FYR Macedonia Special Focus Note: Pension Reform The former Yugoslav Republic of (FYR) Macedonia needs to reform its pension system to contain fiscal pressures from the pension system and strengthen system’s equity. By international standards FYR Macedonia pension spending is high (over 10 percent of GDP), which would rise further over the next two decades without reforms. FYR Macedonia’s high pension expenditures emerge mostly from the supplementary ad-hoc indexations and the parametric features of its Pay- as-You-Go (PAYG) pensions. Projections reveal that without the reform the FYR Macedonian pension system will continue to generate a sizable deficit, already at 4 percent of GDP. Despite Past Reform Efforts, Pension Spending is Comparatively High and Rising Aging and early retirement practices, combined with ad-hoc supplementary pension indexations, brought the pension spending at above 10 percent of GDP despite the significant reforms undertaken a decade ago. The FYR Macedonian pension system rests on three pillars: (i) a solidarity PAYG pillar; (ii) a second fully-funded mandatory pillar based on individual accounts; and (iii) voluntary private open and occupational pension funds. A systemic pension reform was carried out in 2005-06 to improve the fiscal sustainability of the system and reflect the demographic changes: mandatory retirement age was increased to 64 for men and 62 for women, accrual rates were reduced, and the so-called Swiss pension indexation formula (50% wages and 50% consumer price inflation) introduced. In 2006, the second pension pillar was introduced as a mandatory defined contribution component for all first-time employed, and the voluntary third pillar was introduced in 2009. Parametric changes in 2012 reduced the accrual rate for post-2013 service years of the PAYG-only system participants and tightened the criteria for disability pensions. The pension reform managed to eliminate all early retirement options except those for hazardous and arduous occupations, done in lieu of raising retirement age. As a result, the system dependency ratio1 improved from 1.31 in 2005 to 1.85 in 2017, the highest among the Western Balkans and new EU member states (Figure 1). The basic parameters of the reformed pension system, currently in place, are presented in Box 1. Notwithstanding initial positive reform outcomes, the pension system financing worsened in the last decade. Instead of embarking on further reforms of key pension system parameters such as changing effective accrual rates, retirement age, and indexation of pensions, the authorities engaged in ad-hoc supplementary pension increases, reduced contribution rates, and introduced contribution payment waivers to promote employment. Such policies resulted in rising pension expenditures and growing deficit (Figure 2).2 Figure 1. System Dependency Ratio Figure 2. FYR Macedonian Pension System Finances, % of GDP Overall pension expenditures, % GDP Contribution revenues, %GDP 3.0 Overall pension deficit Current PAYG pensions deficit 12.0 2.5 10.0 2.0 8.0 % GDP 1.5 6.0 1.0 4.0 2.0 0.5 0.0 0.0 LU RO PT IT IE LV PL DK BG DE BE MK MT NL HR HU NO AT SK SI FR FI EL CZ SE CY EE EA ES Source: EU Aging Report 2015 and PIOM Source: PIOM and State Statistical Office of FYR Macedonia Accrual rates3 in FYR Macedonia are higher than in EU countries but misaligned for multi-pillar participants. Parametric changes in 2012 reduced the accrual rates for post-2013 service years of the PAYG-only system participants from 1.8-2.6 percent, depending on gender, down to 1.6-1.8 percent. FYR Macedonian effective gross accrual rates for individuals in the first pillar only are currently slightly below the EU average but still above those of most new EU member states (Table 1). Most EU countries with an accrual formula award same accrual for all cohorts and genders. FYR Macedonia, however, links the accrual rates to specific cohorts, gender, and contribution periods. Voluntary and mandatory second pillar participants are awarded low PAYG accruals–well below their share of paid PAYG contributions4. The objective of setting such accrual rates at the start of the 2005 reforms was to have a smooth transition from the PAYG system to a multi-pillar system without 1 System Dependency Ratio (SDR) is the ratio of contributors/workers and pensioners. 2 Deficit is defined here as cash pension deficit, i.e. pension benefit payments minus PAYG pension contributions. 3 Accrual rate is a share of the pension base a pensioner is entitled to for one year of service. 4 Voluntary and mandatory second pillar participants pay 2/3 of their pension contribution to the PAYG pillar. As Table 1 shows, in all periods accrual rates for these categories are below 2/3 of PAYG-only participants. abrupt differences between “new” and “old” pension levels, and for the effective accrual rates to gradually reach sustainable levels. However, the outcome has been the opposite: the over-proportionally reduced pension accruals for voluntary second-pillar participants resulted in first multi-pillar pensions standing significantly below the old first pillar (PAYG) pensions. Pension benefits of first multi-pillar pensioners (around 100 new beneficiaries by end-2017) were reduced by 20-60 percent depending on the length of service. Such a socially unacceptable reduction in pension benefits requires immediate policy response, which the new pension law aims to address. Pension indexation in FYR Macedonia has been more generous than in most other European countries. Best international practice suggests maintaining the initial replacement rate stable through the wage valorization of the pension base and keeping the real purchasing power of pension benefits constant via the price indexation. Most EU countries apply these practices. From 2019, FYR Macedonia switched indexation from half by wage and half by price growth to the price indexation. This would help reduce the pension deficit while preserving the purchasing power of pension benefits. Improving Adequacy and the Sustainability of the Pension System in FYR Macedonia In the absence of reforms, pension PAYG expenditures and deficits would grow over the next decade. Slowly declining workers to pensioners ratio and relatively high replacement rates of old system participants (PAYG only) would without reforms result in further rise in PAYG expenditures and deficits (Figure 3). By early 2030s, PAYG expenditures would reach 12 percent of GDP, with the overall pension deficit reaching 6 percent of GDP. Pension replacement rates would remain high, but with prevailing inter-generational imbalances. Without the adjustment of accrual rates and a correction of the PAYG accrual cap for multi- pillar participants, replacement rates for voluntary and mandatory second-pillar participants would continue to be lower than for the PAYG-only retirees. The recently enacted pension reform will stabilize the system over the near term. The Law on Pension and Disability Insurance plans to address pension system fiscal sustainability, adequacy of multi-pillar pensions, and overpaid and underpaid contributions to the funded pillar.5 The list of pension policy measures aimed to secure fiscal sustainability and strengthen equity includes: (i) the price (CPI) indexation of pensions with a supplementary 25-percent wage indexation in case a real GDP grows above 4 percent per year; (ii) harmonization of accrual rates by lowering the PAYG-only accruals for post-2018 service and raising all service year accruals for the second-pillar participants; and (iii) a contribution rate increase by 0.4 percentage points in 2019 as well as 2020. However, the list of measures also includes the switchback of second pillar members older than 50 to the PAYG pillar and transferring all employees in hazardous occupations from multi-pillar to the PAYG pillar. The opening of the second pillar for exit to the PAYG pillar and repatriation of their second pillar savings will bring revenues to the budget in the short run, but will also lead to increased budget costs when they retire. The Law on Social Security for Elderly Citizens also introduces a means-tested social pension (at the level of 24 percent of average net wage) for elderly above 65 with at least one day of pension contributions, subject to the CPI indexation, which aims to address elderly poverty in fiscally-responsible 5 Inadequate second pillar transfers are related to the identification of the first employment (i.e. mandatory second pillar members), and second pillar contributions for hazardous and arduous occupations that had a choice of selecting the second pillar. In both cases these administrative issues resulted in missing or overpaid second pillar contributions from/to individual accounts. The Government proposal is to compensate for all missing contributions in 2019 and reform the second pillar administration to prevent such events in future. manner. While this is a good reform start for the near future, there is still the need to generate fiscal savings in the long run. A strong package of policy measures could fiscally stabilize and improve the equity of the pension system in FYR Macedonia. For example, raising the retirement age would prolong workers’ stay in the labor market, increase new replacement rates, and reduce pension expenditures and deficits by up to 2 percent of GDP annually by 2030s. Harmonizing the PAYG-only accruals for the entire service period with the pension accruals of the second-pillar participants would also sharply improve the pension finances. Removing the constraining accrual cap for voluntary second-pillar participants immediately raises their new replacement rates close to the PAYG-only level and eliminates the current multi-pillar system inequity. However, lifting the accrual cap for voluntary and mandatory second-pillar participants, introduction of the social pension, and returning the 50+ second-pillar members to PAYG-only would generate additional costs in both short and long run. Figures 4 and 5 show how a combination of strong pension measures6 could reverse the pension expenditures and deficit trends in comparison to the no-reform (Status-quo) and the recently enacted pension package. Figure 4: Simulated PAYG Expenditures 2017-80, % of GDP Figure 5: Simulated PAYG Deficit 2017-80, % of GDP 13% 0% 12% -1% 11% -2% Status quo Strong pension reform scenario -3% Status quo Government pension reform 10% Strong pension reform scenario -4% Government pension reform 9% -5% 8% -6% 7% -7% 2017 2020 2023 2026 2029 2032 2035 2038 2041 2044 2047 2050 2053 2056 2059 2062 2065 2068 2071 2074 2077 2080 2017 2020 2023 2026 2029 2032 2035 2038 2041 2044 2047 2050 2053 2056 2059 2062 2065 2068 2071 2074 2077 2080 Source: World Bank PROST Model for FYR Macedonia Box 1. Pension Parameters in FYR Macedonia Before 2019 Retirement Age 64 M/ 62 F with 15 years of contributions; Accrual rate Service Period for: Until 2001 2001 - 2012 2013 - (Net) Non II-pillar members with 2.33% - men 1.8% - men 1.6% - men less than 15 years of 2.60% - women 2.05% – women 1.8% - women service Non II-pillar members with Declining (art 228) Declining (art 228) 1.61% - men more than 15 years of 2.3% - 2.0% - men 2.3% - 2.0% - men 1.61% - women service 2.6% - 2.1% - women 2.6% - 2.1% - women II-pillar members that From 2003 0.75% - men 2.33% - men opted in the system 0.75% - men 0.86% - women 2.60% - women 0.86% - women II-pillar member that - From 2003 0.75% - men mandatorily joined the 0.75% - men 0.86% - women system 0.86% - women Maximum net For PAYG-only participants: 79.4% in 2017, declining to 72% in 2040. accrual rate For voluntary 2nd pillar participants: 79.4% in 2017, declining to 72% in 2040, but with maximum PAYG net accrual rate for service before 2006 of 11.65% (men), and 13% (women). For mandatory 2nd pillar participants: no maximum PAYG accrual rate Pensionable base Career earnings, net wage revalued with historical average wage growth Minimum pension 35%-41% (scaled in proportion to service period) of 2002 average net wage indexed same as regular pensions. Maximum 2.7 * average net wage in FYR Macedonia in previous calendar year. pension Indexation post- Swiss formula: 50% average gross wage rate of change plus 50% CPI rate of change. retirement 6This scenario assumes CPI indexation of pensions, retirement age increase, 3-years pension freeze and pension contribution rate increased to 20 percent. Eligibility for Professional incapacity: at least 50% reduced work capacity, minimum age of 45, and 1/3 of contribution disability pension period above age of 20 (26 for tertiary education); General incapacity: 80-100% incapacity, minimum 20 years of age, (26 for tertiary education), and at least of 1/3 of contribution period above age of 20 (26 for tertiary education); for injury at work, regardless of service period. Level of Disability 80% of the old age pension for full incapacity in case of work injury and professional disease; declining to Pension 72% by 2040; Professional incapacity: 38% M/ 44% F is the replacement rate upon attainment of age; pension supplements 10-20% for 80-100% incapacity; Eligibility for Age 50 in case of widow; survivor’s pension Age 55 in case of widower; Children aged 15 or under and until age 26 if students or lifetime if incapacitated Level of survivor’s 70% of contributor’s entitlement if 1 person; 80% to be divided by 2; 90% to be divided by 3; and 100% to pension be divided if 4 or more Second pillar New entrants (regardless of age) since 2006 mandatory, voluntary opt-in for others participation Pension Total: 18%; contribution rate PAYG: 12%; Second Pillar: 6%. Source: Pension and Disability Insurance Fund (PIOM); Ministry of Labor and Social Policy