Don’t raise social security rates – IMF

Better ways to tackle the pensions timebomb

 

Increasing social insurance contributions rates is not the answer to the looming pensions crisis, the IMF mission chief for Cyprus Alexander Hoffmaister said in a telephone interview with reporters last week.

Hoffmaister said that Cyprus’s current system had “fallen behind the demographic trend” and that there was a “chief weakness” in relying on increased payroll taxes (ie social security contributions) to address it because it relies on taxing an ever-shrinking pool of labour.

Labour taxes “fall disproportionately on people who are working,” he said.

“We proposing addressing these issues by increasing other taxes but more importantly by adjusting pensions rules”, he said.

This included raising the retirement age not only to 65 but also beyond in a system that is automatically adjusted.

Pensions system should be adjusted “systematically and automatically” to changes in key variables such as life expectancy, fertility rates and immigration.

Hoffmaister also said that the government needed to address the “mismatch of generosity” in public and private pensions provision. Some public-sector workers get a lump sum payment of 28 times their monthly salary on retirement as part of their retirement package, he noted.

The average de facto retirement age in the public sector is 57 and civil servants can retire five years early without penalty.

Hoffmaister also recommended linking pension increases to consumer prices, rather than wages (which tend to rise more quickly).

 

The pensions timebomb

 

The telephone interview was conducted against the backdrop of two lengthy IMF reports published last week—the Staff Report and the Selected Issues report—the latter of which goes into great detail on the looming pensions problem.

The working-age population—those who through their social security contributions  are paying the pensions of the people who have already retired—will fall from 68.1% of the total population in 2004 to 60.5% of the population in 2050, owing to gains in life expectancy and lower birth rates. 

Moreover, notes the IMF, “these population projections [of the government] assume a substantial amount of immigration”, up from 103,000 (14%) in 2005 to 329,000 (34%) in 2050.

This fall is not as dramatic as in the EU25, but the impact on the Cyprus budget will be bigger.

“Without reforms, pensions expenditure in Cyprus will rise by 12.9 percentage points of GDP by 2050, compared with an average increase of less than 3 percentage points in the EU,” says the report

Expenditure on the government’s employment scheme would rise from 6.3% of GDP in 2005 to 12.6% of GDP in 2050.

One of the reasons for this, which is not spelt out in the IMF report but is no doubt written into the econometric model they ran to test how soon Cyprus would go bust, is that Cyprus budget currently relies very heavily on an annual social security surplus that will not last.

In 2006 the social insurance surplus amounted to 3% of GDP (according to the government’s Convergence Programme report). This means that without it, we would have been looking at a budget deficit of about 4.4% of GDP in 2006 (way above the Maastricht criterion), rather than the 1.4% of GDP recorded.

 

No pain, no growth “for decades”

 

Another point underlined by Hoffmaister in his telephone interview was that the earlier we start to tackle the pensions problem, the less painful it will be.

“It is quite urgent … by moving ahead promptly the authorities, society, will be able to phase in reforms,” he said.

The IMF written report noted with concern that the time line for reforms such as tightening eligibility criteria had not been spelled out.

The penalties of not reforming, however, are severe.

“Not reforming the social security system would substantially reduce output growth and economic welfare for decades,” said the report.

It would lead to “require sharp increases in consumption taxes”.

The baseline “no-change” scenario also leads to an even greater imbalance between the generosity of public- and private-sector pensions.

 

Convergence Programme is not enough

The IMF also looked at the reforms outlined in the government’s annual Convergence Programme and also found these wanting.

“Although the macroeconomic results under the CP are better than those under the baseline scenario, quantitatively they differences are not substantial,” it says.

Additional “parametric” reforms are required in order to address the demographic shock and increase the relative generosity of the public v. private pensions provision.

Note that this does not mean ‘increase private pensions’, it is essentially IMF-speak for ‘decrease public pensions’.

How to do this without bringing everyone out on the streets is the government’s big challenge.

But as indicated by the IMF, there are ways to do it without cutting nominal benefits as such: lengthening eligibility periods, raising the retirement age, linking some or all of the pension to consumer prices and, I suggest, matching public servants’ social security contributions with those of the private sector.

“Setting in place the needed pensions reforms is thus urgent”, concludes the IMF, but in Cyprus, urgent means “after the presidential election”, so at least another year away.

 

By Fiona Mullen

Sapienta Economics Ltd

www.sapientaeconomics.com