Pension reform still up in the air

The latest in a series of pension reform proposals - and one likely to influence the final product - seeks to divert part of mandatory contributions into separate investment funds. But the big question that remains unanswered is how to make up for the gap in direct contributions to the state fund needed to support current pensioners.

The government-appointed National Economics Council (NERV) released a proposal Dec. 13 that is built on the framework of a so-called "three-pillar" system. In it, the pension contributions of workers would be reduced from the current 28 percent of monthly salary to 23 percent, with 3 percent going into the new second pillar of investment funds, either on the private market or through the state. That amount would likely increase to 5 percent later on. To make up for the reduction in payments to the state, the proposal suggests introducing a flat 19 percent value-added tax (VAT).

Reforms in the Czech Republic come as part of a larger movement in Central and Eastern Europe to grapple with aging populations and pension systems with roots in 20th-century socialism. Many countries, including the Czech Republic, have relied on a so-called two-pillar, pay-as-you-go model that is largely focused on a single state pension fund with the option of supplementary pension savings. Mandatory contributions from workers go directly to the state, which uses the money for payments to current pensioners. However, the growth in the population of pensioners is outpacing workers.

"Let's say the current ratio is three workers for every retiree. Well then, in 20 years, it's two to one. Then, in 40 years, it could be one to one, so that one worker would have to pay a huge amount from his or her paycheck to support that pensioner," said Martin Lobotka, an analyst at Česká spořitelna.

In the Czech Republic, pension payouts reached 350 billion Kč ($18.5 billion) in the 2010 budget, or 9.4 percent of GDP - the largest single government expenditure for the year. At the same time, higher unemployment and increased life expectancy were forecast in an International Monetary Fund report earlier this year to increase social spending 6 percent over the next 50 years.

"People are living longer, healthy lives. This is a great news story," said Nicholas Barr, a professor of public economics at the London School of Economics. "But successive governments have ducked the issue, so that the pressure of pension finance has grown, though the economic crisis has brought things to a head. The underlying issue is the long-run and has been well known for a long time."

However, a switch like the one NERV recommends is expensive, as governments have to immediately juggle reduced income from pension payments with paying for the transition - a cost that prompted Hungary to sharply revert to a pay-as-you-go system in order to boost its budget. There are fears that other countries will follow Hungary's lead, but a deal with the European Union sealed by Poland at the Brussels summit Dec. 16-17 allows more budget leniency to member states working to reform pension systems.

The VAT proposed by NERV is a way to address that budget gap but has caused the most disagreement among politicians. Members of the Public Affairs (VV) party have said they do not approve of the flat VAT, particularly on food items, while Labor and Social Affairs Minister Jaromír Drábek and Finance Minister Miroslav Kalousek have said it is the only way to achieve pension reform and have even suggested the higher VAT be implemented in January 2012 in order to raise money in advance of any change to the pension system.

Pension reform will likely begin in 2013, according to Drábek, although NERV's proposal is for introduction in 2015.

NERV experts say they have done all they can and declined to comment on political reactions to their proposal, though Jan Procházka, a NERV member and an analyst with Cyrrus brokerage firm, said he is unsure why the main discussion in the media is centered on the VAT.

"It is increasing one tax and decreasing the other, so the same amount of money is staying in the system," he said. "We did our work. Now, it's up to the politicians to start working. There is not a need for members of the commission to ask about what they are thinking. We will see what they do."

Miroslav Zámečník, also a member of NERV and an economic consultant, would only say the proposal should allow for a useful political debate.

"It needs to be addressed with a bipartisan approach. That is really important because we cannot afford to go back and forth with reforms of this importance," he said.

A "funded pillar" system has been hailed by many analysts as more sustainable, but it also introduces an element of uncertainty because, like any other investment, there is the risk that money could be lost.

"The characteristic of a 'good' retirement system is the balance between funded and public pillars, because both are exposed to different risks, like the capital market versus political risk," said Renate Finke, the senior pension analyst at Allianz, an international provider of integrated financial services. "Diversification of retirement income increases financial security in old age."

Cat Contiguglia can be reached at
ccontiguglia@praguepost.com