Reforming the pension system: in search of sustainability

Spain is entering an historic moment: the first batches of baby boomers are beginning to retire in 2023 and will continue to do so over the next 17 years.1 Considering that in the coming decades the population over the age of 66 will gain prominence while that of the working-age population will diminish, it is of vital importance to evaluate the sustainability challenge facing our public pension system following the latest reform – a task which has been addressed by various agencies and which we analyse in this article.

According to the demographic projections produced by the National Statistics Institute, between 2023 and 2050 the working-age population in Spain will decrease by more than 800,000 people,2 while the population over 65 will increase by more than 6 million. Thus, by 2030, almost 4 million baby boomers will already be enjoying their thoroughly deserved retirement, and this figure will exceed 11 million by 2040. Given that the Spanish public pension system is a redistribution system in which today’s contributors pay the pensions of today’s retirees in exchange for receiving a pension in the future based on their present contributions, it is worth asking how the increase in the relative weight of the senior population will affect the system’s sustainability and what measures are being taken to balance it out. Wide-ranging estimates have been made regarding the impact of the pension reform on the long-term Social Security deficit, after the second part of the reform was approved in March. In this article, we will focus on the analyses carried out by the Independent Authority of Fiscal Responsibility (AIReF),3 the European Commission in its 2021 Ageing Report (AR21) and the Ministry of Inclusion, Social Security and Migration (MISSM).

In 2022, the Social Security deficit stood at 0.5% of GDP,4 with expenditure on contributory pensions amounting to 12.0% of GDP.5 The AIReF estimates that contributory pension spending will increase by 2.8 pps between 2022 and 2050, bringing it to 14.8% of GDP, due to the high cost of the indexation of pensions to inflation (+2.7 pps), the repeal of the sustainability factor (+0.8 pps)6 and the inertia of demography, the labour market, etc. (+0.4 pps). On the other hand, these factors will be partially offset by expenditure savings (–1.2 pps), which will come mainly (–0.8 pps) from people taking later retirement because of the new monetary incentives. The AR21 gives very similar estimates of the impact of indexing pensions to inflation and repealing the sustainability factor, but it estimates that the inertia of demographics, the labour market, etc. will add 0.7 pps (rather than 0.4 pps) to expenditure in terms of GDP.

The second part of the government reform has introduced measures focused on boosting revenues, the bulk of which comes from the gradual increase in social security contributions. The burden of this increase in contributions will fall mainly on those with high incomes, while the highest pensions will not grow at the same rate.7 According to the AIReF, revenues will increase by 1.3 pps of GDP by 2050, which is less than the 2.8-pp increase in expenditure. Of these 1.3 pps, 0.8 points are expected to come from the aforementioned increase in social security contributions and 0.5 points from the new social security contribution scheme for self-employed workers.

The MISMM, meanwhile, has a more optimistic projection: contributory pension spending is expected to increase by around 1.5 pps of GDP to approximately 13.5% of GDP by 2050, some 1.3 pps less than according to the AIReF projections.8 In particular, the indexation of pensions to inflation and the improvement of minimum pensions, the repeal of the sustainability factor and the inertias are expected to increase expenditure by almost 3 pps of GDP, but delayed retirements will also enable savings of 1.5 pps of GDP. On the revenue side, they project an improvement of 1.5 pps in terms of GDP by 2050.9 This increase in revenues is very similar to the increase in expenditure, so the deficit would not increase.

One of the two main factors that explains the differences between these various projections is the underlying macroeconomic scenario: that of the MISSM is more optimistic, with an average annual real GDP growth of 1.9% in the period 2023-2050. This is 0.6 pps higher than that of the AIReF and 0.4 pps higher than in the case of the AR21, as it incorporates a long-lasting and substantial impact on potential growth of the reforms and investments under the NGEU Recovery Plan. This higher economic growth is fed10 by an average labour productivity growth in 2023-2050 of 1.5% (0.4 pps more than the AIReF and 0.1 pp more than in the AR21), net annual migration flows of 308,000 people in 2023-2050 (compared to 229,000 according to the AIReF and 182,000 in the AR21), a reduction in the unemployment rate to 5.5% in 2050 (compared to 7% in the AIReF and 7% in the AR21)11 and a participation rate of the population aged between 20 and 64 of 84% in 2050 (82% in the AR21).12 These differences in the macroeconomic and demographic assumptions have a substantial impact on the anticipated expenditure as a percentage of GDP. Specifically, the macroeconomic scenario according to the MISMM is relatively similar to an alternative, more optimistic scenario presented by the AIReF in which it considers average GDP growth of 1.6% in 2023-2050, an unemployment rate converging towards 5.0% by 2050 and net annual migration flows of 271,000 people. In this alternative AIReF scenario, pension spending in 2050 would be 1.3 points lower than in its baseline scenario; that is, spending would grow by just 1.5 pps, an increase very similar to that of revenues (+1.3 pps).

The second factor to consider is the impact of the monetary incentives for delaying retirement:13 according to the AIReF, these incentives will give rise to savings in pension spending of 0.8% of GDP in 2050, because 30% of workers will delay retirement by three years or until they turn 68.14 In contrast, the MISMM estimates that these incentives will result in spending savings of 1.5% of GDP in 2050, which would mean that 55% of workers would delay retirement by three years or retire at age 68.

Due to the high degree of uncertainty surrounding how the country’s macroeconomic situation will evolve over the next 30 years, the reform establishes that the AIReF will review its impact every three years beginning in 2025. Moreover, it establishes that measures will have to be taken (by default, additional increases in the so-called Intergenerational Equity Mechanism, an extra social security contribution which from 2029 will be 1.2% on all wages) if the total expenditure on public pensions on average in the period 2022-205015 exceeds a certain threshold, which in its assessment of the reform the AIReF has preliminarily placed at 14.3% of GDP. Initially, the AIReF forecasts that the spending limit will be exceeded, which would result in additional measures as early as 2025, when it estimates that pension spending in 2022-2050 in its baseline scenario would amount to 15.1% of GDP and in its optimistic scenario, 14.5% of GDP. The Bank of Spain, for its part, also considers it highly likely that further measures will be needed as early as 2025.16 In contrast, the government is more optimistic and projects in its 2023-2026 Stability Programme published at the end of April an average total pension expenditure of 14.0% of GDP in 2022-2050, which would render the introduction of new measures unnecessary.

In short, while there are no magic solutions to bolster the sustainability of our pension system, there is considerable scope for action and the task will be easier if a favourable economic scenario materialises. For this to be the case, it will be key to boost productivity through reforms linked to the NGEU programme and to illuminate a greener and more digital economy that allows a buoyant and sustained level of potential growth to be achieved.