Private pensions: future developments of complementary pension schemes

4) Private pensions: future developments of complementary pension schemes

The social security system emerged from the ‘90s will, however, no longer be able to provide to young generation the replacement rate (the ratio between the first pension annuity and the last salary) actually granted to those retiring nowadays. The implementation of the reforms undertaken will, in fact, be very gradual and provisions will apply differently depending on age cohorts. In particular the pension award formula will vary according to whether the worker belongs to the Amato regime (workers with at least 15 years of contributions on 31 December 1992), the pro-rata regime (workers with fewer than 15 years of contributions on 31 December 1992) or the Dini regime (workers hired after 31 December 1995) (Forni and Giordano 2001). Boeri and Brugiavini (2006) suggest that even assuming severance pay contribution (TFR) of 30/40 years, it will be impossible to reach the present level of replacements rates since public pension schemes will only be able to provide labour income replacement rates of 35-40%, well below the present 65-70%. They conclude that the only possible way of overcoming the issue implies providing, besides the first pillar, higher rates of return on the funds accumulated in order to receive severance pay benefits (TFR), especially for younger generations. TFR contributions retained by the firm and managed by the employer are capitalized at a rate of around 2.5%. If invested in the financial market by pension funds, it is argued, they would gain on average higher returns.

As Forni and Giordano (2001) point out, the contribution scheme established by recent legislation places a great burden on employment. The fictitious INPS accounts are financed by a 33% flat payroll tax rate that leaves little space for contributions to supplementary private pension funds. To reduce this lack, the 1995 reform introduced the possibility for new workers to convert their severance pay contributions, 6.9% of their salary, into contributions to an occupational pension fund. However, since deciding to join a private fund does not reduce contributions to the first pillar, the actual contribution rate toward social security is still around 40%.  As a result, the Italian private pensions market is still extremely undeveloped. New provisions from the current government, to be phased in during 2007, again involve transferring workers’ severance pay into private funds, this time as a first choice. Differently from the past, in fact, the principle of “consenso-assenso” was introduced, implying that with out any specific prescription from the worker, contributions would automatically flow to complementary pension schemes. From the 1^st of January 2007 then, both, workers employed in the private and self-employed, will have to decide whether they want to join complementary pension schemes by moving future flow of severance pay contributions into private funds, or instead continue to accumulate them in the company accounts like in the past. Choosing the former does not imply the obligation of further contributing to the fund (with funds different from TFR), for both employer and employee, although it does not even preclude the possibility of actually doing so. For those that agree joining the complementary pillar a new individual position will be created. Contributions, accumulated on this new position, will then be invested by specialized financial institutions, such as pension funds, banks, and insurance companies, into financial instruments with different risk profiles, depending on the individual’s preferences.

This new regulation is the object of heated debates since severance pay has for many years been a major source of cheap capital for firms. Firms accumulated and kept this monetary benefit owed to employees until the former reached retirement, using it in the mean time in day-by-day investment operations and only then transferring the entire sum to the pensioner. TFR contributions helped finance production operations, constituted a debt firms owed to employees, for which although firms paid a price (2.5%, the capitalization coefficient) well below the average 5% attainable on the market. From the workers perspective, this amelioration takes away a large lump sum the worker would have received at this stage of his retirement and that constituted a way of financing a rather large investment such as buying a house.Furtherthe passage to private pension funds introduces a wider spectrum of risks of which some can be directly chosen by the worker, and some not.  Depending on variables such as age or life expectancy the worker will be free to choose a high profile (shares etc) or low profile (bonds etc) risk investment. He will though face further risks regarding the quality of the administrators of the funds, potential frauds, the variability of the outcome of the investment. Thus compared to public pension schemes, there will be a shift from a political risk (i.e. unexpected changes from future governments) to a market risk. Not to forget,the reason for this new provision is the need to ensure the fiscal sustainability of the system. Indeed, Forni and Giordano (2001) argue that the replacement rates obtainable by combining both systems should be much higher, i.e., between 53% and 113%. Transferring severance pay into occupational funds would foster a shift towards a more privately funded system, making possible reducing the current level of social security system contribution. Hence, this must be considered only as the first step towards a deeper change involving a re-equilibration of the rates of contribution in favor of supplementary pension schemes.

However, the benefit actually accruing to the sustainability of the system by developing a privately funded pillar has been questioned somewhat in literature. Barr (2002) in particular argues that by shifting workers contributions (from the 1^st pillar) towards a privately-funded scheme the state faces a higher fiscal burden in the transitional period since it faces the obligation of financing a certain amount of pensions on a pay-as-you-go basis even though it no longer receives the same amount of contributions to do so. Forni and Giordano (2001) point out, although, that the initial increase in the deficit would be gradually offset by the growing reduction in pension expenditure, and that the final result would hence depend on the actual time needed to phase in the transition. Barr (2003) further underlines the inconsistency of the belief that funded schemes are consistently “insensitive to changes in the dependency ratio”. Like pay-as-you-go schemes, in fact, the former “built claims on future production”, guaranteeing to pensioners a fraction of the output produced by the work force. Hence, he concludes, shrinking dependency ratios, should rather be offset by output growth, achievable through supply-side policies aimed at increasing the individual level of productivity, education, at raising retirement age, and at demanding selected flows of immigrants.

The desire to implement the use of private pension funds emerges as a way of moving capital into the undeveloped Italian financial market. It is argued that the loss of competitiveness of Italian firms could be somewhat challenged if large capital flows were directed towards the more competitive and productive among them. This belief is based on the assumption that pension funds operating into a competitive financial market, hence seeking high returns on investment, would accentuate a process of positive selection, by allocating financial resources to the economic actors with the greatest prospects.  The success of a strong second pillar will although depend on the fraction of new pension funds entering the market, as well as on the established market degree of competition. Nowadays the private market for pensions is extremely underdeveloped.