The Danish Pension System Properties, outcomes and challenges

Torben M. Andersen

Aarhus University, Denmark

Eight International FIAP- ASOFONDOS Congress,

Carteagena April 2015

Pension system: Multiple objectives

• Distribution: Ensuring that all elderly have a decent living standard (minimum standards)

• Consumption smoothing: Ensuring that living standards after retirement stand in a resonable relation to living standards while working

• Insurance: Coverage of various events (spouse, long life……)

Danish pension system

I: Public pensions (PAYG – defined benefits) – Base pension for all (flat rate)

– Supplements – means tested

– All benefits are wage indexed

II: Labour market pensions (defined contribution) – Bargained, but mandatory for the individual

– Covers the majority of the work-force

– Provide annuitities + insurance (spouse/children; health)

III: Private pension saving – Tax subsidized and tied until retirement

– Free savings (property, financial assets…..)

International comparisons

Background -Danish welfare model

• Extended welfare state – Pensions

– Health

– Old-age care

• Universalism – Equal entitlements for all

– Tax financed

• Strong distributional objectives

Current pension system -

developments

• 1980s – Savings deficit – systematic current account

deficits

– Political discussion on employee-owned firms (wage-earner funds)

– Social partners: Agreement on development of labour market pensions (centralized labour market; high unionization)

• Collective - voluntary /bargaining

• Individual - mandatory

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Labour market pensions – stepping up

7

0

50

100

150

200

250

19

84

19

87

19

90

19

93

19

96

19

99

20

00

20

01

20

02

20

03

20

04

20

05

20

06

20

07

20

08

20

09

20

10

20

11

20

12

Pension wealth, % of GDP

0

2

4

6

8

10

12

14

16

18

20

% Contribution rates

LO-DA blue collar

LO-DA white collar

Teachers

Nursery teachers

Changing importance of public and

private pensions

0

1

2

3

4

5

6

7

8

9

1985 1995 2005 2015 2025 2035 2045 2055 2065 2075

% of GDP

Public pensions Private pensions

Pensions, % GDP

Current system

0

50

100

150

200

250

300

350

400

450

0

50

100

150

200

250

300

350

400

450

- 50 100 150 200 250 300 350

Supplement I Supplement IIBase amount Private pension

1.000 kr. 1.000 kr.

Private pensions

Phasing out of public pension supplements

Replacement rates (2012)

0

20

40

60

80

100

120

140

0

20

40

60

80

100

120

1 2. 3. 4. 5. 6. 7. 8. 9. 10

Income decile

Capital income Private pensions Public Pensions

% %

Projections:

- Replacement rates will increase

- Private pensions will increase in importance

- Public pensions will remain important

Low income among pensioners

0,0

0,5

1,0

1,5

2,0

2,5

3,0

0,0

0,5

1,0

1,5

2,0

2,5

3,0

65 66 67 68 69 70 71 72 73 74 75 >75

%. %.

Age

Share with income below 50%

of median income for entire

population

0.3 % of persons above 64 falls

below the official poverty line

Financially robust?

• Labour market pensions: – Funded

– Non-firm specific

• Public pensions: – Criteria for fiscal sustainability are met!

– Reforms to increase the statutory pension age • Reducing possibilities for early retirement

• Discrete increases in pension age from 65 to 67

• Indexation of pension ages based on life expectancy at the age of 60; expected pension period 14.5 years

Challenges

• Interplay between public and private pensions (means testing)

• Taxation of various types of savings

• Not all are covered by a labour market pension

• Balance expansion – macroeconomic (in)stability

Distribution dilemma

• Binding distributional constraint – ensure some minimum income (working age and pensioners)

• Impossible to reach this target through mandatory pension savings for groups with income close to the limit

• Division of labour between public and private pension via means-testing – targeting public pensions towards low-income groups

Means-testing and incentives

• How to transit from public to private pensions? (means-testing)’

• If higher private pension =

lower public pension ; implicit form of taxation in addition to regular taxes

• Effective tax rates can be high

- Slow phasing out: low tax rates, but costly

- Quick phasing out: high tax, less costly

0

20

40

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100

120

140

160

180

200

0

20

40

60

80

100

120

140

160

180

200

- 50 100 150 200 250 300 350 400

Public pensions

Supplement I

Supplement II

Base amount

1.000 kr. 1.000 kr.

Private pension

Incentives – savings and retirement

• High effectiv tax rates

on pension savings

and later retirement

• Applies for low

income groups!

35

45

55

65

75

0 100 200 300 400 500 600

Private pension(1.000 kr.)

% %

Effective tax rates on pension savings

Means-testing and insurance

• Low contribution due to involuntary unemployment, illness etc.

• Low return on investments

etc.

= lower private labour market pension

= higher public pension

Stabilizes/insures total net pension

Taxation of savings

• ETT-regime for

pension savings

• Large variations in

taxation of various

types of savings

– Asset allocation

– Balance expansion

0

5

10

15

20

25

30

35

40

45

0

5

10

15

20

25

30

35

40

45

Returntaxation -pensions

Property Shares Capitalincome

% %.

Pension

savings

Other types of

savings

Balance expansion

• High level of pension savings (illiquid)

• High level of borrowing (large share with variable interest rate)

• High risk exposure?

• Effects on macroeconomic stability

Financial assets Financial liabilities Financial net assets

Pension wealth, after tax Deferred taxes

% of GDP

Pensions for all!

• Bargained solution= support from social partners

• But not all covered! (recipients of social transfers, some employed, self-employed)

• ”Myopia” – insufficient savings (The argument for mandatory pensions saving)

• Free-rider aspects + effect on public budgets

• Solution: Mandatory pension savings for all??

Conclusions

• Long transition phase – still on-going

• Robust system

– Meets distributional objectives

– Ensures high replacement rates

– Financially viable

• Unsolvable dilemma – how to reconcile (re)distribution with incentives?

– Current system has clear incentive problems (savings, retirement)

– Uneven taxation of various types of pensions saving

• Ensuring coverage for all – mandatory scheme or?