Finland: Reforming the pension system

The Finnish public pension system recently underwent a far-reaching reform, prompted by concerns about the aging of the population, the low effective retirement age of workers and the erosion of the tax base after the slump in the early 1990s. The reform, which is based on a consensus between government. employers and unions, strikes a balance between preserving income security for the elderly and strengthening the link between individuals, life-time earnings and pensions. By so doing, the reform is deemed to enhance labour-force participation and career development. There is nonetheless scope for improvement.1

Since the early 1960s the public pension system in Finland has consisted of a universal national scheme complemented with a compulsory employment scheme granting earningsrelated benefits. The combined pension is limited to 60% of the pensionable wage on a pre-tax basis, although this ceiling will be attained only when the employment pension scheme reaches maturity by the year 2002. The statutory retirement age is 65 years, but on average workers retire at 58 years through disability or similar programmes. The national scheme is centrally administered: the employment scheme, [by contrast. is managed by over sixty private pension institutions, each covering an industry, company or group of companies. Both schemes are financed from contributions paid by workers and employers, even though the employment scheme is partially funded: financial assets cover roughly one-third of the present value of its pension obligations.

A combination of shocks in the early 1990s - the collapse of the Soviet Union, the world recession and a banking crisis - risked undermining the welfare system in Finland, adding to concerns about the cost of population aging: official projections at the time indicated that pension expenditure would increase from 10% of GDP in 1990 to 19% of GDP by the third decade of the next century. Such prospects prompted a far-reaching reform, the thrust of which was to promote longer working careers, reduce benefits and improve the management of the pension funds - while maintaining the inherited structure of the system.

The reform has been introduced in successive packages:

1993 - favourable pension treatment of civil servants discontinued

1994 and 1996 - measures introduced to improve the pensions of older workers who remain active in a lower-paid or part-time job and to reduce those of people who retire early

1996 - the pensionable wage redefined to include the last ten years rather than the last four years of every employment contract; indexation of benefits also changed, lowering pensions in relation to earnings; decision to phase out the national scheme for individuals with sufficient coverage from an employment pension, to the extent that its cost would fall from 4% of GDP in 1995 to 1% in the long run

1997 - the pension institutions authorised to expand their solvency margins to allow them to undertake more risky investment, with a view to raising the rate of return.

The OECD has run a modelling simulation on the employment pension scheme, which thus appears to be financially sustainable under the new rules, at least on the assumption of a 3% real rate of return on assets (Figure). Although expenditure would rise from 8% of GDP in 1995 to 13% by 2030, an increase in employmentpension contributions from around 8 1/2% to almost 12% of GDP over the same period would raise the financial assets of the scheme from 37% of GDP to 65%, which will then start to be depleted. The assumed rate of return on the assets of the pension funds is central to these calculations. An alternative model simulation suggests that an improvement of two percentage points in the rate of return would double the financial assets by the year 2030 to 130% of GDP, allowing pension contributions to be reduced by 1% of GDP once and for all. This step would be worthwhile on its own account; and experience in the Netherlands and the United Kingdom shows that even higher rates of return are possible on a sustainable basis - which would require the funds to have a much larger weight of shares (as opposed to other savings instruments, which in Finland include loans to employers paying into the funds) in their portfolios than is currently the case.

More ambitious portfolio-management could be encouraged by allowing the pension institutions to compete for clients on the basis of investment performance, although that would call for regulation to avoid excessive risk-taking. The admission of foreign entrants in the Finnish market for statutory pension insurance could help reinforce such competition, as would the removal of penalties on employers who switch institutions (for instance, they lose the right to take out loans against contributions paid in the past).

On current assumptions the implicit rate of return Finnish workers expect to achieve on their contributions is likely to be small, if not negative, as their contributions are high relative to the benefits because of the aging population. As a result, workers - and their employers - may seek ways to minimise contributions and maximise benefits, thereby undermining the sustainability of the system.

A so-called `defined-contribution' scheme (with pension annuities financed from individual savings accounts) does not have this disadvantage, as its implicit rate of return depends solely on the yield on the financial investments, irrespective of demographic developments.2 But defined-contribution schemes have drawbacks. Not only is the management of such schemes relatively costly; they also expose workers to risks from downturns in the financial markets. In addition, the introduction of a definedcontribution scheme would require a transition period in which the existing scheme would have to meet its obligations although the inflow of contributions would have ceased (as workers enter the new scheme). Nonetheless, defined-contribution pensions have enough advantages to make their gradual introduction in Finland seem worth considering.

1. OECD Economic Surveys: Finland, OECD Publications, Paris, 1997

2. Lans Bovenberg and Anja van der Linden,Pension Policies and the Aging Society. The OECD Observer, No, 205, April/May 1997.

OECD BIBLIOGRAPHY

OECD Economic Surveys: Finland, 1997 Mark Pearson and Peter Scherer 'Balancing Security and Sustainability in Social Policy, The OECD Observer, No. 205, Apr:/May 1997

Lans Bovenberg and Anja van der Linden, 'Pension Policies and the Aging Society, The OECD Observer, No. 205, April/May 1997

OECD Economic Surveys: Canada, 1996 Hannes Suppan; `Canada - The Pension System: Options for Reform', The OECD Observer, No. 203, December 1996/January 1997

Peter Hicks, lhe Impact of Aging on Public Policy, The OECD Observer, No. 203, December 1996/January 1997.

Paul van den Noord works in the Country Studies Branch of the OECD Economics Department.

E-mail: eco.contact@oecd.org

Copyright Organisation for Economic Cooperation and Development Oct/Nov 1997
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