The public pension system is the largest expenditure program of the Spanish state. In 1994, this expenditure reached 5.5 trillion pesetas, representing 8.5% of GDP. Even under conservative assumptions, this expenditure shows a clear upward trend in the future, both in absolute terms and as a proportion of GDP.

 

This study advances three theses:

 

-The current state pay-as-you-go system is destined, from an economic perspective, for bankruptcy.

-The individual capitalization system, administered by the private sector, is superior to the pay-as-you-go system, both for the worker and for society.

-The transition proposal presented here, from one system to the other on a gradual basis, is fiscally viable.

 

To demonstrate numerically the first and third theses, a comprehensive model of the Spanish pension system has been developed. This model projects its future evolution under different assumptions regarding the key parameters that determine it and presents these results transparently. The model can thus be obtained for any set of assumptions and, at the same time, simulate the effect of a reform, with all its possible variants.

 

The current system is on the path to bankruptcy

 

Using a set of exogenous data, such as the most recent population projections, and incorporating “reasonable” assumptions about the evolution of crucial macroeconomic parameters, such as employment growth, Gross Domestic Product, and real wages, the unequivocal conclusion is reached that the current system is not viable in the medium term while maintaining the rules it has today, particularly those concerning contributions and benefits.

 

The pay-as-you-go regime has managed to maintain a precarious financial equilibrium in recent years, explained in large part by the significant increase in contributions from active affiliates and also by greater state contributions to the system. The former responds to higher contribution rates and wage growth, while the latter is due to increased disbursements that the Spanish treasury has had to cover as contributions for the unemployed and supplements for pensions below the guaranteed minimums. It is clear that contribution rates cannot continue to rise.

 

On the other hand, the higher wages of recent years will inevitably transform (if the current rules are maintained) into higher pensions in the future, an expenditure that the pay-as-you-go regime will not be able to meet. The possibility of permanently increasing the state's contribution to the system seems highly improbable, given the substantial Spanish public debt and the high fiscal deficit currently recorded.

 

The pension system deficit will grow exponentially in the coming years, reaching 5.5 trillion pesetas (1994) by the year 2025, or 37% of pension expenditure in that year. Assuming GDP grows at an average annual rate of 2.5%, the pay-as-you-go system deficit would exceed 4% of GDP in 2025.

 

It is evident that adjustments can be made to the current system, along the lines of the agreements in the so-called “Toledo Pact,” all of which imply higher contributions from current workers or lower benefits for future retirees as a way to reduce this deficit. However, other studies conclude that none of the modifications proposed in the public debate, by itself, eliminates the deficit, much less reverses its trend. They only manage to mitigate its upward trajectory.

 

The immovable fact that condemns the Spanish pay-as-you-go system to bankruptcy is the demographic trend. The decline in the birth rate and the progressive aging of the population mean that the ratio of active workers to retirees will decrease. Since in a pay-as-you-go system the former finance the pensions of the latter, the burden will become unsustainable. Persisting in increasing the tax on hiring workers—what high Social Security contribution rates represent—will lead to even greater unemployment.

 

The current system makes it impossible to escape this dilemma: higher unemployment or lower benefits for current or future retirees.

 

The individual capitalization model is better

 

For the above reasons, one motive for reforming the current Spanish pension regime is the growing cost that maintaining this system will impose on workers, the state, and the Spanish economy. But it is a mistake of perspective to believe that this is the only reason for reform.

 

The second major reason is that creating a system based on individual capitalization, administered by the private sector under competitive conditions, generates such benefits that this reform should be undertaken even if the pay-as-you-go system were financially viable.

 

The benefits of the individual capitalization system have been highlighted in numerous publications. These achievements have been confirmed in the Chilean experience, now 15 years old, where the results are eloquent. The benefits can be summarized as follows:

 

Raises pensions. The return on an investment portfolio in a private capitalization system will, with certainty, exceed the wage growth rate over a 40-year period (as is well known, the wage growth rate sets the ceiling for possible pension increases in a mature pay-as-you-go system).

 

Increases employment. A capitalization system is financed by mandatory worker savings, which, being perceived as individual property, does not constitute a tax on labor hiring. Moreover, the system can operate with a mandatory savings rate far lower than the contribution rate required by the pay-as-you-go system. Thus, a distortion in the labor market that hinders job creation is eliminated (the state subsidy for the minimum pension is financed with general taxes).

 

Increases savings. By imposing a minimum savings rate and creating incentives for additional savings, the net result is highly likely to be an increase in national savings, especially if the state cooperates by reducing superfluous expenditures as a contribution to financing the transition.

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Improves capital productivity. By allocating this savings through competitive and transparent capital markets, without any obligation to finance public spending or deficits of state-owned enterprises, the efficiency of the economy's savings-investment process is enhanced.

It boosts the GDP growth rate. Through increases in savings and employment, as well as improvements in the productivity of labor and capital.

 

Reduces the state's power in the economy. By transferring control of resources associated with pension provision to the private sector, the reform implies a massive decentralization of power from the state to civil society.

 

Depoliticizes the pension system. Since the level of benefits in the pension system no longer depends on legislative decisions, this issue ceases to be a permanent topic of political discussion, eliminating uncertainties for current and future retirees.

 

Fosters a work culture of savings and disciplines national economic management. As workers can design their retirement as they prefer (retirement age and pension level), this encourages savings and personal effort as decisive factors in achieving personal goals for old age. Likewise, the link created between the value of the individual account and the sound performance of the economy transforms all workers in the capitalization system into “watchdogs” of good corporate and economic management.

 

The gradual transition is possible

 

It must be clarified from the outset that the reform does not consist, as some mistakenly claim, in transforming the current pay-as-you-go system into a capitalization one. In other words, there is no intention, under any circumstances, to create a fund to capitalize the current liability of the public pay-as-you-go system.

 

The reform proposed in this study—with a deliberately gradual and prudent transition—consists of giving all workers under 45 years of age who currently belong to the pay-as-you-go pension system the freedom to opt to switch to an individual capitalization system administered by specialized private companies. Those entering the workforce in the future automatically access the individual capitalization system. For workers over 30 years of age who decide to switch, the state issues a Recognition Bond that compensates them, fully or partially (depending on age), for contributions made to the pay-as-you-go system.

 

Those who choose not to switch—the over-45s and current retirees—remain in the pay-as-you-go system under all its rules, including pension updates.

It is assumed that 60% of workers under 45 transfer to the new system at a rate of 10% per year, starting in January 1997. It is also assumed that the state captures 50% of the resources managed by the pension funds by issuing government bonds at market interest rates. The state can begin amortizing this “bridge debt” of the transition as future fiscal expenditure on pension payments decreases.

 

In the capitalization system, a contribution rate of 13% is calculated, lower than the existing 21.35%. Furthermore, it is assumed that the difference between the current contribution rate to the pay-as-you-go pension system (21.35% for the General Regime and Self-Employed) and the capitalization regime rate (13%) is maintained during the transition for those transferring to the new system as a “Transition Contribution Rate.”

 

It is concluded that the proposed solution represents fiscal resource savings in the long term. Indeed, the relevant comparison is with reform. Only until the year 2003 (seven years from the start of the new system) does the reform imply, in the most likely scenario (defined as the “Intermediate Scenario”), a fiscal cost higher than maintaining the current system.

 

In the “Intermediate Scenario,” where the economic growth rate rises by 1% per year as a result of the process initiated by this reform (from 2.5% to 3.5% annually), the fiscal cost of the transition to be financed from exogenous sources evolves as follows over the next seven years (as a percentage of GDP): 1997: 0.12%; 1998: 0.27%; 1999: 0.37%; 2000: 0.41%; 2001: 0.38%; 2002: 0.32%; 2003: 0.09%; and finally, in 2004, the first surplus relative to the no-reform case is recorded, at 0.12% of GDP. From then on, this surplus grows to reach 5.4% of GDP in 2025.

 

These calculations do not consider the possible additional positive fiscal effect that the reform would produce. This refers to the fact that, once a structural reform of the pension system is implemented, along the lines recommended by institutions such as the World Bank and the OECD, it is almost certain that international financial markets will reduce the risk premium they demand on Spanish public debt.

 

Conclusion

 

Therefore, the bad news for Spain is that its current pension system is not viable. The good news is that an alternative system exists, which has been proven to work, and that scenarios exist to make a gradual transition possible from the current pay-as-you-go system to one of individual capitalization.

 

Spain has the opportunity to be the pioneering European country in definitively resolving the pension system crisis. An individual capitalization system would not only provide true social security to the Spanish worker but also give Spanish companies and the economy a competitive advantage in the unified Europe of the 21st century.