The pension system in Finland: Design

1. The pension system in Finland: Design Nicholas Barr London School of Economics http://econ.lse.ac.uk/staff/nb Evaluation of the Finnish Pension System Helsinki, 7 January 2013

2. The pension system in Finland: Design 1 The backdrop 2 Strengths of the system 3 Weaknesses 4 Recommendations 5 Topic for discussion: age-related accrual rates 6 Conclusion Nicholas Barr, January 2013

3. 1 The backdrop Nicholas Barr, January 2013

4. Key principles of analysis • It is essential to think of the different parts of a pension system as a system • There is no single best system for all countries Nicholas Barr, January 2013

5. Objectives of a pension system • The primary objective: income security for all elderly people • Four elements • Consumption smoothing • Insurance • Poverty relief • Redistribution Nicholas Barr, January 2013

6. Four and only four solutions to problems of pension finance • A smaller pension, i.e. lower average monthly pension • A later pension, i.e. an unchanged monthly pension from a later age • Higher contributions • Higher national output Nicholas Barr, January 2013

7. 2 Strengths of the system • Successive reforms in Finland have • Contributed to the achievement of the main objectives • Been timely • Have commanded consensus • Thus discussion of improvements can be reflective rather than crisis response • Most of the discussion below is of potential problems but – to repeat – the system is functioning well and is not in crisis Nicholas Barr, January 2013

8. Strengths • Consensual: the system is run consensually • Unified: earnings-related pensions operate within a unified national framework • Constrained choice: workers choice is limited, both over how much to save and over pension provider; these features comply with lessons from information and behavioural economics • Compatible with labour mobility because the pension systems of workers in the private, public and municipal systems are all basically the same • Adequacy: the system scores well for most people • Coverage is high Nicholas Barr, January 2013

9. 3 Weaknesses Though the system is not in crisis, a number of features create pressures that over time will compromise its ability to achieve its objectives • Tunnel vision, i.e. a failure to consider adequacy and sustainability together • Inadequate adjustment for a delayed start to pension • Inadequate account of changes in family structure Nicholas Barr, January 2013

10. 3.1 Tunnel vision • In many countries the Ministry of Finance worries about sustainability and the Ministry of Social Security about adequacy, with little dialogue between the two departments • Though institutional arrangements in Finland are different, the outcome is similar • Life expectancy has been rising, which is great good news • However, if the present system remains unchanged, the result will be • Diminishing adequacy, and/or • Declining sustainability Nicholas Barr, January 2013

11. The problem • Diminishing adequacy • If nothing changes, people will retire at 63 with a lower and lower earnings-related pension via the longevity factor • After (say) 25 years, more and more people will receive the national pension but little earnings-related pension • Declining sustainability • Alternatively, contributions could rise as life expectancy increases; but contributions are already fairly high by international standards, so the scope for increase is limited • Sustainability matters not only for Ministry of Finance reasons, but also to protect pensioners and older workers from shocks • Declining sustainability is undesirable because it threatens the ability of the system to provide old-age security Nicholas Barr, January 2013

12. Two recommendations discussed below directly address these issues • More flexible retirement is desirable for its own sake • It also facilitates a second policy direction – later retirement – whose purpose is to promote adequacy and sustainability simultaneously Nicholas Barr, January 2013

13. 3.2 Inadequate adjustment for a delayed start to pension • Benefits should • Either start at a given age without requiring an end to work • Or increase significantly for a delayed start • The way earnings-related pensions are adjusted for a delayed start (discussed below) is faulty in a number of ways Nicholas Barr, January 2013

14. 3.3 Inadequate account of changes in family structure • Social policy in Finland, as in many other countries, was based on an assumption that people got married and stayed married • Neither is as true today as in the past, so that family structures are more fluid • In addition, the individual basis of pension benefits is a partial cause of the fact that the incidence of poverty for single pensioners is strikingly higher than for pensioner couples Nicholas Barr, January 2013

15. 4 Recommendations Nicholas Barr, January 2013

16. 4.1 Features to preserve • Maintain the current consensual approach • Retain a clear focus on the primary objectives and the weights accorded to each; a narrow concentration on instrumental objectives, e.g. the status of pension funds, may blur focus • Retain constrained choice for workers about how much to save and about pension provider. These features are useful, and should be protected from naïve arguments that increased choice necessarily increases welfare Nicholas Barr, January 2013

17. 4.2 Recommendation 1: Later retirement but more flexible retirement • Why? To preserve adequacy and sustainability simultaneously Nicholas Barr, January 2013

18. More flexible retirement • Mandatory full retirement made sense historically, but no longer • Increased choice about when to retire, and whether fully or partially is desirable • To promote output growth • As a response to individual preferences • More flexible retirement is desirable for its own sake, and would be part of good policy even if there were no problem of financing pensions Nicholas Barr, January 2013

19. Later retirement • Longer healthy life + constant or declining retirement age creates problems of pension finance • The problem is not that people are living too long, but that they are retiring too soon • The solution: pensionable age should rise in a rational way as life expectancy increases • Most work is less physical than in the past • The ‘lump of labour’ fallacy • Another way of sharing risk; if they have to bear some of the cost, many pensioners would prefer a shorter duration of retirement to lower living standards in retirement Nicholas Barr, January 2013

20. What happens in Finland Nicholas Barr, January 2013

21. Policies to assist later and more flexible retirement • Partial deferral, e.g. option to draw 25%, 50% or 75% of pension, while deferred element continues to grow • Avoid fixed costs of employing a worker, which create an incentive against part-time employment • Review employment law to reduce transactions costs and legal uncertainty where a worker wishes to downshift at his/her existing employer • Provide access to training for older workers • Policies to change attitudes: gradually increasing earliest eligibility age is important not only for fiscal reasons but because of the signal it gives Nicholas Barr, January 2013

22. 4.3 Recommendation 2: Adjusting for changes in life expectancy • Instead of reducing pensions at earliest eligibility age as the only adjustment to rising life expectancy, there is a good case for adjusting at least in part by gradually increasing the earliest eligibility age without any compensating increase in pension • Why? International evidence, explained by behavioural economics, shows that many people retire as soon as they are allowed, even if not in their best interests or that of their family (next slide) • Instead of talking about standard retirement age and later retirement, it would be useful to talk about the earliest eligibility age and normal retirement age Nicholas Barr, January 2013

23. What happens in Finland Nicholas Barr, January 2013

24. Raising pensionable age: How • Changes should be announced a long time in advance • Rules should relate to date of birth, not date of retirement • Changes should be made annually (or monthly), to avoid large changes across nearby cohorts • The rules should be explicit Nicholas Barr, January 2013 23

25. Example • There are different ways of raising pensionable age • Perhaps the simplest: suppose policy makers regard it as appropriate that on average retirement should be half of working life • This would be achieved by raising pensionable age by 8 months for every increase in life expectancy of one year, or pro rata • Thus pensionable age is adjusted to relate the number of expected years receiving benefit to the number of accrual years. Nicholas Barr, January 2013

26. 4.4 Recommendation 3: Adjusting for a delayed start to pension • National pension should continue to be increased broadly actuarially for a delayed start • Adjustment of earnings-related pensions for a delayed start should be applied to the pension a person has accumulated till age 63 rather than as a higher accrual rate of 4.5 per cent on the flow of earnings after age 63 • The current system may be roughly actuarial for an average case but takes no account of the variance around the average, for example, over-compensating a delayed start to pension for someone whose post-63 earnings are high relative to the earnings-related pension he or she has accumulated at age 63 Nicholas Barr, January 2013

27. 4.5 Recommendation 4: Individuals and families • The problem • In 2009, over 30 per cent of single pensioners in Finland were poor, compared with 4.3 per cent of couples • The introduction of the guarantee pension in 2011 will improve matters, but is not a complete solution • Individuals and couples: these findings suggest a need to review benefits for single pensioners • Is the relative size of the national pension and guarantee pension for single people and couples the right one? • There is a good case for making the taper in the withdrawal of earnings-related pension more generous, or otherwise ensuring that the pension of a surviving spouse or partner is adequate • Divorce: given the frequency of divorce, there is a good case for an option to transfer earnings-related pension rights between partners at divorce or retirement Nicholas Barr, January 2013

28. 5 Topic for discussion: age-related accrual rates • The higher accrual rate of 1.9 per cent for workers aged 53-62 gives greater weight to earnings in later years, which benefits those whose earnings rise faster later in their careers, typically higher earners • If a higher accrual rate at some ages is retained, thought should be given to transferring it to earnings in earlier years • Such a move would benefit lower earners (who have high labour-force participation in early years) relative to higher earners (who are more often in education or training when young and, at least in the past, have had more options to continue working at older ages) • The move might be a useful political balance to raising eligibility age over time Nicholas Barr, January 2013

29. 6 Conclusion • No single best system for all countries • Four and only four policies to fix problems of pension finance • Reform strategically and with a long time horizon • Addressing demographic change: any solution that does not include later retirement over the medium term will fail Nicholas Barr, January 2013

30. References On Finland Barr, Nicholas (2013), Evaluation of the Finnish pension system: Part 1: The pension system in Finland: Design, Helsinki: Finnish Centre for Pensions Ambachtsheer, Keith (2013), Evaluation of the Finnish pension system: Part 2: The pension system in Finland: Institutional structure and governance, Helsinki: Finnish Centre for Pensions For a summary of the issues Barr, Nicholas (2012), The Economics of the Welfare State, OUP, Ch. 7 Barr, Nicholas and Diamond, Peter (2009), ‘Reforming pensions: Principles, analytical errors and policy directions’, International Social Security Review, Vol. 62, No. 2, 2009, pp. 5-29 (also in French, German and Spanish) For broader discussion Barr, Nicholas and Diamond, Peter (2008), Reforming pensions: Principles and policy choices, New York and Oxford: OUP. Nicholas Barr, January 2013