In response to the recent approval of a modest pension increase by the Spanish government, thousands of pensioners marched the streets of major Spanish cities last Thursday in protest. Madrid saw particularly heated demonstrations when 3,000 people broke through the police cordon and surrounded the Congress of Deputies.
Since the 2013 reform of the Spanish public pension system, pensions have ceased to be indexed to inflation. Instead, pension rises were left at the discretion of the government, which will be in charge of deciding how much to increase pension benefits each year depending upon the economic situation. This reform hardly affected the purchasing power of pensioners between 2014 and 2016 because prices remained practically flat over the three-year period, and pensions were increased by 0.25 per cent (the minimum established by the new law) per year.
Yet the economic recovery (or better said, the erroneous ECB inflation-targeting policy) is bringing inflation back on track. In 2017, the CPI increased by 1.1 per cent, which means that, in real terms, pensioners saw their income decrease by around 0.85 per cent. This does not seem like much, but taking into account that inflation is expected to accelerate in 2018 and 2019, the loss of purchasing power for pensioners will be substantial over the next years.
This has led many sectors of civil society to demand that pensions be indexed again to the CPI. Intuitively, this sounds reasonable. After all, the high unemployment rate has pushed many families to live off the pensions of their elders. The least the government can do is to maintain their purchasing power. However, can the Spanish public pension system afford it?
First of all, let us take a look at public pensions today. In 2017, the public pension system reached a deficit of 1.5 per cent of GDP, which implies that pension payments made in 2017 exceeded social security contributions by €16.800 million. In fact, the system has been in deficit since 2011. Until recently, the gap had been financed via an emergency fund established in 2000 to guarantee the payment of pension benefits in times of economic crises. Yet the fund is almost empty and the government will be compelled to seek new financing sources, namely tax increases or public debt.
However, these solutions are only temporary remedies that fail to address the underlying demographic problem that Spain has been suffering over the last decades. By 2030, the worker-to-beneficiary ratio will have decreased by 43 per cent, moving from 2.28 now to 1.3 workers per beneficiary. This means that improvements on the income side resulting from increasing employment will not be enough to make the system sustainable in the long term.
Apart from the deindexation of pensions, the 2013 reform introduced other measures aimed at preserving the public pension system. In 2019, a sustainability factor will come into effect whereby life expectancy will be factored into calculations of the pension amount. According to the Ministry of Employment, this will reduce the nominal value of pensions by 5 per cent every ten years.
This reform along with the one undertaken in 2011 will make the system sustainable at the expense of pension benefits. The replacement rate at retirement (the ratio of the last salary of a worker to the pension benefits he or she is entitled to) will move from around 80 per cent nowadays to 45 per cent in 2050. Is there any viable alternative to avoid such a significant cut?
A mixed pension scheme would likely mitigate the impact of declining public pensions by devoting part of social security contributions to private savings mechanisms (pension plans, mutual funds or any other investment vehicle) that allow workers to build a capital cushion that complements the meager public pension they are bound to receive. Another alternative would be to incentivise the creation of corporate pension plans, which only 1 out of 5 companies offer nowadays in Spain.
The demonstrations that took place last week are understandable. When the purchasing power of your only source of income is eroding slowly but inexorably, it is normal to feel frustrated and demand solutions. Yet the resources of the public pension system are limited, and demography is not helping either. Unless we implement an alternative arrangement whereby private saving schemes play an important role, Spanish pensioners are condemned to a drastic reduction in pension benefits in coming years.