Begegnungen
Schriftenreihe des Europa Institutes Budapest, Band 7:87–93.
KÁROLY CZIBERE
The Hungarian Pension System*
The first Hungarian pension system was created in 1912. After World War II the system was financed on a pay-as-you-go basis. Laws in connection with the old age security were unified in 1975. At present these articles – II/1975 – determine fundamental features of the Hungarian pension system.
Insurance and solidarity are the basic principles of the system. Saving and income smoothing on the one hand, poverty alleviation on the other. The difficult and very complex task of balancing between these objectives is performed by the government. The most important device of the government to balance is the social security system. The Hungarian social security system is strongly associated with the Bismarckian model, based primarily on maintenance of workers’ status through earnings-related social insurance.
The pensions are financed on a pay-as-you-go (PAYG) principle. This means that workers today pay pensions to retirees today, expecting that their pensions will be paid by future workers. Current revenues of the old age security plan cover its current obligations. There is no stock of savings to pay future pensions.
The pension system is unified for all sectors of the economy. The retirement age is 60 for men and 55 for women. Special parts of the system are the retirement with advantage of age (in case of possibility of dismissal), early retirement (for the unemployed). Retirement pensions are earnings-related and require a minimum contribution period. The condition of the full pension is to be at work and to pay contribution for 20 years. The payroll tax for pensions is 6% of gross wage (for worker) and 24.5% (for employer). The formula determining the amount of pension shows the redistributive character of the system since there is a minimum pension (HUF 9600 in 1996) and the rate of the growth of the pension decrease the in case of increase of years and wage covered by contribution.
Current problems of the pension scheme
The simplest way to examine problems of the pension system in Hungary is to observe trends and structure of the expenditure on retirement pensions. Table 1 shows national expenditure on pensions, percentage of GDP and rate of growth of expenditure in Hungary between 1970 and 1994.
Table 1
Expenditure on pensions 1975-1994 (HUF billions, %)
Year Expenditure Percentage Rate of growth
of GDP
1970 13.0 3.5 11.0
1975 27.1 5.1 15.9
1980 56.0 7.1 15.6
1985 91.7 8.1 10.4
1990 202.1 9.0 17.1
1991 262.8 10.6 30.0
1992 288.7 10.0 22.5
1993 344.4 9.8 19.3
1994 436.9 10.1 26.9
1995 478.1 9.9 9.4
Expenditure on pensions considerably increased in the 90s. Previously expenditure was doubled every 5 years, but between 1990 and 1994 it grew by 25 per cent on average every year. There are a lot of reasons for this phenomenon. This is why we have to investigate the data in Table 1 in detail, examining those factors which basically determine the expenditures and the main reasons for changes. These factors are as follows:
POP(EMP) – number of workers actively contributing to retirement scheme
POP(PEN) – number of older people receiving pension
POP(18-60) – number of people between age of 18 and 60
POP(60+) – number of people over 60 years old
AVE(EMP) – average wage
AVE(PEN) – average pension
The first is the ‘title-ratio’. This ratio shows the maturity of the pension scheme. The second factor is the dependency ratio, which gives information about the demographic conditions. The third one is the employment ratio. This index shows proportion of people paying contributions to working age people. A fourth one is the replacement rate: the average value of a pension as a proportion of workers’ wage during base period. Finally, the fifth index shows the value of annual GDP produced by 1 HUF of wage. Now we have to examine how these rates changed in the past years. (Table 2)
We can see that the Hungarian pension system has reached a high degree of maturation since the number of pensioners exceeds the number of people
Table 2
Factors explaining change of expenditures on pensions 1970–1995 (%)
Year EXP/GDP Fact. 1 Fact. 2 Fact. 3 Fact. 4 Fact. 5
1970 3.5 66.7 38.7 91.2 37.5 299.1
1975 5.1 82.1 37.3 87.8 45.4 309.1
1980 7.1 93.0 38.2 87.3 54.7 314.1
1985 8.1 100.0 40.4 86.9 61.2 351.6
1990 9.0 109.9 41.8 86.4 66.2 390.6
1991 10.6 114.1 41.9 81.3 64.6 357.8
1992 10.0 111.6 41.7 73.7 60.1 379.5
1993 9.8 113.7 41.4 68.1 59.8 420.7
1994 10.1 115.7 41.1 65.4 59.7 430.5
1995 9.9 118.0 40.0 61.0 59.0 460.0
over 60 years. This strange fact is due to the labour market programmes that have been developed in the beginning of 90s. These programmes were launched to answer hard and difficult questions of the unemployment that appeared in 1989 and grew over the next years. These programmes – and the increasing black part of the economy – made possible to survive for people who were sacked. Retirement with advantage of age is possible if the worker lives to the age of 55 years and she/he is threatened with unemployment. Early retirement can be paid for people over 57 years old. Beyond these programmes there are other instruments as well: partial pension, pension for political rehabilitation etc. Finally we have to mention the most interesting one: the disability pension. The number of people retiring due to physical incapability of work has substantially increased. While at the end of the 80s the ratio of people gaining disability pension to the number of people retired in the year was around 30%, in 1995 it increased to 37%. It is likely that the reason for this shocking fact is not the bad health condition of Hungarian society, but it was too easy to get this pension.
The old age dependency ratio (the ratio of persons aged 60 and above to those aged 18-59) increased over the last three decades. The index proves the aging character of the Hungarian society. In 1990 slightly more than 19 % of the Hungarian population were over 60 years old. By 2000 the number will increase to 21, by 2010 to 23, and by 2020 to 26.7. (Analogous indexes of other Eastern European countries are lower than Hungarian ones.) In the long run increase of life expectancy and decrease of the birth rate lead to a change of the old age dependency ratio. As we can see, the increase of the dependency ratio slowed down: in 1990 the number of people over 60 years old was 2.287 million, in 1995 2.293 million. The number of people aged 18-60 was 5.956 million in 1990 and 6.082 million in 1995. These changes are due to the fact that people at the highest point of the population bulge entered work these years.
The employment ratio (Factor 3) has considerably decreased in the last years. In 1989 the number of the employees was about 5 millions, in 1993 only 3.9 million persons worked. More than 1 million people fell out of the labour force of the formal economy. A considerable part of them became unemployed, many retired (in the forms of retirement mentioned above), and a large number withdrew entirely from the labour force or escaped to the informal economy. Meanwhile the number of people retired increased from 2.5 million (in 1989) to 3.1 million (1995). These significant changes broke down and overturned the intergenerational contract. This overturn led to an increase of the budget deficit and later, when it was set up, to a deficit of the Pension Insurance Fund.
The replacement rate (Factor 4) compares average level of pensions to average level of wages. The reduction in the average replacement rate was largely due to the manipulation of three key indexation parameters in the determination of pension benefits. First, the lack of full actualisation of past contributions in the benefit formula resulted in an erosion of real entry pensions. (Since 1988 the annual wage history is taken into account for the determination of new pensions, but the wages in the last three years before retirement are not adjusted for wage growth or inflation.) Second, wage brackets in the redistributive benefit formula were not fully adjusted for wage growth, leading to a ‘reverse bracket creeping’ effect. These two factors resulted in a sharp drop of entry level pensions, both in real terms and in relation to the average wage in the economy. Third, less than full indexation of pensions to gross wages also contributed to the reduction in the ratio of the average pension to the average gross wage. During this period, pensions were indexed to movements in the expected net average wage during the upcoming calendar year. As it happened, the average pension failed to fully adjust to changes in net wages, ex-post, and fell even more relative to gross wages during the same period, because of the increase in average personal income tax rates.
Factor 5 characterises the productivity of Hungary’s economy because the index shows the amount of GDP produced by HUF 1 of wage. Dynamic increase of this index contributed to the moderation of growth of expenditures on pensions. Behind these changes we can find the transformation of the economy which is due to the constraint originating from the opening towards the world market. Hence it is probable that this index will increase during the next years.
The Hungarian pension system is characterised by high dependency ratios, large expenditures relative to GDP, high contribution rates and an unstable financial situation. Under current policies, this demographic pressure will lead to a situation in which one worker will have to support one pensioner by the year 2035. It is essential to examine the potential impact of such deterioration in fundamentals on the finances of the Hungarian pension system.
A scenario of no reforms has been elaborated under a number of assumptions. First age and gender specific, formal labour force participation rates are held constant at 1995 levels. This may be considered pessimistic. However, an exogenous recovery in formal sector participation rates is rather improbable in the absence of a well-designed package of reforms (lower pay-roll taxes, disability reform). Second, unemployment rates are assumed to fall from around 10 % in 1996 to 7 % after the year 2000. Third, contribution rates accruing to the pension fund are assumed constant. Fourth, the simulations assume backward indexation of pensions to net wages, a rule adopted in 1996. Fifth, inflation rates are assumed to decline gradually, and real GDP is assumed to grow.
Under these conditions, the PAYG system would generate growing deficits which rise to more than 6 % of GDP by the year 2050. This result is essentially due to the assumption of a declining rate of inflation, and to adverse demographic trends. The decline in the rate of inflation implies increasing real average pension benefits because of the backward indexation rule, and also increasing real entry pension benefits because of the smaller inflation-related losses built into benefit formula. This is a scenario of large and increasing pension deficits. In the absence of offsetting increases in private savings, these deficits would imply much lower national savings or extremely high contribution rates.
Attempts to reform the system
The pressures on expenditures resulting from Hungary’s economic transformation led to a progressive recognition that the pension system needed to be reformed. However, reaching an agreement on the type of reform needed has proven very difficult. The National Pension Insurance Fund (PIF) proposal comprised two publicly-managed tiers plus a small, voluntary private tier. The first tier would play a redistributive role by establishing a minimum pension of 30 % of the average net wage without relation to earnings or contribution history, and financed by raising the income tax. The second tier would be modelled on the German point system, in which benefits are calculated on the basis of the number of years of contribution, weighted by the ratio of the worker’s covered wage to the average covered wage.
The Ministry of Welfare proposal was based on the view that the Hungarian pension system contained excessive elements of solidarity – a very redistributive formula establishing higher replacement rates for lower income individuals. The proposal reflected an attempt to tighten the link between contributions and benefits within the PAYG, and deal with redistribution outside the pension system through a minimum income guarantee provided on a means-tested basis and financed from increases in the income tax. The second tier would consist of a point system closely resembling the German system.
The Ministry of Finance proposal contained a means-tested minimum income guarantee of 25 % of the average net wage. This guarantee would top up the first pillar, which would remain redistributive and PAYG. The second pillar of the proposal differed fundamentally from the other two proposals, as it consisted of a fully-funded, defined-contribution scheme managed by the private sector. The Government proposal at the time of writing would give workers the choice to stay in a reformed PAYG or to switch to a new, three pillar pension system. New entrants in the labour force would be automatically shifted to the new pension system after 1998. Workers would be given approximately one year to exercise their option to switch to the new pension system.
The reformed PAYG would include a higher retirement age of 62 for both, men and women, stricter eligibility criteria, several changes in the benefit formula designed to tighten the link between contributions and benefits. The first step was taken in the summer of 1996 when the Parliament passed a law gradually increasing the normal retirement age to 62 years and minimum years of service for early retirement by about 10 years.
The tightening of eligibility criteria would be achieved by eliminating credits for non- contributory years, such as university and technical training, and by tightening the criteria for a disability pension. The changes in the formula aimed at tightening the link between contributions and benefits include reducing the progressivity in the benefit formula and full adjustment of covered wages before retirement.
Workers remaining in the PAYG would initially pay a contribution rate of 30.5 % (later expected to be reduced by 2-3 percentage points), and the average income worker could expect to obtain a replacement ratio of around 60 % of the net average wage. Workers staying in the reformed PAYG could also obtain additional coverage from the voluntary, third pillar, which has been in existence since 1993, encouraged by generous tax incentives.
Workers opting for the new system would initially pay 20.5 % of wages to the first pillar (also expected to be reduced by 2-3 percentage points), and a contribution of 10 % to the second mandatory pillar. Additional coverage could be obtained by the voluntary, third pillar. The first pillar of the new system would contain the same rules as the reformed PAYG, including higher retirement age and minimum years of service, tighter eligibility criteria. The benefit formula would also contain the same rules as the formula of the reformed PAYG, but would be scaled down by a 2/3 factor in proportion with the size of the contribution rates. Therefore, a full career average income worker opting for the new system could expect a replacement ratio in the first pillar amounting to about 40 % of the net average wage.
The mandatory contributions to the second pillar would be placed in pension funds legally structured along the lines of the existing third pillar-mutual benefit funds managed exclusively by their members. A young average income worker opting for the new system could expect a replacement ratio of 25-30 % in the second pillar. That would make the new system particularly attractive for young workers. The worker would be subject to some risks, raising the issue of guarantees for fraud, theft and negligence.
The Government’s original proposal involved a mandatory cut-off age of 40 years. Workers below that age would be forced to switch to the new system, whereas older workers would remain in the reformed PAYG. However, a mandatory cut-off age could spark a constitutional debate over accrued rights and prove too costly to implement. These problems led the Government to make the reform mandatory for new entrants to the labour market and voluntary for anyone with a contribution history under the old scheme.
Hungary has been finalising preparations for a comprehensive pension reform, and will probably become the first Central European country to implement a three pillar system.
References
MTA VKI (1995): Changes in Expenditures on Pensions and in Pension System in Hungary. OECD (1995): Social and Labour Market Policies in Hungary.
Rocha, R.–Palacios, R. (1996): The Hungarian Pension System in Transition.
World Bank (1994): Averting the Old Age Crisis, Oxford University Press, New York.
As of spring 1996, when this paper was written.