Andres Sutt. Welcoming word

Adequate and sustainable pensions through private provision: lessons from and for reforms in Central and Eastern Europe
Tallinn, 23-25 April 2003

Welcoming word by Andres Sutt, Vice President of Bank of Estonia

Ladies and gentlemen,

I am very pleased to welcome you on behalf of the central bank of Estonia. It is well known that because of declining birth rates and increasing longevity, the share of the elderly in the population of almost all industrial as well as many developing countries has been growing during the past decades. Although demographic projections are subject to a higher degree of uncertainty, it is quite probable that this trend will accelerate as the post-World War II baby boom generation begins to reach retirement age at the beginning of the 21-century.

There are few subjects in economics more topical today than pensions and the reform of current social security systems As the number of consumers relative to producers is on the rise, financing of different public services becomes more and more complicated. One of the important public services directly dependent to the changes in tax base is the pay-as-you-go pension system, which currently exists in one form or another in most of Western countries. Until today pay-as-you-go systems have performed quite efficiently, but as the ratio of taxpayers to pensioners shows a steady decrease their sustainability becomes more and more questionable.

Some countries have attempted to prop up their pay-as-you-go systems through different combinations of reduced lifetime benefits and higher social taxes. Some countries have opted for more fundamental reforms, in particular, a move toward fully funded or the "three-pillar" pension system.

Reforming the pension system will affect the whole macroeconomic climate of the country. There are a number of potential advantages in moving towards fully funded schemes, including possible increase in retirement income and national savings, and enhanced efficiency of capital and labour markets. However, such a move also imposes important costs, in particular on the current generation and on the budget. The net effect on the welfare of present and future generations is difficult to assess and, in any case, depends, to a large extent, on the specifics of the reform and future demographic developments. Thus, the introduction of a mandatory fully funded scheme need not, in itself, solve the problems associated with ageing societies. Whether such a reform would be more effective in this regard than a policy aimed at shoring up the long-term finances of the pay-as-you-go system depends on several factors, including the distribution of so-called transition costs and the extent to which fully funded pensions can increase labour supply, national savings and deepening of financial markets.

Like in many advanced industrial countries, the long-term sustainability of the pension system became more and more questionable in Estonia over the last decade. At the beginning of the nineties when Estonia regained its independence the system was mainly affected by the socio-economic consequences of the transition to a market economy. The number of employees decreased more than 25%, whereas the number of pensioners stayed almost unchanged. There were some additional factors further aggravating the situation - e.g. the growth of grey economy and ineffective institutional framework. The outcome was a considerably reduced revenue base for the pension system.

From mid-nineties the demographics became the main argument for a pension system reform. Projections showed that the pay-as-you-go system would run into constant deficit starting from the second decade of the 21-th century. Under the budget constraints the outcome would have been a decrease in replacement ratio (purchasing power of pensions compared to wages) and/or steady increase in tax burden. As the fast ageing of population in Estonia was still at least a decade away, a good chance for escaping the crisis scenario was perceived.

By now, Estonia has successfully introduced a three-pillar system. The success could be said to rely on two crucial factors. First, the participation rate is surprisingly high. That makes it possible to expand the tax base, making the inevitable increase in the dependency ratio less painful. Second - high credibility of the financial system is an important prerequisite for a high participation rate.

The fact that almost one third of the eligible work-age population in Estonia joined privately managed second pillar within the first year is a clear indication of the confidence. Further, augmenting domestic long term funding should foster financial deepening and increase the efficiency of Estonian financial markets. Pension reform should also enhance financial integration with the EU through the process of asset diversification.

Ladies and gentlemen, I believe that discussions of today and tomorrow will offer everybody some new insights into the complex issues of promoting sustainable pension system and will help us to be better prepared to meet the challenge of ageing population.

Andres Sutt. Welcoming word