Miguel Fernández Ordóñez: Taking of stock of the Toledo Pact
Testimony by Mr Miguel Fernández Ordóñez, Governor of the Bank of Spain, before the
Non-Standing Committee for the Monitoring and Assessment of the Toledo Pact
Agreements, Madrid, 15 April 2009.
* * *
Five years since the last assessment of the Toledo Pact, and under a new assessment
process initiated by Parliament in 2008, I appear today before this Committee to convey my
views on the situation of and possible reforms to the pension system. These opinions are the
summary of a note drafted by the Banco de España Research Department, which will shortly
be forwarded to you.
Before I begin, I should stress that the content of the Toledo Pact, i.e. the pension system
and its reform, does not come under the purview of the Banco de España. Defining specific
reforms to the pensions system is an eminently political matter and is thus for the legislature
to decide upon. Accordingly, the note the Research Department is finalising and whose
content I shall outline for you today should not be considered as a reform proposed by the
Banco de España. It is simply a summary of what may be taken as a consensus among
experts regarding the diagnosis of our pension system and its attendant problems, and the
potential means for tackling them. Indeed, the summary is an update of that presented
before this same Committee by the Director General of the Research Department in 2000.
As you know, the Toledo Pact has already been in place for more than 13 years. Over that
period demographic and, until recently, macroeconomic developments made for a significant
improvement in the Social Security system's financial position. Since the signing of the Pact,
the Spanish population has grown strongly by more than 6 million, most of whom immigrants.
Immigration has been significant not only in terms of volume but also of its composition,
insofar as it tends to be concentrated in the younger age groups.
In parallel, macroeconomic developments enabled this strong growth in population to be
absorbed by the labour market. Notable in this connection was not only the contribution of
the foreign population but also the significant role played by female nationals progressively
joining the labour market. These developments occurred against a background of very low
growth in the number of pensioners as retirement was centred on the generations born
during the Spanish Civil War and the post-war period.
As a result, Social Security registrations far outgrew pensions in recent years, which explains
how the Social Security system ran growing surpluses, rising to 1.3% of GDP in 2007. These
surpluses were assigned, in part, to the Reserve Fund, which reached a significant size of
close to 5% of GDP at the end of 2008.
In the past year, however, the impact of the economic crisis has also been felt in the Social
Security accounts, meaning there has been a rapid deterioration in this surplus, which could
even disappear within a year.
Analysis of the Social Security system should not, however, be based on its results in the
short term. The signing of the Toledo Pact was but an acknowledgement that the viability of a
pay-as-you-go pension system should be analysed from a long-term perspective.
Taking this perspective, I should stress that, according to analyses conducted by national
and international analysts and institutions, neither the Social Security surpluses of the past
decade nor the foreseeable worsening of the financial situation in the coming years will
essentially alter the diagnosis. Accordingly, we may assert that the problems relating to the
financial sustainability of the current Social Security system were the same ones that led at
the time, among other reasons, to the signing of the Pact.
There are essentially two factors at the root of these problems: the sharp reduction in the
birth rate and the progressive rise in life expectancy, both of which bear on the current and
future structure of the Spanish population pyramid. On one hand, the outcome of the
increase in life expectancy will see the over-65 segment progressively gain weight in the
population total, while the pyramid base will narrow as a result of the birth rate falling below
replacement levels. Consequently, the shape of the population age structure is changing
from its current pyramid form to look more like a pillar. This will be so even assuming some
pick-up in the birth rate and continuing positive migrant inflows into Spain. In sum, on
Eurostat's current population projections, prepared in 2008, the dependency ratio (the
over65s as a proportion of the working-age population) might more than double between 2008
and 2050 from 24% to almost 59%.
Everybody is aware of the consequences of these population developments for the
sustainability of our pay-as-you-go pension system. Growing pressure would build up on
pension spending, meaning that the models currently available, including those devised by
the Economy and Finance and Labour and Social Security Ministries which incorporate all
the legislative amendments approved in recent years, show that this public spending item
would double over the time period referred to above. As a result, the system could run a
rising deficit as from 2025.
It should also be highlighted that the latest demographic developments, in particular the
heightened migrant inflows into Spain, do not resolve the problem. At best, the inflow of
working-age immigrants holds back the increase in the dependency ratio derived from
population ageing and, therefore, delays the emergence of the problems. But the full scale of
these problems will persist.
How can we tackle the challenge that demographics pose for our pension system? The scale
of the problem calls for a three-pronged strategy. First, the strategy should be far-reaching,
i.e. blending measures on different fronts. Specifically, the measures should pursue healthy
public finances, implement structural reforms in the economy and seek to reform the pension
system, as I shall now expand upon. Second, discussion of these measures should not
stretch out over time. And, finally, the reforms should have sufficient scope, acting along the
lines of the recommendations made in the review of the Toledo Pact.
Regarding the scale of the strategy, its first pillar should be based on maintaining healthy
public finances. Once again, we should adopt a medium-term perspective here. Irrespective
of the fact that 2008 saw the re-emergence of a budget deficit and that, almost certainly, it
will hit significantly higher levels in 2009, two matters will be vital in the medium term, once
the effects of the economic crisis have abated. We must resume a healthy public finances
path and, above all, bring public debt back onto the declining trend witnessed recurrently,
with the exception of 2008, since 1997. These considerations also clarify why the rise in the
budget deficit cannot go unchecked in the current situation, so as to prevent a strong
increase in public debt arising, which would impose an excessive burden on future
generations. In this respect, commitment to the medium-term fiscal rules laid down in the
Stability Pact at the European level and in Spanish budgetary stability laws continue to offer
the best guidelines for conducting fiscal policy.
Secondly, as the specialist reports emphasise, from the macroeconomic standpoint the
public finance sustainability problems are eased if employment and productivity in the
economy trend favourably. Here the room for improvement is extensive and calls for
structural reforms in many areas, such as the labour market and the markets for goods and
services, along with education and job training. Once again, the time perspective is important
here. The long-term view that should underpin any analysis of the sustainability of the
pension system is perfectly compatible with the fact that many of the reforms needed to
improve employment and, above all, productivity in the economy can only bear fruit after a
relatively lengthy period of time.
These two pillars of the strategy are evidently important. And tackling the problem of the
impact of population ageing on the pension system in the long run will also require reforms.
Further, these pension system reforms will complement the structural reforms mentioned
earlier, in particular those relating to the labour market, and the reform to maintain healthy
public finances.
It is this matter which is central to this Committee's mission. It has been working intensely in
this connection over the past decade, particularly on how to modify the pension system's
current parameters to ensure its long-term sustainability. That brings me back to two other
key aspects of the strategy to be agreed: the speed and scope of the changes to be made.
Although the emergence of the first deficit in the system may appear a long way off, it should
be borne in mind that the reform planning and implementation horizon is also long.
Accordingly, the reforms should be discussed without delay so that, following their gradual
implementation, they may prove fully effective when population ageing begins to exert a
more virulent effect.
Pension system reforms must also be sufficient. Since the signing of the Toledo Pact and its
subsequent renewal, various legislative amendments - which may generally be seen as in
the right direction - have been made. Examples include the (still incomplete) separation of
the sources of financing of the Social Security system, the unification of the contribution
bases, the creation of the Reserve Fund and the progressive simplification of the different
contribution schemes, among others. However, among the Pact's recommendations are
other measures worthy of discussion, since they may considerably impact the system's
sustainability.
At this stage we should ask ourselves which pension system reforms merit assessment. The
range of possibilities is an extensive one, and a decision on which reforms should be made
requires not only an expert assessment but a political one too. Resolving the system's
problems may involve changes in the parameters of revenue or expenditure, but choosing
the right or the most reasonable mix requires considerable political assessment. Yet some
combinations may be preferable to others from the standpoint of economic efficiency in that
they may generate greater incentives, for instance, to join the labour market. In this respect,
what is important from a technical viewpoint is to maintain a high degree of proportionality
between benefits received and contributions paid, a point that has been underscored from
the outset in the Toledo Pact recommendations.
Regarding the various options available, I shall refer to some already deployed by European
countries and which, therefore, have been tested to some extent. I reiterate that these are
not proposals of the Banco de España; the aim of my institution is to help this Committee in
its work by setting out the measures applied in other countries.
Taking first some of the measures that affect pension spending, some countries have opted
to raise the legal retirement age. Measures here have been on three fronts. Firstly, early
retirement conditions have tended to be tightened. And this is where the complement to the
aforementioned structural reforms is greatest: pension system rules should generate the right
incentives to remain in the labour market, and it should also be sought to maximise this
permanence through continuous employee training and wage flexibility, tailoring wage rises
to productivity. There have also been incentives to continue working beyond the legal
retirement age. And finally, decisions have been made to put back the legal retirement age,
although only a small number of countries have admittedly adopted this measure. This is so
in Germany, where a gradual increase in the retirement age from 65 to 67 has recently been
approved. The various simulations available indicate that this is a measure with a strong
effect in terms of reducing pension spending.
Secondly, and continuing on the expenditure side, other countries have opted to raise
significantly the number of years of contributions used to calculate the amount of the pension
(the "regulatory base"). Here, the application of a similar measure in Spain would draw us
closer to other European countries. Specifically, France has recently lengthened the period
for calculating the pension entitlement from 10 to 25 years, while Austria has extended it
from 15 to 40 years and a significant number of countries (Finland, Poland, Portugal and
Sweden) have extended it to cover the entire working life. This reform would be in line with
the recommendations of the Toledo Pact and would increase the system's proportionality, i.e.
the relationship between pensions received and contributions made. Connected to this issue,
there would be a possibility in Spain of furthering the reforms in recent years aimed at
bringing the different Social Security schemes onto a more equal footing, so as to ensure
that the contributions made under the different schemes are similar.
Thirdly, some countries have lowered the income replacement rate, defined as the net
pension divided by net income prior to retirement, by reducing the percentage of the
regulatory base received after having contributed for the minimum period (currently set at
50%), by extending this minimum period or by reducing the rates with which this initial
percentage increases for each additional year of contributions.
A more novel alternative has involved linking pensions to life expectancy. Insofar as part of
the problem arises as a result of the rise in life expectancy, adjusting pension amounts more
or less automatically to these increases would be conducive to the sustainability of the
system. Currently, this type of measure has been proposed or applied, to differing degrees,
in almost half the OECD countries.
As regards updating pensions, many countries have ceased to take wage growth as a
reference and have instead used price indices, as in Spain. In this case, potential reform
options might address the possibility of compensation for differences between forecast and
actual inflation acting both in favour of and against pensioners.
On the revenue side of the system, there appears to be no headroom for increasing social
contributions, since that might greatly impair employment. However, accelerating the process
of separation of funding sources should be considered so that social contributions cease to
cover the portion of top-ups to minimum pensions that they currently finance, as should
earmarking the entire Social Security surplus (and not only a portion as to date) to the
reserve fund.
Significantly, all these reforms can be made without having to alter the current pay-as-you-go
system, through changes in its parameters. Some countries have opted to frame these
changes within a single, large-scale change, at least in formal terms. Sweden and other
Central and Eastern European countries have set up a system of notional accounts. Under
this system, the model remains on a pay-as-you-go basis, but a virtual account is set up for
each individual which reflects the individual contributions of each pension scheme contributor
and the notional returns that these contributions generate throughout working life, returns
that are calculated according to a notional rate linked to some macroeconomic variable. This
system provides for a closer relationship between individual contributions and pensions. And,
above all, it significantly improves individuals' perception of this relationship, which may lead
to incentives systems and their impact on agents' decisions in the labour market working
more appropriately, reducing individuals' uncertainty over future income.
In my address I have referred to the projections of various organisations on the sustainability
of the system and to the reforms being applied in other European countries, summarising the
content of the Research Department document that I shall send you this week. But let me
conclude by highlighting the importance of the work entrusted to this Committee, especially
at this current juncture where, for other reasons, economic agents are under a cloud of
uncertainty.
The agreement reached in Toledo whereby pension sustainability may not be used as a
political battering ram is an achievement of which you should all be proud. This agreement,
moreover, does not mean you should not react to the problems that may emerge in the
pension system as a result of future demographic changes. On the contrary, the agreement
obliges us all to examine the problems and seek solutions. I am sure you will be able to
convey to the general public that these problems can be resolved if the appropriate
measures are taken and that, moreover, if they are taken without delay, they need not be
traumatic. And I am convinced that moderate reforms adopted in sufficient time will not only
help resolve long-term problems but, by offering reassurance and reducing uncertainty over
the future, they will also have favourable effects in the short run in the difficult economic
circumstances currently besetting us.