Issue 2, 2015. April-May

   

PRINCIPLES OF GEORGIAN PENSION SYSTEM-TIMING FOR SHIFTING THE PARADIGM

Ketevan Gabelia (Grant Thornton)

Current system at a glance

Georgia's current pension system is operating, for the most part, on a pay-as-you-go (PAYG) basis. Under the PAYG system, the payment of pension benefits to retirees is financed from the state budget, which is financed from tax revenues. As taxes are paid by the current workforce, pension benefits depend on the taxes paid by the current workforce. In such a system, the government acts as intermediary between pension beneficiaries and taxpayers.

In such a system, the current workforce impliedly agrees to finance pension benefits in exchange for the promise that, after their retirement, they will receive pension benefits from the government. From this perspective, the government acts as a guarantor of future pension benefits for the current workforce. However, sustainability of this system largely depends on factors, such as demographic variables, that are outside the government's control.

These demographic dynamics affect the stability of the PAYG system. The growing number of elderly in society means more pension beneficiaries and more pension expenditures, while declining birthrates leads to a decreasing workforce and fewer pension contributors. This results in a negative effect on the support ratio - the number of pension contributors per pension beneficiary - and a positive effect on dependency ratio - the number of pension beneficiaries per pension contributor.

To maintain system stability in spite of demographic changes, governments can either increase taxes to fill the gap, or decrease the pension benefit levels to keep pension expenditures in line with pension revenues. Alternatively, retirement age can be adjusted, which would allow for artificial adjustment of the dependency ratio to maintain balance in the system. These are not always popular decisions for governments since, either way, one segment of society has to make a sacrifice.

Demographic dynamics

Georgia is not an exception in terms of demographic changes: the population is getting older. Life expectancy increased by 8.7% between 1993 to 2011( from 69 years in 1993 to 75 years in 2011), while the fertility rate in 2014 was as low as 1.8 births per woman, compared with 2.2 births in 1990.

Future demographic projections based on historic averages for fertility and mortality statistics suggest that the ratio of the population above age 65 to the population to the age group 15-65 will hit 38%, compared with just 20% in 2010. This means that in the same time period the dependency ratio will increase by 86%.

Such significant change will likely create problems for the existing PAYG pension system balance in Georgia, which will raise the need for reforms that involve increasing taxes, decreasing the level of pension benefits, increasing the retirement age or a combination of these. Alternatively, a more comprehensive reform could be implemented, introducing the funded pension system pillar to the system.

Funded pension system as an alternative

In contrast to the PAYG system, a funded pension scheme implies individuals saving for their own retirement. Contributions made by workers are saved and invested in various asset portfolios untiltheir retirement. At the start of retirement, the portfolio value is available for the individual to withdraw as annuities during retirement years, take as a lump-sum amount, or a combination of both (benefit withdrawal can vary depending on the pension system). The funded system has many benefits: it generates savings within the country, which increases the long-term capital available for investments and therefore contributes to economic growth. It is also known to be more effective, as savings grow over the investment period due to investment returns and generate higher levels of benefits for the same level of contributions.

Capital market development is another benefit created by introducing a funded pension system. As more funds are made available through portfolio investments, new financial securities are developed by companies to absorb the available capital. This will bolster the development of stronger financial institutions (stock exchanges, clearing houses, investment management companies and their regulators, etc), lead to a wider variety of financial services being offered (pension savings management, IPOs, bond placements, etc.), and all of them will represent the positive spillover from the funded pension system. There are, however, some drawbacks for the funded system - a lack of ability to distribute welfare, the lack of total immunity to demographic changes, investment risk and transition costs during reform.

Funded system's lack of ability to distribute welfare

Under the standard PAYG system, contributors with a higher income make larger contributions to the system, contributions that are then equally distributed to pension beneficiaries. Hence, PAYG plays a role in welfare distribution, which helps reduce the wealth gap among individuals and reduce poverty. According to an assessment published by the Caucasus Analytical Digest, in Georgia old age pension benefits have reduced poverty by 9 percent (2007 data). A fund system cannot play such a valuable role, and therefore cannot substitute the PAYG system in this regard.

Lack of total immunity to demographic changes

As there are no intergenerational transfers and dependency ratios involved, a funded system seems to be demographically immune. However this is not entirely true, as demographic change still has an indirect effect on the funded system. A smaller workforce in the future produces a reduced quantity of goods and services. Even if retirees have sufficient funds accrued for their retirement, there might be a shortage of goods and services when they would be willing to buy at that time. To avoid this, it is necessary to heavily invest in productivity growth. Such investments can be financed from the pension savings itself, but their success would still depend on the performance of investment.

Investment risk inherent in funded system

Due to investment risk, funded schemes may fail to generate promised or necessary levels of retirement benefits for individual savings accounts. Such risk is not present in the PAYG system. To reduce investment risk, the government should use regulatory tools and avoid aggressive investments. But even when the government regulates the privately funded schemes as part of a policy of investment risk mitigation, individual accounts might still fail to earn sufficient returns. Due to this risk, many governments go further to regulate and offer explicit guarantees for funded pensions.

Transition costs during reform

If the pension system switches from PAYG to a funded system, there will be some "overlap"of the two systems, since PAYG system liabilities will still need to be met. At first sight, this puts double burden on a working generation caught up in the transition phase - they will still need to pay taxes to support PAYG beneficiaries, while also creating savings for their funded pension schemes. However, there are various ways to finance the transition cost to avoid a double burden on the current workforce, such as raising state debt, cutting public spending, privatization of state assets, etc.

Concluding remarks

PAYG pension system in Georgia is facing challenges due to changing demographics, while the alternative (the funded pension system) offers many benefits. However, the PAYG system plays an important role in poverty reduction and serves a valuable welfare distribution function, so its disappearance would have many undesired social consequences. Nevertheless, the country's changing demographics calls for the introduction of more sustainable system. One possible solution is a reform that is a mix of PAYG and the funded pension system. Any decision about a possible mix of systems should be based on comprehensive quantitative analysis and a study of international experience.

Currently Georgian pension system also has a voluntary funded system pillar, but due to its small size (total assets of GEL 11,289,694 as of 2012; source: National Bank of Georgia) the funded pillar system is not considered in this article.

Ketevan Gabelia is a consultant at Grant Thornton. She holds Master's degree in Economics and Finance from Rhine-Waal University of Applied Science and a Bachelor's degree in business administration from Georgian American University. Prior to joining the Grant Thornton advisory team, Ketevan worked as a sales specialist and trader on capital markets. During her time with Grant Thornton, Ketevan has worked on a range of assignments, including valuation, market research and feasibility study.

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