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World: Steering Away From The Iceberg

  • Robert Lyle

Washington, 12 March 1999 (RFE/RL) -- The World Bank puts it bluntly: old government pension systems are already unsustainable in most Central and East European Countries as well as in the nations of the former Soviet Union.

On the other hand, says the bank, the good news is that a wave of pension reforms is sweeping over East and Central Europe and spreading rapidly to Asia, reforms which entail what the bank says are unprecedented changes in managing the allocation of people's income during their lifetime.

The old systems were based on the pay-as-you-go plans still used throughout the world, including in the U.S. and Western Europe. The leader of the World Bank's Social Protection Sector project for Europe and Central Asia, Michal Rutkowski, says that system is really a pyramid scheme:

"You can think of it like the pyramid schemes in Albania, which collapsed. And this is exactly what we are all in -- those who participate in a state-run, pay-as-you-go, as we call them, meaning those who are currently workers are taxed in order to pay the government pensions. This is the key issue."

As the older population becomes so much larger while the younger working age population shrinks, the cost to continue providing pay-as-you-go retirement, disability and survivorship pensions would increase from the current 10-15 percent of GDP (gross domestic product) to over one quarter of the entire economy within 50 years.

Rutkowski says the World Bank is working with most of the nations in Central and East Europe and Central Asia to reform the current systems into what are called "multiple pillar" systems -- where different parts of a person's pension are financed by different vehicles.

"When we talk about pension system reform, we talk about the movement to a multi-pillar system -- where the first pillar remained the state pillar financed by taxes called contributions, but where the second pillar is a pillar which is a funded pillar -- funded by individual contributions which are invested, which bring a return. It is a pillar which takes advantage of the contemporary financial market."

Rutkowski says that in keeping the old pay-as-you-go system as one pillar in the reformed systems, the bank recommends that it be made transparent, in which pensions depend on contributions paid -- an incentive to contributions because people know the taxes have a direct impact on the size of their future pensions.

Current systems have no direct linkage between contributions and benefits, says Rutkowski, and in many places some people pay large contributions to get small pensions while others pay little but get large payouts.

The second pillar the bank recommends is called a "funded" pillar, meaning that workers are required to also pay into a mandatory government-supervised individual savings account which is invested into the financial markets. Rutkowski says the worker can then draw out his savings, in addition to its earnings and hoped-for market-based growth, as a second part of his or her state pension:

"The role of the state needs to be transformed from the role of somebody who actually manages the pension system, to somebody who manages only part of the system, which remains pay-as-you-go. But as far as the funded part is concerned, the role of the state converts into making sure that the system is properly regulated, licensed, supervised and therefore safe." The third pillar in the World Bank recommendation is private savings which can be sheltered from current taxation specifically to provide for retirement. These special savings accounts, which can be kept in a bank or invested in the stock and bond markets, are already popular in the U.S., Denmark, Switzerland, the United Kingdom, and Australia.

All three pillars are essential to a long-range sound system, says Rutkowski, because the mandatory parts give a balance for the poor while the private savings side lets the wealthy build additional savings.

Poland, Hungary and Latvia have this past year introduced multiple-pillar systems embracing in various ways all three pillars. Croatia is expected to do so shortly.

Rutkowski says these multiple-pillar systems do require the existence of a somewhat vibrant private capital market in addition to a level of trust in markets by the people:

"We're talking about relative trust compared to the social security system. These people in Central and Eastern Europe received proof beyond any reasonable doubt that the pay-as-you-go system is not safe either. In the early, 1990s, there were tremendous drops in pensions related to the macroeconomic shock through which those countries went in the transition. So real pensions, pay as you go pensions, pensions paid by the social security systems, dropped by 10, 12, 15 percent in real terms."

For the non-Baltic countries of the former Soviet Union, especially those in Central Asia and the Caucasus, Rutkowski says the bank recommends a slightly altered approach which recognizes that there are no real financial markets yet and won't be significant markets for many years to come.

In those countries, Rutkowski says, the bank suggests a go-slow approach centered on making the current pay-as-you-go system transparent:

"The strategy which we try to support is, you keep your pensions relatively flat to make sure that they protect people from falling into poverty. And then by doing that, there is obviously a space, especially for those who earn more, to introduce additional provision of pension security. We try to support putting in place at the moment legislation for voluntary pension provisions, so that if somebody has money, he or she could safely start investing in the country to increase future pension and that meets the existence of the law of supervisory institutions."

Rutkowski says the bank recognizes that in these countries, a very small number of people will start such private savings:

"It doesn't solve the pension provision problem, but by doing that there will be an increased trust in using the financial markets for the purpose of pension provision, so there might be a time which comes in the future when moving more aggressively would be done against the background of popular support, as opposed to being done against the background of lack of support. So it's just a much slower strategy."

Rutkowski says it has been a difficult process getting most of the transition nations to move ahead on pension reform. Slow, that is, except in Kazakhstan which surprised the bank by introducing a kind of multi-pillar system at the start of 1998. Kazakhstan "should not have done it," says Rutkowski, "it was premature" because it replaces the current pay-as-you-go pillar with a mandatory funded pillar (but which is only invested in government securities). Worse, it is being introduced in an underdeveloped financial market and with no third pillar of voluntary long-term savings available.

As the bank predicted, pension contributions in Kazakhstan dropped in 1998 because the people did not believe their money was really invested since it only goes into a state accumulation fund. Says Rutkowski, "it doesn't make much sense to introduce this type of reform if there is no private sector to invest money and no financial market to invest it in." Still, the bank is aggressively helping Almaty make the best of the situation.

Ironically, says Rutkowski, Germany, France, Spain and Italy in Western Europe could take a real lesson from the nations in Central and Eastern Europe which are moving ahead with multiple-pillar systems.

This is one case, says Rutkowski, where the developed west needs to learn from the transitioning east:

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"It's a different situation. In some sense it's easier, in some sense it's more difficult. But we hope they avoid mistakes. In hind-sight it's easy to say, but now if we could say that they will avoid mistakes which were done in developed countries with their exclusive reliance on state provisions of pensions."

The World Bank has been actively providing technical assistance on pension reform to Hungary, Kazakhstan, Russia, Croatia, Macedonia, Kyrgyzstan and Bulgaria. It has technical assistance and investment programs in Latvia and Romania and is preparing loans for Poland, Kazakhstan, Slovakia, Moldova and the Czech Republic.

Most of the nations of the region which do not have already multiple pillar systems yet in place do have them in preparation. Some, such as Russia, Bulgaria, Ukraine, Georgia, Lithuania, Estonia, Albania and Moldova have already given preliminary approval -- and in some cases already passed the necessary legislation -- to allow private pension savings.