ECB publishes study on consequences of reform reversals.

Dr. S-W – 05/2020

The European Central Bank has published a study compiled by several authors that examines the long-term costs of reversing recent pension reforms. The authors make use of the 2018 Ageing Report projections and develop them further using their own modelling. This was done using only two countries cases, namely Germany and Slovakia.

Germany’s ‘double threshold’ measure comes under particular criticism from the authors. Under this reform, the benefit ratio should not fall below 48% and the contribution rate should not rise above 20% until 2025. Germany is considering extending the ‘double threshold’ cap until 2040 and so the study uses this year to make its projections. The study also mentions that Germany is toying with the idea of introducing a basic pension, although it would appear that this has not been included in the extended projections. In Slovakia, the government had originally decided to automatically link statutory retirement age to life expectancy – a decision it has now reversed. As a result, retirement age will be gradually raised to 64 years by 2045, at which point it will be capped. In addition, there have been generous adjustments to the minimum pension.

The study also mentions some other examples. Spain had implemented a ‘sustainability factor’ which links the replacement rate to life expectancy. This has now been postponed until 2023. Italy has partially reversed earlier reforms by temporarily facilitating early retirement. Greece has been forced by court decisions to reverse pension cuts. Even in the Netherlands, there are discussions about loosening the agreed link between retirement age and life expectancy. However, in this case it should be noted that life expectancy there is not developing as well as originally forecast. In all these cases, a significant increase in public debt would be inevitable.

The modelling in the study took the following steps:

  • A baseline scenario was generated which projected public debt by 2070 if the legal situation remains as it is before the reversal of cost-cutting pension reforms.
  • It then looked at how retirement age, contribution rates or benefits ratios would have to be adjusted to offset the increase in debt.
  • This is then repeated under the assumption of a reform reversal scenario.

The results are striking. In Germany, the estimated increase in the public debt-to-GDP ratio under the baseline scenario would be 100 percentage points by 2070, i.e. from around 60% today to 160%. The effective (not the statutory!) retirement age would be 65.5 years. Slovakia would not be much better off. Its debt-to-GDP ratio would also rise by about 100 percentage points. In order to offset this effect, that is, to keep the debt ratio constant, the effective retirement age in Germany would have to increase by 3.5 years to 69 years by 2070.

Slovakia would have to increase it even more by 4.5 years. Alternatively, the replacement ratio could of course be reduced. Germany would have to more than halve its benefit ratio by reducing it 26 percentage points and Slovakia would have to reduce theirs by 21 percentage points. The last alternative to restoring the financial balance is to raise the contribution rate – by 11 percentage points in Germany and by 7 percentage points in Slovakia. A combination of measures is of course also possible.

Although these projections are far from rosy, reform reversals initiated after completion of the 2018 Ageing Report could result in an even worse fiscal situation. It is assumed that Germany will extend its ‘double threshold’ until 2040. Under this scenario, the public debt-to-GDP ratio would rise by a further 60 percentage points compared with the baseline scenario. In the case of Slovakia, the increase would be a further 50 percentage points, unless the benefit ratio is reduced by 29 percentage points.

Although only Germany and Slovakia were studied, the authors claim that their framework can be applied to other countries.

The study is called ‘A framework for assessing the costs of pension reform reversals’ and was published as Working Paper No 2396/April 2020 of the European Central Bank. The study can be read here.