Transition Costs and their Impact on Pension Adequacy

1. Transition costs and their impact on adequacy Vidija Pastukiene Seminar on Private Pension Provision Transition costs and decumulation phase Tallinn, 6-7 September 2007 Ministry of Social Security and Labour of Lithuania

2. Outline of the presentation • Lithuanian pensions: main features • II pillar pension reform: main features • Key components of transition costs • Transition costs evolution • Sources for covering transition deficit • Social insurance fund prognoses • Replacement rates • Issues under discussion

3. Lithuanian pensions: main features • Old age dependency ratio: 22% in 2004, 45% in 2050. • 85% of labour force are insured • Average pension to average wage (gross) – 32%, net – 44% • Total social insurance contribution rate 34% • CR for pension insurance – 26%

4. II pillar pension reform: main features • Contribution rate to funded individual DC account: 2004 – 2.5%, 2005 – 3.5%, 2006 – 4.5%, 2007 – 5.5% out of existing social security contribution rate for old age pension insurance (21%) • Participation voluntary for everybody insured under retirement age but no switching back • Benefits available from legal retirement age, compulsory annuity with floor and ceiling • Heritage of pension assets • Benefits non taxed • No central guarantee fund nor explicit state guarantees

5. Key components of transition costs Each year the size of the transitional deficit is calculated by the following equation: Transitional deficit (year) = A – B • A = flow of contributions into the second pillar • B = reduction in PAYG expenditures as the result of introduction of the second pillar

6. Key components of transition costs 1. Flow of contributions into the second pillar depends on: • Contribution rate to funded pillar (2.5%-5.5%) • Participation rate evolution (from 55% in 2005 to 75% in 2050) • Income level of participants • Economy real wage growth (sharp changes up to 20% recently)

7. Key components of transition costs 2. Reduction in PAYG expenditures as the result of introduction of the second pillardepends on: • difference in CR diverted to supplementary part of PAYG pension (10.5 in 2006) and CR diverted to II pillar (5.5 from 2007) • fraction of pensioners getting benefits from funded component (8% in 2008, 58% in 2030 and 75% in 2050) • RR of PAYG component (32.5%, constant due to pension indexation to wages)

8. Transition costs evolution

9. Sources for covering transition deficit • Social insurance fund surplus (available until 2020) • Privatization fund assets • Transfers from state budget • Parametric reforms of current pension system (increase in retirement age to 65 from 2012 to 2026 is under consideration )

10. Social pension insurance fund surplus (available until 2020)

11. Past trend and nearest prognosis of transition costs

12. Replacement rates

13. Replacement rates • RR in PAYG mono-pillar system (32.5%) is constant all projection period due to assumed pension indexation to wages (there is no automatic indexation rules in the Law) • The diversification of pension sources and reduction of PAYG program (8.8 % lower replacement rate) will reduce the expenditures of social insurance fund by 0.6% GDP in the end of transition period in 2050. • Due to projected higher real rate of return of funded part switchers of two pillar system are projected to get higher replacement rate by 2 percentage points

14. Issues under discussion • Financing of transition costs is agreed annually while composing social insurance and state budgets. So far it is shared 50/50 by both. • There are proposals to increase contribution rate up to 10% by 2010. This could lead to enlarging of transition burden to 1.8 % GDP

15. Social insurance fund expenditure projections

16. Thank you for your attention!