Demands of an ageing population: proposals for a viable pension system

By Andreas Charalambous and Omiros Pissarides

Within the context of the upcoming presidential elections, various topics related to pensions are at the forefront of the public debate in Cyprus. These include, among others, the abolition of the co-called penalty of 12 per cent for retirement at the age of 63, as well as the expansion of the provident fund framework.

The purpose of this article is to present a rational set of proposals aiming at a viable and adequate pension system in Cyprus.

An internationally and widely accepted benchmark for adequacy of pensions is to reach 60 per cent of the latest annual earnings. Such a level is considered essential on social grounds, given that a substantial percentage of pensioners belongs to the most vulnerable groups. It is also considered important on economic grounds, considering that pensioners account for an increasing share of the overall population and thereby exert a growing impact on consumption, investment and savings.

The worldwide phenomenon of an ageing population, which leads to increasing expenditure and at the same time lower contributions, constitutes the major challenge of the pension system.

The two major objectives, that of adequacy and financial viability of pensions, can be achieved via a comprehensive policy based on three pillars, in line with international best practices.

The first pillar concerns the existing social security fund. Gradual increases in the tripartite contributions (employers, employees, state) are necessary to cover part of the population ageing issue and the related higher expenditure. However, such increases do not suffice to cover the expected gap and to safeguard the adequacy of pensions. It is estimated that, given the projected demographic developments, an increase of the contributions to about 50 per cent of earnings would be required to cover the widening gap, a level which is rightly judged to be prohibitive.

Demographic ageing renders a gradual increase in the retirement age unavoidable. For the same reason, the proposed abolition of the so-called penalty of 12 per cent for early retirement at the age of 63 would not be effective, since it would lead to a further deterioration of the population ageing-related financial gap.

In order to address the gap more effectively, it is necessary to develop a second supplementary pillar, via a reformed provident fund framework, which should target the coverage of those employees not currently benefiting from existing schemes. At present, only a small share of the working population in the private sector is covered by occupational pension schemes, thus raising inequality issues. The financing of such a supplementary scheme could be covered by employers’ and employees’ contributions at 5 per cent each, in a similar manner to the agreement reached recently for public sector employees. Considering the current challenges facing the economy, the introduction of the proposed island-wide provident fund framework should take place in a gradual manner, thus providing the enterprises with the necessary adjustment period. Those employees who are currently benefiting from arrangements that are more generous compared to the proposed one, should be given the option to opt out and retain their current scheme.

The first and second pillar should target reaching the internationally accepted benchmark of 60 perc cent of earnings. On a voluntary basis, the existing third pillar should be maintained, via schemes supported by tax incentives and offered by insurance companies.

Safeguarding the professional management of both the social insurance fund and the provident funds, in line with the strict requirements of the related EU provisions, is of utmost importance, as is safeguarding their independent supervision.

Andreas Charalambous is an economist and a former director in the finance ministry. Omiros Pissarides is the managing director of PricewaterhouseCoopers Investment Services