The Methodology of Pension Projections
Methodological Compendium, author: Jindřich Marval, Zbyněk Štork.
Long-term pension projections are an important part of the long-term sustainability analysis conducted by Ministry of Finance, European Commission, International Monetary Fund, Organisation for Economic Cooperation and Development or for example rating agencies. Unlike forecasts, projections depict the trends on a “what-if” principle. Thus, the interpretation of the results is less straightforward and the length of horizon might pose some questions about usefulness of such exercises. Their important contribution is in indicating future pressures on public finances if the reality goes like the assumptions, weighing less on exact value.
Necessarily, projections start from creating a demographic scenario, which serves as a main input for long term projections. All scenarios of future development of population show that the Czech Republic, like many other countries, will face the problem of ageing population. In other words, it means that in following decades we will witness a relative increase in the share of elderly people on younger, economically productive population. The trend in demography is quite predetermined even in the long run as newly born generations will get retired around 65 years or later. Applying calculated fertility and mortality rates, one can set a trajectory of future population development. What is completely unknown is migration that must be projected virtually entirely based on some assumptions. Based on population development, assumptions about macroeconomic scenario can be created. On top of the demographic consequences for labour input, the current state of the economy and possible way forward due to convergence of the Czech economy that is constantly underway is taken into account.
This also answers the question of the projection horizon. If the population projection is reliable at least in the terms of its trend, 50 years or more ahead projection can provide a good deal of information. The pension system is itself a long-run scheme. One is obliged to pay contributions for at least 35 years (or 30 years respectively) to receive the pension benefit. In other words, the contributions to the scheme are the government’s liability to pay pension benefits in the future. Being aware of the future risk is highly needed for the government.
Beside the baseline projection the sensitivity analysis is necessary. As the long-run assumptions are always highly uncertain, the sensitivity analysis may have two main goals. The first one is to tackle the uncertainty itself. The second goal may be the look at the possible ways forward. The examples for the latter are clear: different net migration and thus affecting the labour force, linking retirement age to life expectancy, higher fertility rate, different indexation formula etc. All these results should support the government’s efforts to explain the possible future risks to general public.
Projections of future pension expenditure pressures are important part of broader aspect of sustainability of public finances. Changes in population structure also affect other social security systems, namely health care, long-term care and education. How to project these expenditure types are explained in a separate compendium (Bělohradský, 2018). All these types of expenditure together represent so called age-related expenditures and are inputs for sustainability analysis.
The Ministry of Finance has been involved in the pension projections mainly via the Economic Policy Committee’s Ageing Working Group since 2004. The semi-aggregated model is used to fit the assumptions provided by Eurostat (demography) and European Commission (macroeconomic development). The model consists of three blocks, the first dealing with the number of pensions, the second with newly granted pension benefits and finally the third one computing the average pension and total pension expenditure. The pension projections of the Ministry of Finance deal with the pay-as-you-go scheme excluding the schemes for armed forces (amounting approx. to 0.2% of GDP). There are all types of pensions included, i.e. the old-age, disability and survivors pension benefits. The results are regularly peer reviewed within the Ageing Working Group and published in Ageing Reports and in the publications prepared of the Ministry of Finance like Convergence Programme of the Czech Republic and Fiscal Outlook of the Czech Republic.
Long-term projections are also reflected in the European Union’s fiscal rules. The medium-term budgetary objective, the crucial part of Stability and Growth Pact’s preventive arm, contains part of the future costs of ageing. The governments fulfilling the medium-term budgetary objective are contemporaneously frontloading resources to offset higher pressure on public expenditures that are to come due to ageing. Moreover, the Fiscal Pact conditions, to a certain extent, the magnitude of medium-term budgetary objective with the sustainability risks; the higher the risks, the higher structural balance required.
Thus, the governments and their economic policies are affected nowadays by long-term projections in several aspects. The future risks caused by costs of ageing are visible and the pressure to find the solution is harder. At the same time, lower long-term sustainability of public finances sets larger limits to expenditure policy in present time. Solving the sustainability issue brings more opportunities now and higher confidence for the future.