Pensions Black Hole

17^th April 2009

The Malta Independent - Friday Wisdom

If the government were a commercial organisation it would be unquestionably bankrupt. We always knew that our pay-as-you-go pension system is a huge burden on future governments who will find it progressively harder to maintain it. Longevity will explode entitlement payments whereas contributions will fail to keep pace as the economically active will grow at a much slower pace, if at all, than those claiming entitlements. However no one had ever put a number on it.

Now at last someone has. A Eurostat/ECB task force is undertaking a project to arrive at a statistical measurement of the assets and liabilities of pension schemes of EU member states. Malta took part in the pilot study for calendar years 2006 and 2007 and the result is mind boggling.

Our pension system has no assets as it goes completely unfunded. It has only liabilities to fund future payments of current pensioners from the contributions of those currently economically active and, in case of any shortfall, to fund this from the consolidated fund.

If Malta were a commercial company the auditors would insist on showing a liability in its balance sheet reflecting the current value of such future obligations using best estimates regarding longevity, inflation, economic growth and making a subjective judgement on the rate with which to discount future obligations to their present value.

It is this theoretical liability that was calculated by the Eurostat/ECB project team and it represents the current value of pensions to be paid in future on the basis of accrued pension rights without taking into consideration the future contributions of current workers or the accrual of new pension rights to such workers. In short if we were switching to a fully funded pension system this liability would have to be put up in cash by the pension sponsor as part of the switch.

The liability was estimated at e14.3 billion equivalent to 264.2 per cent of the GDP. No commercial company could survive and remain financially stable if it had to recognise in its books a pension liability equivalent to 264 per cent of its internal value-added.

But government is no commercial company. It has no obligation to include such liability in its financial statements although Eurostat and the ECB seem minded to include it in a revised version of the national accounts of EU countries to distinguish those who like us are fully exposed to such obligations from others who have full or partial funding mechanism in place.

Government can change the rules of the game in a way that a commercial company would find it hard if not impossible to do. For example the project team calculated that by raising the statutory pension age from 61 to 65 in the period between 2014 to 2023 pension liabilities reduced by seven per cent of the GDP. To contain such obligations within manageable proportions, governments will in future have to consider further extension of the pension age, higher contributions from the economically active or some freeze on the pension entitlements. They will also have to create economic growth to increase the activity rate among females which is still among the lowest in the EU.

It is possible that in the long term the problem could take care of itself if, as I expect, the present concept of retiring on pension will gradually disappear. Longevity will make current pension arrangements unsustainable or irrelevant in quantum terms thus forcing people to continue working indefinitely for as long as their health permits. As work will be much more brain intensive, requiring little or no physical effort and offering flexibility on the location where employee services have to be imparted (most employees will be able to work from their own home without having to attend the office regularly) working until death could well be the norm fifty years down the road. It will not be punitive. It may well be fun and the only way to keep up a comfortable lifestyle for forty or fifty years beyond current retirement age.

So while shocking at face value, the quantification of the black hole in our pension obligations need not force us to despair. We have long known that as the baby boomers retire, the pension system will come under severe stress and failure of politicians to take, admittedly, harsh decision to reform it, will by default lead to the gradual irrelevance of the whole public pension structure.

Of much more immediate worrying stuff is the return for the months of January and February 2009 of government’s financial situation. The bottom line deficit has deteriorated by a harrowing 40 per cent even though government slowed down capital expenditure funding and in the process “saved” (probably postponed is a more appropriate definition) e15 million. Government revenue is down 12 per cent with sharp drops in all principal revenue sources except for social security contributions. Customs and Excise is down 29 per cent, VAT down three per cent and Income Tax down seven per cent. That social security contributions kept up fits within the theory that unemployment is always a lagging indicator of economic performance.

If there was any doubt that in the first quarter our economy went into a deep recession one now needs little further proof. The recession forces government budget to behave counter-cyclically even if government has not projected accordingly. The recession chops ordinary revenue as economic activity retreats and it forces expenditure to increase as social protection payments kick in through unemployment benefits and other incentives to protect the economy from falling deeper into a recession.

Government refused to prepare a budget taking into account the reality of the recession affecting our major trading partners. The 2009 budget is being rendered irrelevant by the unfolding events and at this rate government will have a lot of explaining to do for its obstinacy in refusing to look at the recession in the eye and to budget accordingly. The real outturn is showing that the budget for 2009 was built of hope rather than realistic expectations.

And we have not hit bottom yet. We will probably hit bottom this summer when a failed tourist season will shock the many who normally benefit from tourism instant powers of multiplication. Government will have adopted the EU’s proposed additional 2 per cent stimulus by default rather than by plan.