El sistema español de pensiones: implicaciones de no hacer nada

The Spanish pension system: implications of doing nothing
by Sergi Jiménez

The unstoppable process of aging of the Spanish population, due to a combination of a greater life expectancy coupled with a drastic reduction in births will result in, almost certainly, an increasing depletion of the Social Security accounts. So, according to a report by the Economic and Financial Director of the European Commission (see here) of the current moderate surplus (1% of GDP due to income contribution of 10% and benefit costs of pensioners of 8.3% - see here) it will continue ((to deteriorate -trans)) in the absence of reforms and, taking into account the demographic projections of the INE for the years 2009-2049, a deficit of 6% of GDP will be reached by 2050 (produced by income contribution of 10% and benefit spending of 16%) and, assuming that income contribution does not change, close to 10 percent in 2060. The magnitude of the projected deficit makes proposals to limit the generosity of the system and the need to work more and longer indispensable to maintain our pension system. Most OECD countries, following an aging process similar to that of Spain (although not always combined with the decimation of births that we have), have already implemented or are in the process of implementing measures of containing and restructuring pension spending. Advances of reform in Germany (raising the retirement age among other reforms), France (also raising the retirement age), Italy and the United Kingdom also suggest that such measures are necessary.

As Figure 1 shows, the Spanish situation (compared to Germany and Italy for example), has the unique property that the largest pension cost in the near future will occur when the working-age population decreases (the bar representing the current 10 year old cohort group is about half as long as for 30 year olds, which is in turn is practically double that of 65 year olds). The dependency ratio, measuring the proportion of the population of working age divided by the population 65 or older, is currently around 4 but should be around 1.75 in 2049. In this context, we wonder what implications maintaining the current system will have given demographic projections. We will start by detailing the consequences of pension spending in the absence of reforms and later consider the fiscal changes ((increase in taxes -trans)) needed to sustain our current level of generosity.

[Figure 1. The size of insurance cohort groups in European countries for various ages relative to the 40 year old group.]

Pension spending in relation to GDP can be seen as the product of four factors: the coverage rate of pensioners (denoted tc) defined as the number of pensioners over the total number of people 65 and older, the dependency rate (denoted td) defined as the number of workers for each person 65 and older, the inverse of the employment rate (1/e) and the ratio between the average pension and the average productivity, also known as the generosity of the system (g). So, we get

Spending on Pensioners / GDP = (NP * P) / (E * Q) =
= (NP / P65) * (P65 / PET) * (PET / E) * (P / Q) = (tc)*(td)*(1/e)*g

Where:

NP = Number of Pensions; P = Average Pension; E = Employment; Q = Average Productivity; P65 = Population older than 65; PET = Working age population (from 16 to 64).

Supposing that the primary factor is constant (although it normally tends to grow), if spending is not changed (i.e. the pension eligibility rules and calculations) the fourth factor would not vary. The second factor is the rate of dependence. According to the latest demographic projections of the INE, it will increase from 25% in 2010 to 60.6% in 2049, or similarly, it will more than double (a 2.42x increase). So, if the system is not changed, and only the rate of dependency increases, pension spending will increase from 8.3% of GDP (in 2009) to 20.1% in 2049.

If this happens, only a higher rate of employment would help to absorb this increase in spending. A simple calculation reveals that in order to maintain pension spending at 8.3% of GDP we would need an employment rate of 144 percent! But the problem is that, in 2049, even in reaching a "Swedish" (?) employment rate, total employment would decline by 5% due to the decimation of the working age population (remember that the size of the 10 year old cohort group in 2009 is 51% of the 30 year old group in 2009 and that the current best is only 60%). Consequently, with a productivity growth rate of 1.5% per year, GDP will only be (approximately) 1.5x the current level. Certainly in 2049 everyone will be much richer, but that is not the main point, as there is a limit on the degree of between-generation transfers of wealth that can be had without generating disincentives for effort and growth.

Then, can we finance pension spending of 20.1% GDP? Currently 2.4 individuals are required to finance each pensioner, 9 units out of each 100 generated go to finance pensions. In 2050, there will be 1.05 workers for each pensioner, and there would have to be 27 units - three times more. This supposes that fiscal pressure coming from pension spending would increase by 2.78 times (=27*2.4/(9*1.05*1.48))!! Other ways of financing, for example financing by general taxation would bring us to similar conclusions, as the associated increase in fiscal pressure would have grave consequences with respect to employment (financed by the IRPF) or investment (financed by taxing companies) or wrt. both.

There are some who question the projected long-term pension spending, arguing that the demographic projections aren't completely reliable. Even if this is true, what we know with certainty is that, in absence of extraordinary unforeseeable changes in the current demographic trends, the future dependency rate will be much higher than it is now, and we must take measures in anticipation of this today.

The picture will be somewhat darker if we consider other spending related to aging in the analysis, such as health expenditures and related costs, that should probably also be overhauled. Although there are some that think we spend relatively little on the older population (see here), the problem isn't really how much we spend as a society on this group, but at what rate this will become a larger part of total spending. Without altering the growth rate of said parts in due time will leech resources from other programs of public spending (infrastructure, education, training) that are crucial for the future growth of the Spanish economy, and consequently for the sustainability of the pension system that, remember, is sustained by the work of our children.