Pension Reform in a Mature Welfare State

– Danish Experiences

Lars Haagen Pedersen

June 8, 2007

The Scandinavian Welfare model

Public transfer income and services:

• Universal entitlements based on objective criteria • Equality issues are central (transfers are indexed to

wages)• Large public production of individual service• High level of standards for public provision of welfare

services

Financing• Direct and indirect taxation of income

The social contract

• The public sector redistributes income over the life cycle

• The responsibility of individuals in the working ages towards children and the elderly is institutionalized in the public sector

• Enables and requires a high labour market participation rate of both men and women. Implies high tax rates by international standards

• High sensitivity to changes in demography

Aims of the retirement reform

• Maintaining the share of life in employment with increasing life expectancy (i.e. a constant labour force relative to population)

• Maintaining the current level of social pension relative to wage income

Age distribution of net contributions to the public sector per individual, 2004

-40

-30

-20

-10

0

10

20

30

0 10 20 30 40 50 60 70 80 90 100

1.000 EUR

-40

-30

-20

-10

0

10

20

30

1.000 EUR

Dependency Ratio and Old Age Dependency Ratio

0,000

0,100

0,200

0,300

0,400

0,500

0,600

0,700

0,800

1981 1991 2001 2011 2021 2031

0,000

0,100

0,200

0,300

0,400

0,500

0,600

0,700

0,800

Dependency Ratio Old Age Dependency Ratio

Danish pension system

• Voluntary early retirement scheme from 60 years for individuals in the labour market

• Disability pension for individuals up to 65 years with diagnosed reduced ability to work

• Universal social security pension for individuals from 65 years

• Fully funded labour market related pensions (DC-schemes)

• Private pension schemes (DC-schemes)

Distribution of 50 – 80 years old population in 2004

0

10

20

30

40

50

60

70

80

90

100

50 52 54 56 58 60 62 64 66 68 70 72 74 76 78 80

Disability pension Employment

Others Public pension

Sickness benefits Unemployment

Voluntarily early retirement Cash assitance

Primary and total public budget relative to GDP

-8

-6

-4

-2

0

2

4

6

2004 2009 2014 2019 2024 2029 2034 2039

-8

-6

-4

-2

0

2

4

6

Total budget surplus/GDP at market prices

Primary public budget/GDP at market prices

Baseline: Macroeconomic levels in 2040 in the projection compared to 2004

• Real GDP has grown 92.8 percent• Employment is reduced by 7.2 percent• Private consumption has grown 106.4 percent• Public consumption has grown 119. 8 percent• Fiscal sustainability requires an annual reduction in

public expenditures of 4.0 percent of GDP

The retirement reform I

• The legal pension age of the VERP and the social pension is indexed to the life expectancy of a 60 year old average individual.

• The legal pension age of the VERP is increased by a ½ year in each of the years 2019 to 2022.

• The legal pension age of the social pension is increased by a ½ year in each of the years 2024 to 2027

The retirement reform II

• Starting in 2025 the legal pension age of the VERP is increased according the increase in life expectancy of a 60 year old in the period from 2010-2015. The increase is announced in 2015.

• The legal pension age of the social security pension is increased according to the same increase in life expectancy – in 2030 (This keeps the pension period of the VERP constant).

• Legal pension age is increased by 0, ½ year, 1 year each fifth year after the initiation in 2025

Indexation of the legal pension age

Ann. VERP age

changed

Pension-able age

changed

60 year life exp.

Acc. Chg.

Size of chg

Acc. Chg

VERP age

POAP age

2015 2025 2030 1.2 1.2 1.0 1.0 63.0 68.0

2020 2030 2035 0.6 1.8 1.0 2.0 64.0 69.0

2025 2035 2040 0.6 2.4 1.0 3.0 65.0 70.0

2030 2040 2045 0.6 2.9 0.5 3.5 65.5 70.5

2035 2045 2050 0.5 3.5 0.5 4.0 66.0 71.0

2040 2050 2055 0.5 4.0 0.5 4.5 66.5 71.5

2045 2055 2060 0.5 4.5 0.5 5.0 67.0 72.0

2050 2060 2065 0.5 5.0 0.5 5.5 67.5 72.5

2055 2065 2070 0.5 5.4 0.5 6.0 68.0 73.0

2060 2070 2075 0.4 5.9 0.5 6.5 68.0 73.0

2065 2075 2080 0.4 6.3 0.5 7.0 68.5 73.5

2070 2080 2085 0.4 6.7 0.0 7.0 69.0 74.0

2075 2085 2090 0.4 7.1 0.5 7.5 69.5 74.5

2080 2090 2095 0.4 7.5 0.5 8.0 70.0 75

2085 2095 2100 0.4 7.9 0.5 8.5 70.5 75.5

Resulting labour market participation rates in 2005, 2030, 2050

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

17 22 27 32 37 42 47 52 57 62 67 72

0.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1.0

2005 2030 2050

Share of life in employment

0.47

0.48

0.49

0.50

0.51

0.52

0.53

0.54

0.55

0.56

2006 2026 2046 2066 2086 2106

0.47

0.48

0.49

0.50

0.51

0.52

0.53

0.54

0.55

0.56

Baseline Retirement reform

Expected period as retiree

0

5

10

15

20

25

30

2006 2026 2046 2066 2086 2106

0

5

10

15

20

25

30

Baseline Retirement reform

Employment effects

2320

2370

2420

2470

2520

2570

2620

2004 2009 2014 2019 2024 2029 2034 2039

2320

2370

2420

2470

2520

2570

2620

Baseline Retirement reform

Primary and total public budget

Primary budget surplus

-8

-6

-4

-2

0

2

4

6

2004 2009 2014 2019 2024 2029 2034 2039

-8

-6

-4

-2

0

2

4

6

Baseline Retirement reform

Total budget surplus

-8

-6

-4

-2

0

2

4

6

2004 2009 2014 2019 2024 2029 2034 2039

-8

-6

-4

-2

0

2

4

6

Baseline Retirement reform

Macroeconomic levels in 2040 given the retirement reform compared to 2004

• Real GDP has grown 101.4 percent (92.8 percent)• Employment is reduced by 0.3 percent (7.2 percent)• Private consumption has grown 113.6 percent (106.4

percent)• Public consumption has grown 119. 8 percent (119.8

percent)• Fiscal sustainability requires an annual reduction in

public expenditures of 2.2 percent of GDP (4.0 percent)

Time inconsistency?

• Current generations of voters close to retirement age are exempted from the gradual increase retirement age – whereas future generations of voters will experience this gradual increase

• Changes in the retirement age are introduced by ”jumps” in the retirement age of up to 1 years. This generates large annual changes in labour supply and potential problems in case troughs in business cycles.

Conclusion

• The retirement reform solves the problem of a declining labour supply (relative to population)

• The retirement reform solves approximately half of the fiscal sustainability problem in Denmark by maintaining a constant share of transfers to GDP

• The part of the sustainability problem that follows from

the increased individual public services is not solved