A ticking time-bomb in the Estonian pension formula

By: Ringa Raudla

Based on recent discussions in the media and the political arena, one may get the impression that increasing the retirement age from 63 to 65 was the only shortcoming that needed fixing in the Estonian pension system. In fact, after a closer look, there are other – and perhaps even more urgent – problems that call for solutions, both in the first pillar, which is state-run and PAYG, and in the second pillar, which is pre-funded and run by private pension funds. In this entry, I would like to discuss the problems that may emerge from the existing formula for calculating old-age pension benefits in the first pillar.

According to the State Pension Insurance Act enacted in 2002, the old-age pension from the first pillar is calculated on the basis of three different components: a base component, a working-time component and a contribution-related component. While the base component is paid in equal amounts to all pensioners, the working time component takes into account the number of years worked before 1999 and the contribution-related component is based on the salaries earned after 1999. More detailed technical description of the formula is available at the end of this entry.

In addition to the fact that the formula is rather complex (and putting together the different pieces requires looking into several acts and regulations), there is a ticking time bomb hidden in this formula. Namely, the contribution-related component, if left unchanged, will lead to huge disparities between pension pay-outs in the future. In order to grasp the implications of the contribution-related component, let us have a look at extreme examples. First, how large would be the sum of annual factors for a person who works for 40 years and earns the minimum wage? Making some simplifying assumptions, the formula would grant him an annual factor of 0.3 per year, which adds up to the sum of 12 over 40 years of working. If we were to calculate the value of the contribution-related component in today’s terms, it would be 12 x 68 = 816 EEK. In year 2009, the largest earned annual factor was 100. If this person were to receive the factor of 100 for all 40 years of his working life, it would add up to the sum of 4000, which in today’s terms would mean the benefit of 4000 x 68 = 272 000 EEK. These examples are based on very simplifying assumptions but they clearly demonstrate the inequalities that the current pension formula can lead to, if left unchanged. Of course, there aren’t that many people who earn factors over 10 (see Table 1), but even when we compare those who earn an annual factor of 3 per year over 40 years with those who earn an annual factor of 0.3 per year over 40 years, the resulting differences in the sum of annual factors are stark and would lead to 10-fold differences in the contribution-related component of pension benefits.

Because of the aging of the population (and the ensuing drop in the number of working persons per retiree), the resources available for the Estonian state pension system in 20-30 years are likely to shrink; hence, it is very unlikely that such inequalities in pension benefits would be politically acceptable. Rather, one can imagine, there would be calls for converting the first pillar benefits into flat-rate minimum pension payments for all pensioners. At the same time, the more time passes before this formula is changed, the more difficult it becomes to change the formula without running into constitutional disputes. If people assume that this formula remains in place, they can build up lawful expectations and act accordingly in their decisions concerning retirement savings. For example, if the parliament attempted to the change the formula (and cap the contribution-related component) in 15-20 years, for example, the state could face legal disputes from persons who claim that they decided not to join the second pillar because of the existing pension formula in the first pillar. The more time passes before the formula is changed, the more clout are these arguments, based on lawful expectations, likely to have and the Constitutional Review Chamber of the Estonian Supreme Court would face a very tough dilemma.

One of the motives behind the contribution-related component was to encourage the payment of social tax and constrain incentives for tax evasion. It was conjectured that since individuals perceive a clearer link between their contributions and the future benefits they would be less inclined to collude with the employer by agreeing to receive part of the salary in “an envelope”. However, it is not clear to whether the pension formula of the first pillar should be used for this purpose. On the one hand, the link between the social tax paid and its exact impact on the expected retirement benefits is not easy to calculate and may remain rather uncertain even for those who can compute their annual factors. On the other hand, since the second pillar of the Estonian pension system is defined-contribution, with fund accounts that people can keep track of, the diversion of the part of the paid social tax (4 percentage points out of 20 percent) to the individual accounts already serves the purpose of encouraging the official declaration of salaries paid.

In addition to creating incentives for more extensive tax compliance, the new pension system was intended to stimulate labour supply by creating a better linkage between the contributions paid and pension benefits received as well as providing additional incentives for later retirement. Again, it could be argued that the second pillar is already serving this purpose and using the contribution-related component of the first pillar for that purpose is duplicative. Furthermore, if the sum of the accumulated annual factors during the postponed retirement is low, relative to the minimum pension, they do not yield higher pension than is the level of minimum pension, and the motivation to work for additional years may be undermined. Thus, it is important to recognise that the effects on the labour market also depend on the relative sizes of the minimum pension (or people’s pension), the base part, and the value of one service year. Furthermore, there are specific financial incentives for postponing retirement and disincentives for early retirement built into the State Pension Insurance Act, whereby postponed retirement results in higher and early retirement in lower benefits; these incentives are likely to have a stronger and more direct effect on the retirement decisions.

Alongside the goal of poverty prevention, the designers of pension systems (especially those following the Bismarckian tradition) have pursued the goal of income replacement, which should guarantee that nobody has to face a large drop in the quality of life one is accustomed to. In that light, linking the size of first pillar benefits to life-time contributions seems to serve a legitimate goal. In the case of Estonia, however, one has to keep in mind that the function of income replacement – at least in principle – is already served by the second pillar, where the payouts are directly linked to life-time contributions. Also, those who wish to secure even larger replacement rates for themselves can make use of the third pillar, which is very lucrative in terms of tax deductions (allowing individuals to deduct contributions to the third pillar) and offers very favourable tax treatment of the eventual pay-outs (annuities bought for the third pillar pension savings are not subject to income tax). Altogether, one can say that making the benefits from all three pillars of the Estonian pension system dependent on life-time contributions is overly duplicative with regard to securing income replacement. Furthermore, the disparities created by the different pillars reinforce each other and could give rise to extreme inequalities among future retirees.

Hence, there is a need to change the pension formula of the first pillar as fast as possible. The most obvious way to do it is to add a provision to the State Pension Insurance Act, stating that the maximum annual factor that can be earned in a year is, let’s say 1 or 2. Although an amendment made to the State Pension Insurance Act in 2008 tries to increase the weight of the base component by using a coefficient of 1.1 when the indexation formula is applied to the base amount – and a coefficient of 0.9 when indexing the value of the service year – this change is insufficient to address the disparities. The longer the amendment of the formula is postponed, the louder the ticking of the bomb will become, which could threaten the fiscal and political sustainability of the Estonian pension system.

Technical description of the pension formula

The formula for calculating the pensions in the first pillar of the Estonian pension system can be expressed as following:

B = the base amount

H = the value of a service year

s = number of years worked before 1 January 1999.

Σ α = sum of annual coefficients accumulated after 1 January 1999.

The base amount is paid to all retirees who are eligible for state pension; it was determined in the State Pension Insurance Act in 2002 and has been indexed annually. Until 2008, the indexation was based on equally weighted increase of the consumer price index and increase of the social tax contributions; since 2008, however, the indexation formula attributes the weight of 20% to the increase in consumer price index and 80% to the increase in social tax revenues. In addition to the annual indexing, there have been additional increases, subject to the discretion of the parliament). As of 2010, the base amount is 1793 EEK. The working-time component is calculated as the number of accumulated years of pensionable service attained before 1999 multiplied by the value of one service year. The value of one service year was also determined in the State Pension Insurance Act and is indexed. In 2020, the value of one service year is 68 EEK. The contribution-related component depends on the contributions paid into the first pillar on behalf of the employee after 1 January 1999, and is found by multiplying the sum of a person’s annual factors (or “implicit years”) by the value of one service year. One annual factor or “implicit year” is a person’s pension-earmarked social tax as a fraction of the average pension-earmarked social tax paid by all contributors in the given calendar year. The average part is calculated by adding up the pension earmarked part of the social tax paid by all contributors and dividing it by the sum of accumulated service years earned in that year by all the contributors (if a person has paid social tax on less than minimum wage per month, the “earned” service year is respectively less than 1).