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Posted On: Oct. 5, 1997 12:00 AM CST

European governments are struggling to find politically acceptable strategies for revamping their pension systems, but employers' costs are still likely to increase.

Employers and employees in several countries are paying higher taxes as their governments try to reduce their pension liabilities.

Increases of 5% or more of gross domestic product in pension spending are projected in European Union countries in the next two decades if the systems are not reformed, said Philip Davis, deputy head of implementing the second stage of European Monetary Union. He works for the Frankfurt, Germany-based European Monetary Institute, a think tank that will become the central bank once EMU begins-set for January 1999.

In a recent report, "Public Pensions, Pension Reform and Fiscal Policy," Mr. Davis said recent analyses by the EMI and other organizations, such as the International Monetary Fund and the Organization for Economic Development, show there will be a narrow "window of opportunity" before the economic effects of aging populations drive up governments' costs.

Action now to reduce the burden of pensions may pay dividends, the paper says. Delay would threaten both European nations' economies and the welfare of the elderly.

European taxpayers pay an average of 10% of the GDP toward pension bills, though Italians pay 14%. U.S. taxpayers pay just 5% of GDP.

Why do employers and employees want to stick with the state-sponsored pay-as-you-go systems?

Mr. Davis said Europeans have confidence in the system because of its tradition of reliability. "The pay-as-you-go system is immune to inflation in a way that financial assets (in a funded system) are not," he said.

Only two E.U. countries, Sweden and Finland, partially fund their state pension systems; the rest rely on pay-as-you-go systems. Mr. Davis said the best state pension system in Europe is in Switzerland-which is not an E.U. member-where law requires full funding of state and employer plans.

Reform options include increasing retirement age and reducing benefits.

"There will be cutbacks in benefits. There are clear movements throughout Europe toward a greater self-reliance. But to say that Europe is going the way of the U.S. is not correct," says Paul Kelly, managing director-Continental Europe at Paris-based Sedgwick Noble Lowndes Conseil S.A. Europe has no plans to privatize pensions as in Chile or Argentina.

Under the Latin American model, pioneered by Chile, workers contribute to independently managed funds. The government regulates the fund managers. Chile still has financial obligations to retirees who participated in the previous system and to additional pensions for the military, which was not privatized.

"It is a question of social attitudes," Mr. Kelly said. "Europe is not one Europe but a number of different social structures and different demographics." Many countries have a clear social contract that revolves around a different view of social responsibility. In France, there is a feeling that one generation owes something to the prior. Such solidarity will take a long time to change, he said.

The French Parliament earlier this year approved legislation permitting private pension funds. But the election of the Socialist government of Prime Minister Lionel Jospin in June delayed implementation (BI, June 9).

Mr. Kelly expects private pensions to proceed but said the Jospin government may remove some of the previously offered tax incentives.

Tax incentives to switch to private retirement plans -thus lessening the state's future liabilities-are becoming a political minefield in Britain.

United Kingdom

In the mid-1980s, the British government encouraged people to opt out of the State Earnings Related Pension Scheme. Those who participated in a private pension plan could make lower contributions to the state plan. As a result, 5.6 million people opted out of the state system, and the government lost an estimated $9.6 billion in taxes.

Mr. Davis thinks the U.K. experience shows that the fiscal incentives required to induce a large-scale voluntary switch away from state systems may be so costly that they outweigh any savings.

With more than half the British workforce covered by occupational or personal pension plans, the United Kingdom has made more progress than any other E.U. country in reforming its state system.

But the reform effort increased employers' burden when the Labour government in July repealed the 20% tax credit on advance corporation tax, paid when dividends are distributed to tax-exempt shareholders, such as pension funds (BI, July 14).

Eliminating this tax credit will provide a windfall of 35 billion pounds ($56.3 billion) to the national budget, but it will cause pension plans to lose more than 3 billion pounds ($4.83 billion) a year. As a result, employers will have to make up the difference in defined benefit plans they sponsor, while individuals will have to make higher contributions or take smaller pensions.

Most British employers offer defined benefit plans, though the trend is toward defined contribution plans, which are less expensive.

The British government is studying ways to overhaul the pension and welfare system, but ministers at the Treasury and Department of Social Security differ on how to go about it.


In Sweden, modifications to the state pension system, proposed in 1994, are expected to become effective in 1999, says Jonas Frycklund, an economist at Stockholm-based Industriforbundet, the Swedish Industry Federation, an industrial trade group. The main idea is to ensure that 22% of the pension system will be funded through privately managed funds.

"It has been impossible to get a fully funded system because of the state system's high outstanding liabilities," said Mr. Frycklund.

Employers and employees will contribute equally a total of 18.5% of gross earnings of the employee, which is about 1% higher than the current contribution level. In 1999, total payroll taxes are scheduled to be 32%.

"The new system will have a much clearer relation between what is paid in and what is paid out," he said.


Italy is acknowledged to be in the worst position of all of the E.U. members, spending 14% of GDP on pension payments. Only 5% of the workforce is covered by private plans. The government of Prime Minister Romano Prodi has been negotiating with unions and minority parties in the governing coalition to cut pension spending in the 1998 budget. A reduction is needed to qualify for EMU in 1999. Those cuts could include introducing a higher minimum retirement age, linking pension payments to individual contributions rather than a percentage of an individual's final salary, and freezing early retirement in the public sector. The government has not reached agreement with the unions, though a vote on the budget is scheduled for November.

Eastern Europe

Significant pension reform in Eastern Europe is still some way off, Mr. Kelly said. Pension reform in Poland has been delayed by recent constitutional reform and general elections.

The Czech Republic introduced new regulations in 1994 that provide for voluntary contributions into privately run funds; the contributions were not subject to value-added or insurance tax. Citizens can choose only one plan, and the government will supplement the contributions.

Hungary passed legislation to permit defined benefit and defined contribution plans in 1993. Employer contributions are exempt from the 42.5% social security tax up to 20,000 Hungarian forints ($103) per person, while employees can deduct total contributions from taxable income.

Foreign companies investing in Eastern Europe generally provide death and disability insurance but not pensions and health care. "They are not going to make the same mistakes as in the West by promising big pensions and then finding that they can't keep them," said Mr. Kelly.

European Union

The effects of the planned monetary union on E.U. pension and welfare systems remains unclear. During the past year, critics of EMU have suggested the participants of a future monetary union will have to pool their assets and liabilities, meaning all of the monetary union's participants would bear pension liabilities.

Such a pooling would imply that those countries with low pension liabilities, such as Britain, the Netherlands and Ireland, would be forced to share the high pension liabilities of countries such as Germany, Italy and France.

Pension liabilities are not accounted for as state debt. Mr. Davis said estimates of countries' gross pension liabilities range between 107% and 401% of GDP, or at least three times conventional government debt.

If in order to fund pension liabilities a country must borrow money above the amount of state debt permitted in the monetary union criteria, the stability of the EMU could force the most-indebted countries to leave the system, Mr. Kelly said.

But Mr. Davis said monetary union should not combine E.U. members' pension liabilities unless taxation was unified throughout the European Union. This is unlikely to happen. "Countries jealously guard their taxation system," he said.