EUROPEAN COMMISSION

Directorates-General for 
EMPLOYMENT AND SOCIAL AFFAIRS
ECONOMIC AND FINANCIAL AFFAIRS

Promoting Adequate and Sustainable Pensions Through the Open Method of Coordination

Background paper for the bilateral seminars between the European Commission and Accession Countries

Promoting Adequate and Sustainable Pensions Through the Open Method of Coordination

Background paper for the bilateral seminars between the European Commission and Accession Countries

The aim of these bilateral seminars is to bring together the Commission and national policy makers responsible for pensions issues and to introduce them to the open method of coordination in the area of pensions. By presenting the work done so far with the current 15 Member States we want to prepare the ground for the full participation of accession countries in this joint effort to promote reforms in the Member States that will guarantee both the future adequacy and financial sustainability of pension systems.
This is not about telling national policy makers what they have to do. The open method of coordination that we use in this field is about helping national policy makers in their reform efforts for which they alone remain responsible. And it is about supporting the ambitious goals set at the Lisbon European Council in March 2000: the goal for the EU to become the most competitive and dynamic knowledge-based economy. This requires determined policy efforts in all Member States and a better coordination of national policies with a view to promoting economic and employment growth, but also greater social cohesion. The tools for policy coordination in the areas of economic and employment policy were already in place at the time of the Lisbon European Council. The new open method of coordination was defined as a new, complementary policy tool at EU level that could be used for promoting action for the achievement of the strategic goal set by the Lisbon Summit in areas where no other policy coordination tools are currently foreseen in the Treaty.
We first used the open method of coordination to address the issue of social exclusion. The acceding countries are now being involved in this policy effort through the ‘Joint Inclusion Memoranda’ that are being elaborated in cooperation with the Commission as a sort of precursor to the national action plans that will be required later.
The Open Method of Co-ordination on pensions
In December 2001, the European Council called for the application of the open method of coordination in the area of pensions and endorsed 11 common objectives. These common objectives are the basis of the open method. We have similar fundamental goals for our pension systems all over Europe and face many common challenges. This is what makes cooperation valuable. On the basis of the common objectives, Member States submit national action plans – or national strategy reports, as we decided to call them in the area of pensions. The current 15 Member States presented their national strategy reports in September 2002. 
The national strategy reports were then analysed by the Commission which drafted a report that was jointly adopted by the Commission and the Council and presented in March 2003 to the Spring European Council which endorsed the report and requested that this work be continued.
An important element of the open method of coordination is the development of common indicators. They are crucial for assessing how successful national policies are in terms of achieving the common objectives. And they make mutual learning possible: without comparable data, it is impossible to know how successful the policies of other Member States really are and hence whether it would be advisable to follow similar approaches.
Much of the work that is required by the open method of coordination is prepared by the Commission, but the important discussions take place in committees composed of senior officials from the Member States and the Commission. Since April the acceding countries take part in the meetings of these committees and their working groups. The Social Protection Committee brings together experts from the social affairs ministries. It has established an Indicators Subgroup that looks notably at ways of measuring the adequacy of pension systems. The Economic Policy Committee brings together representatives of the finance ministries and national central banks. It looks at pension systems from the point of view of the sustainability of public finances. It is supported by the ‘Ageing Working Group’ which studies the budgetary implications of ageing populations and has done projections of age-related public expenditure, including pensions, and which develops indicators on the financial sustainability of pension systems and public finances as a whole. Finally, the Employment Committee has an important contribution to make on the employment of older workers and on ‘active ageing’.
The aim of the open method of coordination on pensions is to develop an integrated approach that considers all relevant issues for pension systems at the same time. We do of course examine pension related issues in the framework of economic policy coordination through the Broad Economic Policy Guidelines, and the financial sustainability of public pensions in the broader context of the overall sustainability of public finances context through the Stability and Growth Pact. However, if we do not take into account the adequacy of pensions we risk being surprised, at some point in the future, by strong political pressures to increase public spending on pensions. And this may well turn a pension system that was previously regarded as financially sustainable into an unsustainable one. 
Conversely it would be short-sighted to look only at adequacy. Generous pension promises are of little use if there is no money to pay for them. So adequacy and financial sustainability have to go hand in hand. Our common objectives therefore cover both adequacy and financial sustainability – and a third area, namely the modernisation of pension systems to adapt them to changes in society and the labour market.
An integrated approach is also necessary because the challenge of securing sustainable pensions goes broader than the structure and parameters of pension systems. It concerns, for example, the design of labour market policies as well as other branches of social protection. The open method of co-ordination seeks to consider all issues that are related to future pension provision and all options that are available for preserving a financially sustainable high level of social protection. 
By looking at the interactions between social protection, employment and budgetary policies, we can break out of a debate on the future of pension systems that simply pitches the interests of one generation against those of another: the active against the retired, the young against the old. And it helps avoid the false idea that the future of adequate pension provision only depends on the choice between financing pensions on a pay-as-you-go or on a funded basis.
What is particularly important is the balance between contributions and entitlements, or the balance between the number of years spent in work and time spent in retirement, and the ratio of people in employment to the number of pensioners. And this depends of course also on the overall design of pension systems. A high level of employment, including for people in their 50s and 60s will be important for supporting at the same time high pension levels  and their sustainable financing. The latter also means avoiding levels of contributions or taxation that could be harmful to employment and competitiveness.
The fact that future pension provision and their financing are dependant on the overall performance of economies also requires close co-operation of policy makers across different areas such as pensions, employment and public finances. Furthermore, the design and operation of the pension system is not only the responsibility of governments. The development of soundly based second and third pillars requires the input of social partners and of the insurance and financial services industries. The contribution of social partners is also important in achieving common objectives in other areas such as labour market participation of older workers. We consider it highly desirable that the expertise of social partners and of different types of pension providers be used in the elaboration of national strategy reports – but it is for each Member State to define the best way to mobilise all relevant stakeholders.
Links between the open method of co-ordination on pensions and economic policy co-ordination
As already mentioned, pensions are also dealt with in the context of economic policy co-ordination where pension policies are looked at from the point of view of public finances and economic performance in general. Under the Treaty Member States are called upon to co-ordinate and conduct their economic policies in order to reach higher growth in a stable EU-wide macroeconomic environment. This should be done in line with the broad economic policy guidelines (BEPGs).
In the context of the Stability and Growth Pact the public finances aspects of pensions policies are reported annually in the national Convergence/Stability Programmes and assessed by the Commission and the Council. In addition, the implementation of the recommended reform measures are assessed in the Implementation Report of the BEPGs, on the basis of the so-called Cardiff report on structural reforms. Therefore it is important to ensure consistency at the national level of information provided in different reports.
At the EU level, it is important that conclusions and policy messages are consistent with each other across different co-ordination processes. For instance, the Joint Pensions Report reinforced the views on the importance of ensuring financial sustainability of pension systems and the urgency of reforms in a number of Member States, a message which was sent already by a number of earlier European Councils. The latest European Council in Brussels in March this year reiterated that ‘the reform agenda must now address more effectively the challenges from ageing populations if it is to secure the long-term sustaina–bility of public finances’.
Correspondingly, the assessments made in the Joint Pensions Report feed into recommendations in the BEPGs. The European Council in Thessaloniki on 19/20 June adopted the last BEPGs that include recommendations for the next three years.
The Common Objectives
Adequacy of pensions
There are three objectives under the heading of adequacy in the open method of coordination on pensions.
The first objective refers to the need to prevent poverty and social exclusion among the elderly. They should share in the economic well-being of their country and be able to take an active part in public, social and cultural life. In the area of social exclusion, we consider that people who have less than 60 % of the national median income are at risk of poverty. However, views differ from one country to another on what is an acceptable minimum and on how this can be guaranteed through the pension system or other benefits in cash or even in kind.
The second objective concerns the possibility to maintain one’s living standard after retirement. Most of the current 15 Member States consider that this is, up to a certain earnings level, a task of their public pension schemes, or their first pillar. However, our common objective does not require the first pillar to fulfil this role. Denmark and the Netherlands, for instance, have flat-rate universal pensions as a first pillar – the same amount is paid to all residents above retirement. But these countries also allow their social partners to establish occupational, or second-pillar schemes which cover almost all employees and allow them to maintain their living standard after retirement. Private pension provision also plays an important role in the United Kingdom and Ireland, but there the initiative tends to be left to individual employers and workers.
There is a difference between our usage of the three pillar concept and the World Bank’s. The first pillar comprises statutory schemes, that is those schemes that are mandatory and established by law. They are typically financed according to the pay-as-you-go principle but may also involve a significant degree of funding. For instance, in the reformed Swedish pension system, a small part of the statutory contribution is channelled into privately managed savings funds which are regarded as belonging to the first pillar; the World Bank would regard this as a second pillar. For us, the second pillar consists of occupational pension schemes which can be established by a collective agreement, but they may also be offered unilaterally by the employer or negotiated as part of individual employment contracts. Thus the participation in these schemes is linked to the employment status. Finally, the third pillar comprises voluntary provision for old age at the initiative of the individual. This typically takes the form of life or pension insurance contracts.
The last objective under the heading ‘adequacy’ invites Member States to promote solidarity both within and between generations. This requires that we look at the economic and social situation of older people compared to people of working age and thus at the way in which resources are shared between the active and the retired. But it also implies looking at the way in which the resources of pension systems are shared among older people – or the distributional impact of pension policies.
In the joint report in which we analysed the national strategies of the current 15 Member States we used the European Community Household Panel to get an indication on the current adequacy situation. This is a survey which gathers information on income and living conditions of households in all Member States. The income data from this survey are used to calculate poverty risks, relative income levels and inequality in the income distribution. 
Unfortunately, this tool is far from perfect and we hope that the new Survey on Income and Living Conditions that is currently being developed will address many of the issues. Our latest data reflect the income situation of 1998; so the impact of more recent pension reforms is not reflected. The sample sizes in some Member States are worryingly small. And some important determinants of material living standards are not taken into account. For instance, we do not know how much money households save by living in their own accommodation (imputed rent); or what impact mortgage repayments have on disposable income. Both these elements are likely to affect the comparison between people below and above retirement age: older people are more likely to own their accommodation and not to have to pay back mortgage loans any longer.
Denmark compared results from the European Community Household Panel with results from national registers and found significant differences, even when the same definitions and methodologies are applied to both data sources. There is a consensus on the urgency to improve our data.
Bearing this in mind, let us have a look at some of the results from the European Community Household Panel.

The first chart presents poverty risks for men and women over the age of 65. We consider that people are at risk of living in relative poverty if they have less than 60% of their countries median income. Of course, if we used a lower threshold such as 50% of median income, poverty risks would also be much lower. Women, who are represented by the third column, tend to be more at risk of living in relative poverty than men. However, the picture is very uneven across Member States both with regard to the level of poverty risks and with regard to differences between men and women.
Are older people more at risk of poverty than younger people? The second chart shows that for the EU as a whole there was not much of a difference. But some countries still had significantly higher poverty risks for older people than for younger people in 1998. Moreover, about one in ten people over 65 live in households with less than 50 % of median income and about one in six in households with less than 60 %. One has to be cautious in the interpretation of these figures. If one took into account some factors not captured by the survey, such as savings on rent and mortgages or free services only available to the elderly, the relative income situation of the elderly could look better. But clearly there are some Member States where the situation of older people is not yet satisfactory. And the situation also appears to be less favourable for the oldest pensioners – possibly because there is a high proportion of widows. However, many Member States, notably those with a high risk of poverty for the elderly, reported on measures undertaken in recent years to improve minimum income guarantees for pensioners.

The income level of people over 65 relative to people below 64 reaches about 90%, but again there are significant differences across the EU – and there is a gap between men and women.

All this describes adequacy as it was five years ago – and it does so in a very incomplete manner. What about future adequacy?
We know that the level of benefits from the first pillar are being reduced in many Member States so as to keep pension systems affordable and ensure that the financial consequences of ageing are shared equitably between future generations of active and retired people. The Indicators Subgroup of the Social Protection Committee is currently trying to measure this by developing prospective replacement ratios which show what percentage of one’s earnings at just before retirement one can expect from the pension system today, in 2010, in 2030 and in 2050, taking account of the reforms that have already been decided.
Does this imply that future generations of pensioners will be more likely to live in poverty? The future level of income of older people’s households will depend on several other factors. Women can be expected to earn higher pensions of their own due to their increased labour market participation. Thus they will make a bigger contribution to the household income of older people.
In many Member States supplementary pension schemes are being promoted. As more and more workers have contributed during their entire career to such schemes, they will receive increasing pension benefits from them. 
Increasing life expectancy is likely to imply better health and hence the ability to stay longer on the labour market. More and more pension schemes reward longer careers with increase pension entitlements. This allows people to compensate for a less generous benefit formula. 
Finally, wealth accumulated by future generations of pensioners could also play an important role in securing their living standards. So maintaining adequate living standards for pensioners does not look impossible in spite of the dramatic ageing of our populations.
Financial sustainability of pension systems
Regarding financial sustainability, five common objectives have been identified within the open method of coordination. They refer to different and mutually reinforcing ways of securing the future affordability of adequate pensions in order to cope with the financial challenges arising from ageing populations. 
The first objective with regard to financial sustainability is to achieve a high level of employment. Demographic ageing causes a financial challenge to pension systems because it results in a less favourable balance between people in employment and people in retirement. Therefore the priority has to be to raise employment levels. We are trying to promote this through the European Employment Strategy which was launched by the Luxembourg summit in 1997.
We are particularly interested in raising the employment rates of older workers – and this is reflected in the second of our financial sustainability objectives. Prolonging average working lives has a strong impact on the financial sustainability of pension systems. Achieving higher employment rates for older workers requires a strengthening of employment incentives in pension and other benefit systems, and also a reconsideration of the use of pension systems to patch up labour market problems.
The European Council set precise targets for employment rates to be reached by the EU as a whole by the year 2010. The overall employment rate should rise to 70%, the employment rate for women to 60% and the rate for people aged between 55 and 64 to 50%. And, finally, the average age at which people withdraw from the labour market should be raised by 5 years by 2010. If we look at the gaps between the targets set by the European Council and our actual performance, we find that raising the employment rates of older workers between 55 and 65 represents the biggest challenge.

However, the Economic Policy Committee projections showed that even the achievement of the employment rate objectives and a further increase in employment rates beyond 2010 would reduce the projected increase in pension expenditure relative to GDP only by about one third of the increase under current policies. Although higher employment rates strengthen the financial basis of pension systems, one has to also take into account that higher employment gives rise to increased pension entitlements.
Another common objective concerns the link between pension systems and public finances in general. Clearly, unsustainable public pension schemes are a threat to sound public finances. The objective therefore calls for reforming pension systems with the aim of maintaining the sustainability of public finances. In some countries, further reforms of public pension systems will be needed in order to achieve sound public finances in general. In others public pension systems are already close to being financially sustainable. Conversely, budgetary surpluses can be used for reducing public debt over the coming years, thus creating room for manoeuvre for meeting increased age-related public expenditure needs. The assessment of long-term sustainability of public finances is now a regular exercise in the context of the Stability and Growth Pact on the basis of the Stability and Convergence programmes and they are also considered when setting the Broad Economic Policy Guidelines.
The next financial sustainability objective refers to the need of striking a fair balance, in terms of financial burden and pension benefits, between the active and the retired populations. By changing the levels of benefits and contributions or taxes, such adjustments will determine how the burden of demographic ageing is shared between the active and the retired. Most current EU Member States feel that their levels of contributions and taxation should not rise further. 
The last objective under the heading ‘financial sustainability’ concerns funded pension schemes. They are expected to play an increased role in providing incomes for pensioners across the EU. Many acceding countries have introduced ambitious reforms to promote privately managed funded schemes with the aim of supporting the financial sustainability of public pension schemes and contributing to an adequate provision of retirement income in the old-age. This objective calls for a review of the management and regulatory framework for such pension provision to ensure efficiency, affordability and security against the risks of financial markets. The development of private pension schemes typically implies reduced tax revenues during the build-up of pension entitlements, but by taxing the benefits much of this loss can be recouped. The Netherlands, for instance, expects a significant positive impact on public finances resulting from taxes levied on the occupational pensions of the baby-boom cohorts.
To sum up, a broad range of policy measures is required for ensuring the financial sustainability of pension systems. The common objectives under the open method of coordination are consistent with the so-called three-pronged strategy to tackle the budgetary implications of ageing populations defined by the Stockholm European Council in 2001. This includes (i) raising employment rates, (ii) reducing public debt and (iii) adapting social protection systems, including pension systems. This strategy has also been incorporated in the Broad Economic Policy Guidelines. And finally, the national strategy reports on pensions submitted by Member States confirmed that this strategy has been widely incorporated in their pension strategies.
An important element in the assessment of the financial sustainability of public pension schemes are the long-term projections of pension expenditure carried out by the Ageing Working Group of the Economic Policy Committee. The projections were made on the basis of a common demographic scenario produced by Eurostat and commonly agreed macroeconomic assumptions. Member States used their own models to do projections of pensions expenditure under current regulations and policies. The results were subject to a peer review process within the Ageing Working Group and by the Commission to ensure their quality and comparability.
The results were published in 2001, so the effect of some of the latest reforms are not reflected in those results. Some Member States provided updated projections both in their national strategy reports and in their Stability/Convergence programmes. The projections showed that under current policies, additional needs for public financing will arise in almost all current Member States. For the current 15 EU Member States taken together, the increase would be just over 3 percentage points of GDP, although for most individual countries it would range between 3 and 5 percentage points. This would imply either increased contribution rates or larger transfers from the general budget.
As already mentioned, the Ageing Working Group  looks at long term sustainability of public finance and makes projections of age-related expenditure (not only pensions, but also health, long-term care and education) and develops indicators of sustainability. Their results mainly feed into the assessment of the sustainability of public finances within the framework of the Stability and Growth Pact and the Broad Economic Policy Guidelines, but they also play an important part in the Open Method of Coordination on pensions.
Modernisation of the pension systems
The last group of three objectives concerns the modernisation of pension systems in response to the changing needs of the economy, society and individuals. They provide a reminder that the challenges for the future do not begin and end with demography.
The first objective calls for pension systems to be adapted to the requirements of modern labour markets. Increased labour market flexibility with new forms of employment contracts and greater mobility calls for certain adaptations to pension systems so as to ensure that they cater well for part-timers, people in temporary employment, the self-employed and people who change jobs. In many Member States the need for modernisation is greatest in relation to occupational pension schemes where it is important to improve access for all workers and the portability of pension rights so that people who change jobs do not end up significantly reduced pension entitlements.
The second objective calls for pension systems to be adapted to the changing relations between men and women and to the aspiration for greater equality between women and men. The common objective calls for a review of pension provisions "with a view to ensuring the principle of equal treatment between women and men, taking into account obligations under EU law". However, the Joint Pensions Report adopts a broader perspective on the gender dimension. What we are interested in is whether women are well served by our pension systems. There is – as one would expect – a significant gap between the average pension levels of women and those of men. Increased labour force participation will tend to reduce this. However, women remain more likely than men to interrupt their careers for family reasons. Member States tend to address this issue by awarding pension rights for bringing up children or caring for the elderly. Such redistributive mechanisms are, however, rare in supplementary private pension schemes. Moreover, in personal pension schemes or defined contribution schemes where individuals have to purchase an annuity with their accumulated capital, pension incomes for women, for a given amount of pension capital, will turn out lower than for men due to the higher life expectancy of women. Statutory pension schemes apply unisex contributions and do not take account of differences in the life expectancy of men and women when calculating pension entitlements.
The final objective calls for greater transparency and adaptability of pension systems in a way that will strengthen confidence in them. This requires developing reliable information on the long-term perspectives of pension systems – a precondition for a well-informed public debate and the development of a broad consensus on reforms. Increased awareness of the costs and benefits of current pension scheme designs and various reform options would lead to a better understanding of why changes are necessary and what types of changes are most desirable. The Joint Report also examines information given to individuals about their pension situation. Some Member States are introducing annual statements about individual pension entitlements. This seems quite logical in any pension system that is based on contributions. For instance, since the introduction of the new defined contribution scheme in Sweden, people there receive every year the 'orange pensions envelope' with detailed information about the notional pension capital accumulated so far and an estimate of the future pension entitlement under various assumptions. But this kind of transparency is possible in other pension systems as well. It may have a considerable impact on the future evolution of the system.
Progress with regard to the modernisation of pension systems mainly calls for the use of qualitative assessment criteria. We have already had some discussions within the Indicators Subgroup on how to monitor these objectives, but we do not yet have a systematic overview of the situation in all Member States. The modernisation objectives could also particularly benefit from the exchange of good practice. The gender impact of pension systems, by contrast, should also be examined with quantitative indicators, notably through a gender breakdown of adequacy indicators.
Some acceding countries might have difficulties with the objective on gender equality. All current Member States are committed to abolish different retirement ages or survivors’ benefits for women and men. Such discrimination is still possible under EU law, but a directive of 1979 does call for the abolition of unequal treatment. Moreover, any pension scheme that can be regarded as part of the remuneration package would have to treat women and men equally. This applies to occupational pension schemes, but also to earnings related pension schemes for public sector employees.
The Work Ahead
As mentioned already, the European Council welcomed the joint report and called for the continued application of the open method of coordination in the field of pensions. In 2006 we are expected to review the progress achieved, including for the new Member States. This will be done on the basis of new reports from all current and new Member States which should be presented by the middle of 2005.
The European Council also asked us to maintain the momentum for cooperation by delivering special studies focusing on common challenges for pension systems and to continue the work on indicators covering the adequacy, financial sustainability and the modernisation of pension systems. Regarding the special studies, the Social Protection Committee and the Economic Policy Committee will be actively involved in the coming months. 
The Social Protection Committee recently agreed a list of topics that was submitted to the Social Affairs Council in June.
The first topics to be studied could be the interaction between social protection schemes and the labour force participation of older workers. This is of course particularly important in view of our target of raising the effective age of retirement by five years. The work of the Indicators Subgroup on current and prospective replacement ratios could also be presented as special study. On both of these topics we should be able to present some results to the next Spring European Council.
Other studies should, at a later stage, focus on the regulation of private pension schemes, on the choice between defined contribution and defined benefit schemes, mechanisms for providing information on pensions to citizens, and on the gender dimension of pension systems which could involve a systematic review of gender differences in pension outcomes and the factors which contribute to this such as past labour market participation, the impact of divorce, pension credits for family-related career breaks, and survivors' benefits.
The new round of national strategy reports will be based on a new set of expenditure projections to be carried out by the Economic Policy Committee’s Ageing Working Group. It will use new demographic scenarios by Eurostat that should be available by mid 2004, including for the new Member States.
Based on assumptions and a methodology that will be prepared by the Ageing Working Group, new projections on pension expenditure should be finalised by mid-2005 so as to be available in good time for the national strategy reports and their assessment at EU level. These projections will be used in particular for the assessment of the stability and convergence programmes. This assessment for the first round of the convergence programmes for the new Member States will be based on the currently available information on the long-term sustainability of public finances.
The acceding countries are now taking part in the work of the Social Protection Committee, the Economic Policy Committee and their sub-groups where should soon become active participants. Information on the acceding countries should be included in the special studies mentioned above, and this even before accession. This will ensure a smooth integration of the new Member States into the open method of coordination.