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A grey outlook on Europe’s pension reform

Published in Business Spectator (Melbourne), 19 September 2013

The crisis of its monetary union may be Europe’s most pressing economic problem for the coming years, but it is not the continent’s greatest challenge in the long run. Europe’s demographic change is an even more serious issue.

The reason is simple. At least in principle (and if you are unduly optimistic), solutions could be found and implemented for the euro crisis. In contrast, the ageing (and often shrinking) of Europe’s societies is entirely unavoidable after decades of below replacement level fertility. There is no quick fix to the shortage of young Europeans simply because their mothers had never been born in the first place. Without substantial cuts to entitlements, the growing demands on pension and health system cannot be met without driving governments to default.

Europe is finally recognising this challenge, as evidenced by recent moves to address the pension questions in France and Spain. The rather modest reform proposals by the French government are however once again met with fierce resistance by the trade union movement – plus ça change, plus c’est la même chose.

France’s western neighbour is considering a more daring pensions reform. In Spain some new and unconventional ideas are being discussed to save the pension system. Perhaps they could also provide inspiration to other countries facing an ageing future?

Just to provide some background on what lies ahead for France and Spain on the demographic front, these are the United Nations’ projections for both countries. A good indicator on the age of a population is the median age (the age that separates the population in two halves — one older and one younger than this age.) In 1950, France’s median age was 34.5 years. By the year 2000, it had gone up to 37.6 years. The forecast for 2050 is 45.1 years. Incidentally, this is older than Japan, the oldest today with a median age of 44.6 years.

France at least enjoyed relatively healthy fertility rates for a developed economy. For less fertile Spain, meanwhile, the future looks even bleaker. From a young 27.7 years median age in 1950, Spain aged by about a decade until the turn of the century (37.4 years in 2000). But its ageing is gathering speed until 2050 when the median Spaniard will be 51.9 years old.

The differences in fertility are also reflected in the population size outlook for both countries. France kept growing from a country of 41.8 million in 1950 to 59.3 million people in 2000 and will have a population of 64.2 million by 2050. For Spain, it was a rise from 28 million people in 1950 to 40.8 million in 2000, but the population will shrink to 37.3 million by 2050.

Both countries will face substantial difficulties in the future given these population dynamics, although Spain will be harder hit than France. The worrying fact about such demographic forecasts is their certainty. The people who will be pensioners in 2050 are alive today, so the question of how to deal with their needs when they will have reached pension age is not a hypothetical one.

In response to this outlook, the previous French government under President Nicolas Sarkozy had to fight hard to increase the pension age in 2010. At the time, Sarkozy faced massive protests; public rallies were attended by an estimated 3.5 million people. In the end, the pension age was increased to 62 years.

Now Sarkozy’s successor François Hollande is trying to reform pensions again, but this time without touching the entitlement age – sort of. The current French reform package is a tiny step towards pension sustainability. Whereas currently the French have to pay into the pensions system for 41 years to reach their full entitlements, from 2035 this period should increase to 43 years. Contributions to the public pension scheme for both employees and employers are also scheduled to increase by 0.3 per cent.

All these measures are steps in the right direction, but they are by no means sufficient. Unfortunately, these modest changes are partially compensated by extra allowances for physical work and time taken off work for educating children. Even worse, the proposals do nothing to lower the general level of French pensions, which typically reach about 75 per cent of a pensioner’s final salary. France will struggle to afford such generosity in the future, and so Hollande’s pension reform will certainly not be the last one.

For Spain, the pensions problem is even more severe, which is why the European Commission, concerned about Spain’s public finances in any case, has been pressing for decisive action. Spain’s employment minister Fatima Banez has just revealed what such a substantial reform plan will include.

The Spanish government will end the link between pensions and inflation. Instead, the level of pensions will depend on the development of the Spanish economy and Spain’s life expectancy. In the future, pensions will not increase more than 0.25 per cent above inflation. Their total level will also be linked to the amount of contributions paid into the social security system, and from 2019 pensions payments will also be coupled to longevity. In other words, as Spain gets older (which it will), its pensions will fall (as they must).

There is little room for manoeuvre for the Spanish government. According to Banez, by 2050 there will be 15 million pensioners in Spain out of a total population of 37 million. At present pension levels, the system would not be able to cope with these numbers, so the payouts need to be less generous. It is only plausible, then, to couple the lowering of the pension level to the increased demands on the system.

France and Spain give us a taste of what is to come in Europe in the coming decades. What comes across as a relatively theoretical exercise concerning pension levels in the distant future will become a reality within the next ten to twenty years — and not just in these two countries.

The public’s awareness of the problem does not correspond to the severity of the issue. The protests every time a French government tries to do something about the looming pensions disaster indicate how difficult it will be to make any genuine change to the system.

Perhaps the best way is to be as blunt as the Spanish government: present all the available facts and figures and then propose a link between the levels of pensions and the key demographic and economic factors.

It is hard to argue with the facts. Unless you’re French, of course.

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