EVALUATION OF THE FINNISH PENSION SYSTEM / PART 1 The pension system in Finland: Adequacy, sustainability and system design Nicholas Barr Professor of Public Economics, London School of Economics EVALUATION OF THE FINNISH PENSION SYSTEM / PART 1 The pension system in Finland: Adequacy, sustainability and system design Nicholas Barr Professor of Public Economics, London School of Economics Eläketurvakeskus 00065 ELÄKETURVAKESKUS Puhelin 029 411 20 • Faksi 09 148 1172 Pensionsskyddscentralen 00065 PENSIONSSKYDDSCENTRALEN Telefon 029 411 20 • Fax 09 148 1172 Finnish Centre for Pensions FI-00065 Eläketurvakeskus Finland Telephone +358 29 411 20 • Fax +358 9 148 1172 Waasa Graphics Oy Vaasa 2013 ISBN 978-951-691-174-1 (nid.) ISBN 978-951-691-175-8 (PDF) PREFACE Finland has a pension system that, in a unique way, combines a compulsory legislative basis, similar benefits for all, partial funding and private organization of the pension provision. It is a hybrid, fulfilling the functions of first and second pillar pensions within the same scheme. The main pension scheme is a legislated and compulsory earnings-related scheme, which is supplemented by the residence-based, flat-rate pension scheme. In order to get a fresh international view of the Finnish pension system, the Finnish Centre for Pensions decided in 2011 to commission an independent evaluation study of the Finnish pension scheme. The purpose of the evaluation was to get a forward-looking external view of the Finnish pension system from an international perspective, including recommendations. The evaluation focuses on the following issues: 1. The adequacy of pensions and the financial sustainability of the system: • the roles of the earnings-related pension and the residence-based flat-rate pension, and the interplay of these • the functioning of the economic and actuarial incentives of the pension system. 2. The policy design of the Finnish earnings-related pension scheme: • how does the Finnish pension system look from the point of view of risk- sharing and social insurance? • the impact of the pension system on the economy, the labour markets (incentives to work and to retire), and society in general • the roles of the state, labour market organizations and other interest groups in the decision-making (pension legislation). 3. Governance issues in the earnings-related pension scheme: • the functioning of the organization of pension provision (the roles and relations of various actors in pension provision, including the administrative structures of these organizations) • the roles of co-operation and competition between pension providers • the administrative efficiency and cost-efficiency of the earnings-related pension system. We were very lucky that two distinguished experts agreed to undertake this ambitious task. Professor Nicholas Barr from the London School of Economics agreed to evaluate the first two sets of issues outlined above (adequacy and sustainability issues and policy design), and Professor Keith Ambachtsheer, who is Director of the Rotman International Centre for Pension Management, Rotman School of Management, University of Toronto, to evaluate the governance issues. Both Barr and Ambachtsheer are internationally well- known and highly regarded experts in the pension field, and their services are frequently utilized internationally. These two evaluations are the first ones of their kind made of the Finnish pension system. They comprise sharp analyses, which deserve broad attention in the public debate as well as among politicians and decision-makers. They emphasize that Finland has a pension system with many strengths deserving appreciation. They also provide suggestions for possibly making the system even better. The Finnish Centre for Pensions wishes to extend very warm thanks to Keith Ambachtsheer and Nicholas Barr for accepting our invitation, and for having provided thoughtful and fresh ideas to fertilize the pension policy discussion in Finland. In connection with the evaluation reports by Keith Ambachtsheer and Nicholas Barr, three background papers will also be published. The key results of these three studies are utilized in Ambachtsheer’s evaluation, and we wanted to make the results of the studies available in greater detail and hence decided to publish them. Two of the studies are based on reports provided by CEM Benchmarking Inc. CEM is specialized in providing benchmarking information for pension investment and administration operations. Its clients are pension providers all over the world, who want to benchmark their own performance to the best pension providers in the world. The Finnish Centre for Pensions asked CEM to conduct a comparison of the Finnish pension providers with pension providers using CEM’s databases and services. These studies focus on administrative costs and service levels, as well as investment costs. We wish to thank Mike Heale from CEM Benchmarking Inc. for managing this assignment for us with high professional expertise. Eight Finnish pension providers participated in these studies, and we wish to thank them for being part of the project. In CEM’s analysis, eight Finnish pension providers were combined into a single entity, ’the Finnish Pension Fund’, which is compared to individual pension providers. This analysis gives insight into the costs and service levels in Finland compared with those of the peer group chosen from the database of CEM. The report is not meant to describe the costs at the national level, including all first and second pillar pension providers. In order to achieve this broader view, the Finnish Centre for Pensions conducted a comparative study of the administrative costs of first and second pillar pensions in Denmark, Germany, Finland, the Netherlands, Norway, Sweden and Switzerland. This study, based mainly on publicly available information, was carried out by Antti Mielonen, Eeva Puuperä, Hannu Ramberg and Mika Vidlund from the Finnish Centre for Pensions. We wish to thank them for this essential contribution to the evaluation. Jukka Rantala Managing Director Hannu Uusitalo Director, Professor CONTENTS Executive summary .............................................................................................................8 PART 1: PRELIMINARIES 1 Introduction ....................................................................................................................15 1.1 Organisation of the Report ......................................................................15 1.2 Description of the Finnish pension system .....................................16 2 Analytical approach ....................................................................................................24 PART 2: ASSESSMENT 3 Objectives of the pension system .......................................................................27 3.1 Objectives and constraints .....................................................................27 3.2 Objectives of the pension system in Finland ..................................28 4 The case for non-contributory pensions ...........................................................31 5 Adequacy .........................................................................................................................33 5.1 Poverty relief ..................................................................................................33 5.2 Consumption smoothing ..........................................................................38 5.3 Insurance .........................................................................................................42 6 Choice and competition............................................................................................46 6.1 How much choice? ......................................................................................46 6.2 Implications for pension design ...........................................................48 7 Labour markets .............................................................................................................51 7.1 Containing labour market distortions ................................................51 7.2 Labour-market participation of older workers and pensioners ......................................................................................................56 7.3 Maternity leave .............................................................................................63 8 Risk sharing ....................................................................................................................64 8.1 Principles ........................................................................................................64 8.2 Adjusting the income of pension funds ............................................68 8.3 Adjusting future benefits during working life ................................69 8.4 Adjusting benefits in payment ..............................................................78 9 Sustainability ................................................................................................................79 9.1 Margins of adjustment ..............................................................................79 9.2 How robust is the system? .......................................................................80 10 Disability pensions....................................................................................................82 11 Voluntary pensions ...................................................................................................85 12 Conclusion .....................................................................................................................86 12.1 Formulating pensions policy ................................................................86 12.2 Broad conclusions ....................................................................................87 References .............................................................................................................................91 Boxes Box 1. Multiple risks and uncertainties ..................................................................24 Box 2. The citizen’s pension in the Netherlands ................................................32 Box 3. Why inappropriate use of steady-state analysis is a major error? ...................................................................................................42 Box 4. How much discretion is optimal? ................................................................67 Box 5. Principles for adjusting pensionable age ................................................76 Figures Figure 1. Composition of pension benefits at different levels of income, 2012 .............................................................................................22 Figure 2. The share of national pension and earnings-related pensions to gross income ..........................................................................36 Figure 3. Age at first drawing earnings-related pension .................................59 Figure 4. The life course of men and women in Finland retiring in 1987, 2010 and 2050 ............................................................72 Tables Table 1. Accrual rates by age ......................................................................................17 Table 2. Full rate of national pension and income threshold, 2012, EUR per month.................................................................................................23 Table 3. Guarantee pension payable to persons living alone, 2012, EUR per month.................................................................................................23 Table 4. Incomes of older people, mid-2000s, selected countries ..........34 Table 5. Income poverty rates by age, sex and household type, selected countries, percentage with incomes less than 50% of median household disposable income...............................34 Table 6. Poverty risk by gender, age and household status, 2008 ..........38 Table 7. Funding ratios, 2011 ....................................................................................80 8 EVALUATION OF THE FINNISH PENSION SYSTEM / PART 1 EXECUTIVE SUMMARY 1. This report evaluates the design of the pension system in Finland; a parallel report discusses institutional structure and governance. After introductory discussion (section 1), section 2 summarises the analytical approach. Subsequent sections assess the system: objectives (section 3), the argument for a non-contributory pension (section 4), adequacy (section 5), the role of choice for workers (section 6), labour markets (section 7), risk sharing (section 8) and sustainability (section 9). Section 10 briefly discusses disability pensions, and section 11 voluntary pensions. Section 12 considers the way pensions policy is formulated and offers some broad conclusions. 2. The primary objective of a pension system is to provide income security in old age. That objective has at least four elements: consumption smoothing, insurance, poverty relief and redistribution. Successive reforms in Finland have (a) contributed to the achievement of those objectives, (b) been timely and (c) commanded consensus. Partly as a result, discussion of improvements can be reflective rather than crisis response. In the light of that broad conclusion, much of this report sets out areas for discussion in the continuing dialogue between the social partners and government rather than specific recommendations for change. Strengths and weaknesses 3. The strengths of the system can be summarised as follows: • Consensual: the system involves all interested parties and is run consensually. • Unified: though the earnings-related pensions of workers in private firms are private and competing, they operate within a unified national framework. • Constrained choice: the system constrains workers’ choices, both over how much to save and over pension provider. These features comply with lessons from information and behavioural economics. • Compatible with labour mobility because the pension systems of workers in the private, public and municipal systems are all basically the same. • Adequacy: the system scores well for most people. • Coverage is high because (a) the national pension and guarantee pension