The current Maltese pension system
Malta quickly moved from one stage of social security provision to the next. The pre-1979 system, while not funded, was much more focused on poverty reduction through the national minimum pension, with income replacement above and beyond poverty level left to occupational plans. In 1979, the movement to a two-thirds pension changed the focus to income replacement. The provisions have become more generous over time with individuals being given credit for pre-1979 years of contribution in the two-thirds system. But like many other countries, Malta is reaching a point where the pension system needs to be seriously revisited to ensure that it can provide adequate and fiscally sustainable benefits for workers in the future.
The current Maltese pension system is a traditional defined benefit pay as you go system with contributions from current workers being used to finance benefits for current pensioners. The pensions are determined by a formula based on the average of the best three out of the last 10 years’ salaries for employees and the average of the last 10 years’ salary for the self-employed, with a pension equal to two-thirds of this average wage for those having contributed 30 years. Fewer years of contribution result in linearly reduced pensions, with the minimum years of contribution required to collect a pension set at nine.
A critical feature of the Maltese pension system is its ceiling on income subject to contributions. Currently, this ceiling is 78 per cent higher than average wage. However, the ceiling is increased each year only by COLA (the cost of living adjustment) which is roughly 80 per cent of annual inflation. As a result of positive real wage growth, the ceiling will rapidly fall below the level of average wage and even minimum wage. While pensions are indexed to wage growth, they are subject to a maximum pension which also only grows with COLA. Thus, pensions will soon be reduced, not by changes in the benefit formula, but by hitting the cap on maximum pensions.
Fiscal sustainability
Based on contributions of employer and employees only, which is the usual basis for looking at pension systems, the current system was running a moderate deficit of 1.2 per cent of GDP in 2003, which was being covered by the government contribution of 10 per cent of salary. However, this government contribution is also needed to cover health expenditures, expenditures for social assistance both to the elderly and other age groups, family allowances, and a variety of other social programmes. Based on projections from the World Bank’s PROST model, the deficits accelerate to 3.5 per cent of GDP by 2015 and to 4.7 per cent of GDP by 2030 before levelling off in the future. By 2011, the full 10 per cent government contribution will be insufficient to cover the deficit in pensions, leaving nothing for the other social benefits.
Why does the system turn around? A large part of the answer stems from the demographics. Currently if the working age population is assumed to be all those above the age of 15 and retirees above retirement age, there should be 3.9 workers per old age retiree. At the demographic peak, there will be no more than 1.3 workers per retiree. However, looking at the actual pension system, the change is more drastic. Currently, there are about 5.8 workers per 2/3 pensioner, more than the demographics would suggest. This is largely because many of those retiring under the old occupational schemes are receiving only top-up pensions and not the full 2/3 pension, a function of the immaturity of the system. In the future, the projections suggest that there will be 1.0 workers per 2/3 pensioner. The difference from the demographics arises from the fact that the labour force participation rates of those below the age of 25 and definitely below the age of 20 will be quite low in the future, further limiting the number of workers available to support the same stock of old age pensioners. Furthermore, the system finances more than just 2/3 pensioners. When all pensioners, invalids, widows, survivors and top up pensioners are considered, there are only 2.6 workers per pensioner today and in the future these are projected to be only 0.9 workers per pensioner.
Given these demographics, it is not difficult to figure out why the pension system will be running a deficit. In pay as you go systems, revenues come from contributors paying a percentage of average wage. Expenditures come from the pensioners who are paid a pension, which can also be expressed as a percentage of average wage. If there are currently 5.8 workers per 2/3 pensioner, the system could afford to pay 2/3 pensioners 116 per cent of average wage if there were no other pensioners to pay, or the contribution rate of 20 per cent multiplied by 5.8. Given the other pensioners, the system could afford to pay 52 per cent of average wage per pensioner, with the invalidity pensioners and survivors of course receiving less than 2/3 on average, while the 2/3 pensioner of course receives 2/3. In the future, the system could pay only 20 per cent of average wage to the 2/3 pensioner or if all benefits are considered, only 18 per cent of average wage per pensioner. So, clearly, in a scenario where the system must provide individuals pensions equal to 2/3 of their salaries as well as other benefits, the system will run deficits, and relatively large deficits, with the revenues in the future able to cover only 27 per cent of expenditures compared to 92 per cent today.
(To be continued next week)