pension insurance provided by insurance companies is used by a negligible number of people. This testifies to the fact that retirement provision through special institutions is not very common nor popular in Lithuania. On the other hand, the current supply indicates a potential need for such services and businesses' readiness to render them. Banks, financial brokerage firms and insurance companies are very interested in private fully-funded pension funds and keen to set them up as soon as the legal and tax framework is ready.
According to an expert survey conducted by the Lithuanian Free Market Institute, households allocate over 10 percent of money income to investment and saving, and this share is expected to increase in the future. Pension funds could be involved in managing part of these resources.
Article 52 of the Lithuanian Constitution states that "the state guarantees citizens' right to old-age and disability pensions." Thus, the Constitution does not allow the state to withdraw from the pension system, although it does not specify what pensions are the state's domain and under what conditions they are guaranteed.
At the present moment the problem is with company legislation which is absolutely inadequate for the operation of fully-funded pension funds. In addition to specific rules applicable to pension funds, problems exist relating to ambiguous division of authority between bodies within legal entities and unclear responsibility for fraudulent actions of bodies of legal entities. The institution of trust, according to which many funds in Western countries operate, is under-developed in Lithuania. The company legislation regulates specific relationships and is not flexible. There is even less flexibility in applying legal company norms in court.
There no essential legal obstacles to insurance-based pensions and company pensions.
No technical barriers to pension reform exist. Lithuania has had sufficient experience in financial matters: Lithuania has commercial banks and insurance and investment companies which have expertise and mechanisms necessary to manage loan-, insurance- and investment-related risks. Pension funds are not a novelty on the world market either, so there are good conditions of taking over world-wide experience as much as it is useful and valuable.
The existing pension system is unreliable in financial terms and has no prospects of development. Policy changes adopted to date have failed to solve the problems of financing retirement provision. It is imperative to replace the outmoded and under-funded public pension scheme with a private fully-funded alternative.
The pay-as-you-go system is not capable of handling the worsening demographic trends. Increased retirement age is but a temporary solution that will help reduce the social insurance budget deficit in the short run.
A direct link between contributions made and future benefits earned was expected to bring about a decline in shadow economic activity and an increase in payments to the social security fund. Yet, a lack of confidence in social security persists and people are not inclined to support it. Social security contributions are viewed as simply a tax on income or payroll, so evasion is wide-spread. Social insurance is not based on genuine insurance principles. It is a redistributive mechanism that goes under the cloak of insurance. The treatment of social security contributions as taxation is also justified on the point that:
- most people pay much higher contributions than is necessary to finance their individual pensions;
- a person continues to pay social security contributions after he or she has acquired the right to a pension (in the case of working pensioners);
- a ceiling has been set for pension benefits but not contributions: those who earn more pay more, even though they will not receive larger benefits;
- part of the insured eventually do not qualify for pension benefits despite their payments of contributions (e.g., due to a too short insurance record).
Actuaries have calculated that if social insurance contributions were accumulated rather than redistributed, the level of contributions necessary to finance pensions of the insured could be much lower (about 10 percent instead of 23.5 percent). This indicates that part of contributions do not go toward paying pension benefits and may be regarded as a tax.
Social insurance contributions inflate labour costs and undermine business competitiveness. For employers who pay a sizeable amount of social security contributions they represent another tax that punishes for job creation. In addition to that, employees become as if hostages of their employers given that their future pensions depend entirely on the payment of contributions by the employer.
Although policy changes conducted to date were aimed at restoring pension differentiation and proclaimed social justice, these goals have proved unattainable within the existing system. Although no limits were put on social insurance contributions, pension differentiation proved to be beyond the capacities of the social insurance budget and was reduced. Social insurance pensions depend on political will (pension laws are constantly being changed regardless of pension promises) and therefore cannot be regarded as pensions earned by paying contributions.
Artificial separation of the sources of financing pensions (the social insurance budget and the state budget) coupled with illusionary link between pension contributions and benefits preserve and justify privileged pensions for certain segments of the population. This provides opportunities and incites demand for financing pension benefits for some individuals at the cost of others. The number of recipients of privileged pensions is increasing.
Generally speaking, the public has no confidence in social security. The system provokes evasion of pension contributions and expansion of shadow economy. Among other pernicious effects are reduced incomes, investments and savings. This, in turn, undermines the supply of capital in the country and obstructs economic growth.
The existing social security system can hardly perform the function of pension insurance. Extensive redistribution does not allow it to provide sufficient incomes after retirement. Given the new pension regulations, the state scheme does not provide social protection as only half of individuals of pensionable age will qualify for state pension entitlements. The burden of providing retirement provision will need to be shared with the state budget. Under such circumstances, replacement of the principles of the public pension scheme and creation of efficient retirement provision that will not cripple individual motivations and economic development is necessary and inevitable.
The prerequisites for pension reform are in place. To create a reliable pension system, several conditions should be built. Safety of funds in banks and other financial intermediaries conducting operations with pension fund resources is a crucial condition. An integral part of pension reform is replacement of budgetary policy aimed at reducing the tax burden for individuals and firms. Sound money is another key to a viable fully-funded pension system.
Pension reform is a long-term reform adopted step by step along with changes in other related areas. If these goals are to be achieved, political forces in the country must reach a consensus that will secure stability of fundamental principles of pension reform.
