How to make pension systems more robust – Automatic adjustment mechanisms as a response to longevity

Without adaptation, increasing life expectancy entails cost-increases for statutory pension systems. In Finland, earnings-related pensions have undergone a major reform by adapting both retirement ages and the pension formula to increased life-expectancy. The European Commission’s Annual Employment and Social Developments Review lifts up the Finnish reform as an example of how to incentivize longer working lives. Here I explain the essence and motivation behind automatic adjustment mechanisms.

Adjusting pensions to counter ageing

Increasing life expectancy is a financial challenge for pension systems. Most people think straightforwardly that the increase in life expectancy can be tackled simply by adjusting the legal retirement age. However, in reality, adjustments and their consequences are more complex. A key issue is how to increase the effective retirement age. In addition, reforms also need to answer to other than financial concerns.

In defined benefit (DB) pension schemes, the pension promise is often based on the notion of a monthly pension. In terms of financing, the problem with DB schemes is that, as people live longer, pension expenditure grows. Time spent in retirement has greatly increased in the European Union, currently spanning about 22 years on average. This has caused pension expenditure to grow which, in traditional DB schemes, has been tackled mainly by raising contribution rates.

However, there is a limit to how much contributions can be raised. Some countries have limited the role of DB schemes and introduced defined contribution (DC) schemes instead. Others have transformed their schemes to notional schemes (NDC). Adaptation is possible also in DB schemes. To avoid an undesired financial burden and growing intergenerational unfairness, Finland introduced the life expectancy coefficient (LEC) in its earnings-related pension scheme in 2005.

LEC is a powerful automatic pension level adjustment mechanism that can help pension systems to mitigate the challenge caused by longer life expectancy. LEC is based on the notion of earned pension rights in terms of pension capital, not in terms of monthly pensions. When you work, you earn a right to pension capital, which is paid out as an annuity. If you live longer, LEC adjusts your monthly pension and makes up for the extra months or years that you will spend in retirement. LEC also functions the other way around: if life expectancy were to decrease, and the time spent in retirement was reduced, monthly pensions would increase. It is thus in essence a financial incentive; one can avoid decreases in one’s monthly pension by postponing retirement.

In Finland, LEC was agreed on in connection with the 2005 pension reform, but it has been in force since 2010. Its effect is determined by comparing mortality to the base year of 2009, which means that LEC is calculated according to new statistics each year. In other words, as each cohort reaches the age of 62 years, it will get its own LEC. When a person applies for a pension, the pension is adjusted with LEC. LEC is applied only once, when the pension to be paid out is determined.

Wanted: higher employment

Like many other countries in Europe, Finland has also experienced growing employment rates among the over-55-year-olds since the early 2000s. The effective retirement age has increased by around three years from the year 2000. These positive developments stem partly from pension reforms that were carried out already in the mid-1990s.

However, while employment rates for the age groups from 55 to 64 years is high in Finland in a European comparison, there is great variation within this age group. The employment rate for the 60-64-year-olds is just slightly over 42 per cent, which is considerably lower than in the other Nordic countries. A major reason for the low employment rate among the over-60-year-olds is the current low retirement age of 63 years.

Experiences of pension level adjustment

LEC has now been in practice for seven years. The reducing effect on the pension level is now around four per cent, but it will grow over time. LEC will help achieve financial sustainability in the long run, but it has turned out to be ineffective as an incentive to postpone retirement, at least so far. Resorting to pension level adjustment alone may not be enough.

Firstly, while the overall development in pension expenditures as a share of GDP between now and 2060 looks rather stable (thanks to LEC and other reforms), the cost increase in the pension system will be felt between now and 2030, largely caused by different-sized age cohorts. The LEC effect, in contrast, will increase year-by-year, raising the question of right timing.

Secondly, LEC is an economic incentive that affects the monthly pension at an individual level but leaves the retirement decision to the individual. Finland has a flexible retirement age, but the majority of people prefer to retire as soon as they are allowed to do so. Most accept a reduction in their monthly pension and think less about its long-term effects in an unsure future. In many cases, other reasons to retire are stronger than the economic incentive to continue working created by LEC. It follows that, should the retirement pattern focus on the minimum age also in the future, with LEC in place, employment at older ages would be low. That, in turn, would lead to a higher risk of old-age poverty, especially as the retirement period would be longer.

Thirdly, although LEC has helped to generate sustainability in the pension system, the tendency to retire at a relatively low age in the context of an increasing life expectancy is not helpful for other public finances. According to projections, Finland has a sustainability gap that is caused by the expected costs of health care and long-term care services. Higher employment rates are needed to finance them.

To help solve these issues, the Finnish government and the social partners – after lengthy discussions – concluded that further reforms are needed. In 2011, they agreed on two important measurable targets: firstly, the effective retirement age should rise with three years by 2025 (compared to 2009). Secondly, changes in the earnings-related pension scheme should reduce the sustainability gap by 25 per cent (the remaining 75% are to be reduced through other measures).

How to adapt?

With the automatic adjustment mechanism in place in LEC, meeting the two targets stated above posed two interesting policy questions: should one continue with pension level adjustments or react by changing the retirement age? If the latter, should one raise the retirement age in a discretionary or an automatic way?

Linking the retirement age to longevity has been marketed as a one-size solution to all problems. However, paying more attention to the different goals we want to reach (and their priority), we need to think more carefully about the adjustment mechanism. A single solution may have different effects in different contexts. In turn, the optimal, or acceptable, combination of adapting mechanisms may be different for different countries.

In Finland, the issue of how to adapt has been addressed with several concerns in mind. Above all, the effects of a possible new adjustment was considered against employment and unemployment but also disability as not all are capable to work until a higher retirement age. Effects on pension finances and government finances had to be assessed. Also, the effects of adjustments to pension levels and to flexibility, as well as gender, socioeconomic and intergenerational fairness were addressed.

After considerations, model calculations and other analysis, the decision-makers in Finland chose to increase the retirement age discretionarily, by raising the retirement age with three months per cohort per year over the next eight years. That way, the minimum retirement age will eventually be 65 years. According to assessments about the effects of this change, we can expect to achieve the desired increase in the effective retirement age.

However, although we are likely to meet the retirement target set for 2025, the increase in the retirement age has been deemed insufficient to reduce the other goal for reducing the sustainability gap. That is why an automatic retirement age adjustment after 2025 was also agreed on in the 2017 pension reform. The adjustment mechanism links the retirement age to longevity in a way that is to keep the ratio of years spent in working life over the life course stable. If life expectancy increased by 3 months, 2 months of this increase would be visible in the retirement age, while the remaining one month is subject to LEC adjustment.

A blend of two mechanisms

As a result, Finland will have two automatic adjustment mechanisms: the pension level and the retirement age adjustment. To avoid life expectancy being taken into account twice, the LEC formula was amended to mitigate its effect. As a result, these two mechanisms will work together with a greater emphasis on the retirement age adjustment and a lesser emphasis on the pension level adjustment.

In practice this means, firstly, that people have to retire later, and secondly, in case they retire at the earliest possible time, their pension will be reduced. They cannot avoid this reduction mechanism, but they can compensate for it by continuing to work until the target retirement age that is calculated separately for each cohort. Continuing to work after the minimum retirement age is awarded with a higher pension. The choice of whether to defer retirement after the minimum retirement age or not, and for how many months, is up to the individual.

The justification for having two adjustment mechanisms rather than one or the other goes back to policy concerns. According to analysis, the two mechanisms together yield a more acceptable compromise than using either of the measures alone. For instance, LEC was deemed to create too little employment and too heavy losses in terms of pension levels. An adjustment of the retirement age alone was deemed to induce higher unemployment and disability at a high price.

With two mechanisms, employment will rise, as will the effective retirement age. These will strengthen both pension and public finances. Due to longer working lives, the average monthly pensions will be higher, although the period in retirement will be shorter than expected before the reform. For younger generations, the reform will mean lower contribution rates without sacrifices in pension levels.

Unfortunately, unemployment and disability are more pronounced in later ages. To address that issue, pension formulas were adjusted in a way that yields higher pensions also for those who cannot extend their working lives. A remaining policy challenge after the pension reform is how to better prevent unemployment and disability towards the end of working life.

The blog has also been published on 11 October 2017 in the Etk.fi blog.

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