25 July 2017

Pensioners are feeling the pain in Spain


When the British Government announced last week that it was bringing forward increases to the pension age, there was outrage. Critics claimed it was austerity via the back door, that Britons were going to be working until they dropped.

Entirely missing from the debate was any sense that this is a problem affecting all Western nations – and in fact, that Britain, with its relatively youthful population, is in a rather better position than most.

Here in Spain, for example, the situation is even more urgent. The Great Recession (from which the economy has still not fully recovered) has exposed the longstanding structural problems with public pensions, and the welfare state more generally.

After the trauma of 2008, Spain is finally experiencing strong GDP growth, which has resulted in a sharp drop in the unemployment rate (a 30 per cent decline in barely three years). Yet the social security system has gone from having a surplus of almost 15 billion euros in 2007 to a deficit of around 20 billion today.

Since 2012, the Spanish government has been forced to make use of the social security emergency fund, a savings mechanism created in 2000 to guarantee the payment of pension benefits, to avoid defaulting on its obligations to retirees. As a result, the emergency fund is almost empty.

Obviously, the financial crisis has played a role in creating this enormous deficit. The higher the employment rate, the more workers will be contributing to the system, and vice versa. Yet over the last three years, the deficit has continued to increase despite the fact that the unemployment rate has dramatically decreased.

The reasons behind this seemingly contradictory pattern are varied. On the income side, the still high unemployment rate and decline in real wages since the outbreak of the crisis have resulted in lower social security contributions (which might sound familiar to British readers). On the expenditure side, the increase in life expectancy and the rise in the average pension have both contributed to a rise in spending on contributory public pensions from 7.6 per cent of GDP in 2008  to 10.7 per cent in 2015.

Yet what really endangers the sustainability of the system is the demographic trend present not only in Spain, but in most developed countries. By 2030, the ageing of the population will have reduced the worker-to-beneficiary ratio to 1.3, meaning that each worker’s social security contributions will be roughly equivalent to the cost of one contributory pension. That makes the current system as we know it unsustainable.

And this lays bare the fragility upon which all social security systems are based. As with Ponzi schemes, the early investors (former workers turned into retirees) are totally dependent on the entrance of new investors (workers entering the labour market) to receive their pension benefits. If the link breaks, due to factors such as low birth and immigration rates or declining wages or the gradual ageing of the population – or all of the above – the system either collapses, or needs to be reformed. And any reform will be at the expense of future retirees, who will see their benefits decrease.

In Spain, the social security system has already gone through several de facto bankruptcies over the last three decades. And each reform aimed at ensuring the long-term viability of the system has entailed the breach of the terms promised to future retirees.

In 1985, the socialist government carried out a structural reform that increased the number of years of contribution required to access one’s full pension benefits from 10 to 15 years. In addition, the amount of each pension was calculated based on the last eight years of working life rather than the last two (normally salaries are higher at the end of working lives, so the longer the calculation period, the lower the final pension).

Another reform in 1997 meant that, in order to be entitled to the maximum pension, a worker had to have worked for at least 35 years – and the amount would be calculated using 15 years of salary. In 2011, the retirement age was extended from 65 to 67; the years of contribution to 38; and the calculation period to the last 25 years of working life. Finally, in 2013, pensions were de-indexed from inflation, a subtle way of reducing the purchasing power of retirees while maintaining pensions’ nominal value.

If the goal is to ensure the medium-term sustainability of the system, the reforms are a step in the right direction. For instance, thanks to the 2011 and 2013 reforms, estimated spending on pensions as a percentage of GDP will stabilise by 2050.

Yet this will come at a price – one paid by individual pensioners. As pointed out by the Spanish economist Juan Ramón Rallo, the replacement rate (the percentage of a worker’s earnings paid out by the social security system upon retirement) will – according to estimates from the European Commission – be drastically reduced, from almost 80 per cent nowadays to less than 50 per cent by 2060. That’s a 40 per cent reduction for the average pensioner.

As in Britain, such measures have not gone unchallenged. In an echo of the Labour manifesto, the Left-wing populist party Podemos recently proposed further tax increases on income, corporations and capital gains, as well as creating other taxes and increasing welfare contributions, in order to tackle the social security deficit. That would effectively abandon the contributory nature of the system. Other proposals include bringing the retirement age back to 65, re-indexing pensions to inflation and substantially increasing in the minimum wage.

As with the Labour Party in Britain, these plans would involve a staggering increase in the tax burden. And as with Labour, it’s based on sums that don’t add up. Just as John McDonnell promised to raise billions from corporation tax, Podemos fail to consider the wider dynamic consequences of raising taxes. For instance, they estimate that “a gradual increase of the minimum wage up to 60 per cent of the average wage would levy 3,470 million euros”. Yet this number does not take into account the likely increase in unemployment and the reduction of working hours, which would eventually depress revenues.

In almost every Western nation, the social security system has major, structural flaws that, if nothing changes, will condemn future retirees to increasingly lower pension benefits. Ideally, there will be a gradual transition towards a capitalisation system in which workers oversee their own retirement savings, immunising the system from demographic changes and business-cycle fluctuations.

Yet there are several factors that make such a transition a chimera, at least in the near term: the absence of political willingness, people’s bias against fundamental changes, a lack of financial expertise among the average citizen, the fiscal and practical problems that it would involve, etc.

However, several measures can be undertaken to improve our current systems. In Spain, for example, the demographic problem could be addressed by implementing immigration policies that mitigate the economic problems caused by low birth rates and an ageing population. Among other benefits, an increase in the immigrant working population would push up social security contributions: the higher the worker-to-beneficiary ratio, the better.

Another long-term solution would be a dramatic increase in productivity, which would result in higher salaries and, thus, higher contributions. And the example of the wealthiest countries in the world shows that high salaries can only be achieved by implementing free-market friendly policies, eg flexible labour markets and few and sensible regulations. But in Spain and elsewhere, such reforms are unlikely to be implemented any time soon.

Finally, Spain could shift towards a mixed pension scheme. Under this arrangement, which prevails in some European countries, part of the mandatory social security contributions now managed by the state (which nowadays amount to nearly a third of a worker’s gross salary) go to a privately managed fund, which invests its capital according to the worker’s risk profile. Upon retirement, these savings complement the public pension granted by the government.

The upside of this system is that workers would take advantage of the power of financial markets, growing their savings via investments in stocks, bonds and other financial instruments.

Ultimately, the social security and pension systems are the two sides of the same coin. Both have been deteriorating over the last years due to demographics as well as the financial crisis; and they will continue to do so unless some structural, serious reforms are undertaken. Unfortunately, politicians from all parties only agree to partially amend the system, not dealing with the root of the problem – namely the fragile pillars upon which the system rests.

Luis Pablo de la Horra is a Spanish finance graduate