The Italian pension system: reforms and the change in the future composition of pension income

Transcription

1 The Italian pension system: reforms and the change in the future composition of pension income Zeno Mayr MSc Finance Thesis Supervisor Anders Grosen Department of Business Studies Aarhus School of Business and Social Sciences, Aarhus University January 2013

2 CONTENTS Contents List of Figures List of Tables 1. Introduction Problem statement Structure The Pension System Functions of pension systems Types of pension systems Organization and Financing of pension systems Relation between contributions and benefits Economic considerations Challenges to pension systems Pension reforms The Italian Pension System The crisis of the italian pension system Demographic crisis Crisis in the labor market Crisis of public finances Pension reforms in the last twenty years Public pension (pillar I) Private complementary pension (pillar II) Individual pension integration (pillar III) Different public pension payment systems Old defined benefit scheme Notional defined contribution scheme Complementary pension schemes Product Types Market development ii

3 4. Analysis The simulation Simulation 1: retiring in 2012 (Defined Benefit Scenario) Simulation 2: retiring in 2025 (Mixed Scenario) Simulation 3: retiring in 2035 (NDC) Simulation 4: private pension provision Final considerations and reflections Advantages and challenges for the NDC The challenges for complementary pension provision Literature iii

4 LIST OF FIGURES Figure 1: Intergenerational allocation... 6 Figure 2: Development old-age dependency ratio Figure 3: Population pyramid, year Figure 4: Population pyramid, year Figure 5: Population pyramid, predictions Figure 6: Demographic pressure and public pension expenditure in Figure 7: Demographic and public pension expenditure in Figure 8: Pension assets as a share of GDP (2011) Figure 9: Development of Assets to GDP fraction from 2001 to Figure 10: Development of enrolled members and assets under management 36 Figure 11: Three different pensioning cases Figure 12: Growth of gross wages ( ) Figure 13: Public pension income and replacement rates in Figure 14: Nominal GDP growth Figure 15: Pension income and replacement rates in Figure 16: Replacement rates for pensioning at age 66 and 70 years Figure 17: Replacement rates from private and public pension in Figure 18: Replacement rates in 2013, 2025 and 2035 from public pension iv

5 LIST OF TABLES Table 1: Three pillar structure after reforms Table 2: Old-age dependency ratio Table 3: Active pension payment systems in Table 4: Transformation coefficients Table 5: Salary categories in Euro Table 6: Revaluation coefficients for quote A and B Table 7: Defined benefit scheme calculation of quote A Table 8: Defined benefit scheme calculation of quote B Table 9: Notional defined contribution scheme v

6 1. INTRODUCTION At the beginning of the 1990 s Italy s high pressure of the pension system on the budget and GDP as well as the increasing old age dependency ratio required a deep structural reform of the pension system. Throughout the last two decades the Italian pension system underwent a series of reforms. In 1992 (Amato reform) and 1995 (Dini reform) two main reforms were introduced which caused a change of the public old age pension system from a defined benefit to a notional defined contribution system. A comparable total system change will take decades to be fully implemented. The further reforms of the current Prime Minister Mario Monti currently try to speed up the realization of the process. The past reforms of Dini and Amato designed the "new" pension as a sum of three pillars: 1) The public pension (Pillar I) 2) Employer sponsored or private mandatory programs (Pillar II) 3) Additional voluntary programs (Pillar III) With the introduction of the "new" pension system and the recent decision of the Monti government, the private pension provision will become more and more important. For the population it is inevitable to invest in pension products of the 2nd and 3rd pillar in order to reach a certain level of pension benefit. Within these two pillars different product types are distinguished: - Fondi pensione aperti - open pension funds (FPA) - Fondi pensione negoziali/aperti closed pension funds (FPN) - Piani individuali previdenziali - Individual insurance saving plans (PIP) Furthermore, Italian employees receive a severance indemnity from the Trattamento di fine rapporto (Tfr), which for employees in the private sector is equal to the cumulative total of 7.41% of earnings each year. It is paid by employers and is retained in a fund that the employers manage directly. Since 1

7 the 1st of July 2007 each employee is able to decide where and how this Tfr should be invested. 1.1 PROBLEM STATEMENT During the last decade numerous pension products for the 2nd and 3rd pillars were sponsored by banks and financial intermediaries, employer and employee associations in order to face the increasing demand of a retirement pension supplement. Current statistics, however, show that the private pension market in Italy compared to other important OECD countries is still underdeveloped. As already mentioned in the introduction, recent reforms from the Monti government accelerate the implementation of the notional defined contribution system. On the one hand this implicates a revision of public finances and an improved fairness of the pension system and on the other hand it leads towards a decreasing public (Pillar I) replacement rate between pension and last salary for future pensioners. The main purpose of the thesis is the analysis of the way the replacement rate will develop for different income segments in Italy from 2012 to 2035 given the already introduced reforms. This involves a breakdown of the analysis into the three different pension payment systems, which are currently active in Italy, and their respective impact on the pension income for different salary classes. In this context, the main characteristics of the Italian private pension system will be described. The additional calculation of the replacement rate coming from private pension products serves to simulate the future composition of pension income. In addition, the challenges and problems for the private pension, which could directly influence the development of the replacement rate, will be analyzed. 2

8 1.2 STRUCTURE In addressing the problem statement the thesis consists of several chapters that in continuation of each other help the reader to understand how and why the future composition of pension income in Italy will experience significant changes. Chapter 2 gives an introduction to the general concepts and functions of pension systems. The chapter describes the different possibilities of how pension systems are financed and which types of relations between contributions and benefits exist. Additionally the main challenges, which pension systems have to face and the necessary associated reforms are explained. Chapter 3 addresses the Italian pension system. After a short historical introduction the crisis of the Italian pension which occurred due to the demographical changes, the problems with public finances and further issues in the labor market is described. Going further the chapter gives an overview of the main reforms and decisions taken in order to solve the mentioned problems. Chapter 4, the main part of the assignment analyzes the impact of the undertaken reforms on the future composition on pension income. In the analysis different scenarios and calculation methods are explained by means of numerical examples. Chapter 5 reflects on the content presented in the previous chapters. This includes critiques as well as the potentials for the future development of the Italian pension system. 3

9 2. THE PENSION SYSTEM Before starting to examine the Italian pension system, its change during the time and the current reforms, it is important to investigate the general concepts and functions of pension systems. 2.1 FUNCTIONS OF PENSION SYSTEMS In general, pension systems consist of three fundamental functions (Passini, 2004, p. 11): Firstly, a pension system incorporates a preventive function which should guarantee the same living standard as during the employment period also after retirement to the retired population. Old aged retired people do otherwise not possess the necessary means to maintain a same level of wealth for themselves and their families. Secondly, the pension system has an auxiliary character: it tries to relieve poverty (Barr and Diamond, 2008, p. 25). This function includes the financial support of people unable to work because of age or disability. A minimum amount of income should be guaranteed to those people even though they haven t paid the necessary level of contribution yet to get the respective minimum benefit. Thirdly, a pension system contains a social-economic function since the accumulated pension contributions can be invested in favor of a country s economic development and be returned to the employees in a later period in time in form of poverty relief or regular pension income distribution. From the above mentioned functions it is apparent that an intervention by the state regarding the pension system and an obligation for employees to contribute to the system is needed. Without the mandatory pension programs applied by the state and with a system based on a voluntary contribution 4

10 scheme only young employees could never save enough money to satisfy their future pension income. A system based on volunteers would bear the following risk: the potential development could result in a huge auxiliary support payment from the state, which going further would load even more on the public finances. According to Passini the same risk could be caused if the pension provision was assigned to the private sector only. Pension managers could become unable to guarantee future pension income due to different reasons like market downturns. 2.2 TYPES OF PENSION SYSTEMS Pension systems can be categorized according to the way they are financed and according to the different relation schemes between contributions and benefits ORGANIZATION AND FINANCING OF PENSION SYSTEMS Pension systems can be financed through two main methods. One method is the pay-as-you-go scheme, where pension are paid out to old-age pensioners using the contributions from active employees. The other method instead, the fully funded scheme, uses the paid-in contributions from the pensioner to payoff his/her individual pension. Pay-as-you-go (PAYG) systems PAYG systems are mainly managed by the state. In such schemes the wealth is transferred from one generation, the active employees, to another, the pensioners. Potential variances between proceeds and expenses are filled by the state. This type of system is like an intergenerational contract, where one generation provides the pension needs of another generation, the already retired generation. The following graph shows this concept the young, the active and the retired generation. 5

11 Figure 1: Intergenerational allocation Period 1: 0 A 30 B 60 C 90 Period 2: 0 D 30 A 60 B 90 Period 3: Source: A. Grosen 0 E 30 D 60 A 90 Young generation Active generation Retired generation The advantages of PAYG schemes are the lower management costs, an attractive pension system for young and growing populations and the uncomplicated method to pay out full benefits straight away in comparison to funded systems (World Bank Pension Reform, 2002). A PAYG scheme works well as long as an equilibrium between benefits and contributions exists. Miani (2002, p. 11) shows this concept with the following simple formula. p = average dispersed pension P = number of pensioners c = fraction of pension contribution w = average wage L = number of workers The system is in equilibrium when dispersed benefits (pp) are equal to collected contributions (cwl): pp = c w L From this follows c = p P / w L p/w is the average replacement rate between pension and wage and indicates the incidence per cent of the average pension in respect to average salary. The concept of replacement rate will be used later in thesis. 6

12 P/L is the dependency ratio between pensioners and active workers. This ratio depends mainly on demographic phenomena, like the dynamics of the retired population and active population, the unemployment rate and statutory provisions. In general, the ratio tends to decrease if the retirement age will be lowered or the average life expectancy is extended. The higher the dependency ratio, the higher the fraction of pension contribution needs to be in order to fulfill an equalized system. Fully funded schemes Fully funded schemes are systems where the contributions paid from each single employee are available to pay off his own pension. The contributions are invested year over year to form a capital stock, which will be used directly or as life annuity at the moment when the worker is going to retire. In this pension regime every individual creates a specific pension scheme through the savings according to the individual insurance approach. The fully funded scheme distributes the savings between different phases of the lifetime of an individual. (Barr and Diamond, 2006) The main risks of such a system are basically related to market-financial risk and inflation risk, which could reduce the accumulated contributions in the course of the years RELATION BETWEEN CONTRIBUTIONS AND BENEFITS The calculation of the pension can be based on different payment schemes. In the following section an explanation of three different methods is given. The schemes differ according to the relation between contributions and benefits. Defined benefit schemes In a defined benefit pension plan, the future pension income of an employee is quantified in relation to his individual number of years of service and the wage history. (Barr and Diamond, 2006) For the calculation of the pensions in the past various types of benefit formulas have evolved. Career-average and final- 7

13 pay plans are typical calculation types. In a career-average scheme, the average overall lifetime service salary is multiplied by the years of service. This amount is multiplied by a fractional pension benefit, usually 1.5%. The final-pay plan, which today is the most common one, multiplies the number of years of service by the average salary over the last 3-5 years and then multiplies again by a fractional benefit. (Logue and Rader, 1998) Defined contribution schemes In a defined contribution pension plan, a worker pays a certain percentage of the salary into a pension account. The contributions are invested in different types of assets in order to generate returns. At retirement the pension can be either paid off directly or paid off as annuity. (Logue and Rader, 1998) In the above described defined benefit scheme the pension is obtained as percentage of salary and depends on the number of years of service only and is independent from every type of contribution. In contrast, in a defined contribution system the pension depends on the amount of contributions transferred to a pension account during the working lifetime. A common characteristic of both schemes is that the pension income is reduced if an individual decides to retire early: in the defined benefits case because a minor number of years of service can be used for the determination of the pension, in the defined contribution case because a minor amount of contribution is transferred to a pension account. (Cazzola, 2008) Notional defined contribution schemes A notional defined contribution scheme works similar to a defined contribution plan. The main difference lies in the fact that contributions are directed to a notional account and not to an account where the accumulated capital is invested in assets. The accumulation of the accounts is virtual and almost unfunded and therefore pay-as-you-go. The individual accounts are notional accounts and indexed to a nominal interest rate chosen by the state. Typical nominal interest rates are the growth rate of average wages, price inflation and 8

14 GDP growth. Upon retirement the notional accumulation of contributions is distributed in form of annuities. (Barr and Diamond, 2008) 2.3 ECONOMIC CONSIDERATIONS At the beginning of this chapter the different functions of pension system were presented. Besides the functional view of a pension system it is also possible to take a macro and micro perspective of a pension system. According to a macro perspective, a pension system is no more than a mechanism, which allocates current GDP into a part held by the working generation and a part kept by the retired generation. This scheme reflects the concept of the intergenerational contract, explained in the precedent section. Taking it from the micro - individual perspective, a pension system divides the personal income over the entire life time by planning life cycle consumption. During their active working career, workers acquire rights (pension claims), which will be sold in a later stage once they will retire. (Grosen, 2011) An interesting analysis about the economics of pension systems is also given in the article The Economics of Pensions, from Barr and Diamonds (2006). According to Barr and Diamond is the output, the economic growth of a state, that matters independent of the type of pension system. All types of pension systems, e.g. pay-as-you-go and fully funded have something in common. The general goal of pension systems is to give pensioners an appropriate amount of pension income in order to continue consumption. In a PAYG system this claim is reached by the promise from the government or employer that the pensioner will get his benefits after having stopped to work. In a fully funded scheme this claim is achieved by the accumulation of assets, which after retirement are used to pay off the pension needs. 9

15 2.4 CHALLENGES TO PENSION SYSTEMS Pension systems in practice worldwide today face a series of challenges. Looking at all challenges, two main problems caused the instability of the social security mechanism in the world and especially in Europe. Demographic change The first challenge is the demographic change within the population. The world population is aging. According to the data from the United Nations and Organization for Economic Cooperation and Development (OECD) the old-age dependency ratio, the fraction between the population aged over 65 and the working population between years, will double over the next 40 years. However, when looking at the following chart some differences have to be taken into account. Figure 2: Development old-age dependency ratio 60% 50% 40% OECD-Europe OECD World 30% 20% 10% 0% Source: OECD and United Nations While in 2010 the ratio in the whole world amounted to about 12%, in Europe the fraction was already at the level of around 28%, a higher than projected value for the overall world of 26% in The phenomenon of old-aging dependency is clearly more distinctive in member countries of the OECD. Projections for the year 2050 estimated dependency ratios within the OECD of 10

16 more than 50%. These numbers indicate that most pension systems in the industrialized countries will enter a crisis or even worse are already in a crisis. The aspect of an increasing old-age dependency ratio of a population does not only depend on the increasing longevity but also on the decreasing fertility rates around the world. In the quinquennium the world average fertility rate was 3.8, the OECD average 2.3. During the past period from 2005 to 2010 the value declined to 2.5 for the world and to 1.7 for OECD. For the period projections expect levels of 2.3 for the world and around 1.7 for OECD. These numbers put further pressure on the problem of an increasing old-age dependency. Structural fundamental challenge The second challenge concerns the structure of pension systems in industrialized countries. In many countries like Germany and France public pension schemes are unfunded and based on the pay-as-you-go mechanism. As already mentioned in section 2.2 a PAYG system works good as long as there exists an equilibrium between contributions and benefits. Pay-as-you-go schemes worked pretty well back in the 60 s and 70 s of the last century when old-age dependency amounted to levels around 18% in Europe. At that time a ratio of 7:1, meaning seven workers for each pensioner was normal. Today the ratio decreased to four workers for each pensioner and according to further projections in 2040 this ratio will be 1:1. A consequence of this development is that states have to increase pension contributions, payroll taxes or issue new debt in order to maintain the pension systems. However this brings the negative effect of financial instability of countries and slowed economic growth. (KMPG, 2011) 2.5 PENSION REFORMS An alternative or better said the only way out of this misery is the adoption of reforms and the structural change of pension schemes. The implementation of a pension system based on a sound three pillar structure offers a possibility to 11

17 overcome the challenges explained above. Governments are required to establish pension systems, where the pension benefits of retirees does not only come from public schemes but also from mandatory private and voluntary programs. The table below shows the conception of a three pillar pension system after the implementation of reforms. An important step in such a process is the passage from a defined benefit scheme to defined contribution or notional defined contribution scheme within pillar I. Table 1: Three pillar structure after reforms I State Publicly founded schemes, social security schemes II Employer Employer-sponsored schemes or private mandatory programs III Individual Additional voluntary arrangements Unfunded (PAYGO) Funded Funded DB NDC DB DC DC Source: A. Grosen Examples for the successful restructuring of pension system are Chile and Poland. In both countries the government was able to implement a more balanced scheme by giving more importance and weight to mandatory and voluntary complementary pension schemes. The next chapter analysis in detail the case of Italy: challenges and problems, and the reforms implemented to rebalance the pension system. 12

18 3. THE ITALIAN PENSION SYSTEM The beginnings of the Italian pension system date back to the end of the 19 th - century. At that time a first type of pension was introduced on a voluntary basis. Over the next twenty years the pension provision became mandatory and in 1919 the institution INPS 1 (Istituto nazionale per la previdenza sociale) was established. The fixing of the pension was based on a fully funded scheme. In the postwar period inflation and destruction prevailed. The accumulated pension capital lost all of its purchasing power and a change to a pay-as-you-go scheme was decided. The implementation of the new pension scheme lasted until 1970, when the fully funded scheme was completely abolished. (Cesari, 2007, p. 28) During this period Italy experienced a strong demographic and economic growth. At the same time the expenditure for social security was expanded to broader occupational categories and the level of pension provision was also increased. It was during the 70s and 80s when Italy accumulated huge liabilities for pension expenditure. These liabilities are still a burden on the public finances today. The following chapter analyses the different reforms and changes applied to this three pillar structure over the past twenty years. The importance of the contribution of the three pillars changed significantly in the past and is going to change also in the future as the following sections will demonstrate. 3.1 THE CRISIS OF THE ITALIAN PENSION SYSTEM A pension mechanism based on the pay-as-you-go concept works well as long as there is equilibrium between the employed and retired population. If such an equilibrium is no longer active, this type of pension scheme will enter a crisis. 1 The INPS in Italy is the main institution for social security today. In Europe it ranks as one the biggest institutions as most of Italian employees are obligatorily insured through the INPS. 13

19 The explained disequilibrium occurred in Italy at the beginning of the 90 s as conditions have changed at that time. The increase of life expectancy, decreasing birth-rates, the change in labor markets and the uncontrolled increase of public spending for social security caused the crisis of the Italian pension system DEMOGRAPHIC CRISIS In the context of analyzing the reasons for the Italian pension system crisis, the examination of the demographic evolution plays an essential role as it is closely linked to pension spending. Today the Italian demographic evolution is characterized by two important phenomena (Cesari, 2007, p. 32): A decreasing fertility rate, conditioned by the passage from agricultural to an industrial society, the increasing emancipation and the development of contraception An increasing life expectancy, contingent by the improved economic and humanitarian conditions and the progress in medicine Both phenomena are reflected in the following figures known as the population pyramid. Figure 3 shows the composition of the Italian population at the beginning of the last century. In 1901 the Italian population of 32 million people had a so called pyramid shape, which means that the amount of male and female people decreased with their increasing age. Figure 3: Population pyramid, year

20 Figure 4: Population pyramid, year 2011 Source: Istat In 2011, after more than 100 years, the population increased to 60 million people. As figure 4 shows, the two above mentioned criteria have transformed the shape of the pyramid to a kind of rhombus. Today, the majority of the population is reflected by the adult generation of around 40 years. Young-aged people decreased in absolute as well as in relative terms. Depending on the assumptions, scenarios and models can differ slightly, but they remain the same in their basic message: The ratio of older people to people of working age has increased steadily and will in the future change even more to the detriment of the younger generation. This trend requires reforms that target either funding or benefits. Figure 5: Population pyramid, predictions

21 According to the latest projections for the period until year 2050 the Italian population will stay stable at its recent levels. But the distributions of different age classes within the population will change significantly. In 2050 old-age retired people above 65 years will exhibit the biggest share of Italian s population (figure 5). The preceding figures underlined the problem of equilibrium between contributions and benefits in a pay-as-you-go scheme. To avoid the equilibrium problem, Italian politics used more and more public finances in order to maintain the pension system and in order to react to the mentioned changes and challenges. However, at the beginning of the 90 s it was unavoidable to reform the pension system and to prevent a collapse of the system. (Botta, 2012, p. 33) CRISIS IN THE LABOR MARKET Besides the challenges for the pension system resulting from the demographic evolution, the crisis in the labor market also negatively impacts the pension schemes. Cesari (2007, p. 35) explains this problem with the use of a simple equation. Benefits Pensioners = Contributions Income Workers Benefits Income Worker Populatio n Contributions Old age >65 Pensioners Population Old age >65 The equation shows that the pension benefit in the pay-as-you-go scheme depends on six factors: the benefit increases with the rate of contributions, given by the fraction contributions/income with productivity of labor, defined as a ratio of income and number of workers with employment rate, given by the fraction of workers/population with the intervention of the fiscal system to balance the fraction between benefits and contributions 16

22 The benefit diminishes with the increase: of the old-age dependency ratio given by the fraction between people aged over 65 and the total population of the excess of pensioners relative to old age people conditioned by the Italian phenomena of old-age pensioning Considering the increasing old age dependency, the decline of benefits can be avoided in four ways: with the increase of employees generating higher contributions, with the enhancement of productivity, with increase of aliquots and with reduction of old-age pensioning. The other two factors can only be changed through a legal intervention. In theory, these concepts appear to be logical, but in practice it is different. Over the last 30 years, the dynamics in the Italian labor market were unfavorable for the pension system. New technologies and restructuring in production caused an increase of the unemployment rate from 6% at the end of the 70 s to 12% at the end of the 80 s. Furthermore, new types of contracts, such as part-time contracts, distorted the equilibrium in the pension system. This kind of contracts involved minor costs for companies, as the pension contributions were inferior than for regular contracts. As a consequence, a smaller amount of contributions accrued the pension finances. The increase of the old-age dependency ratio is a phenomenon, which didn t affect Italy only, but also the majority of other industrialized countries. However, the dimension and level of the Italian ratio were tremendous. The following table compares the old-age dependency ratios of Italy, Germany, OECD-Europe and the United States. 17

23 Table 2: Old-age dependency ratio Italy Germany OECD Europe United States Source: OECD, Pensions at Glance 2009 The data indicates that back in the 70 s Italy didn t face the problem of a high old-age dependency. However, over the last 40 years things have changed drastically and Italy exhibits one of the highest ratios today. The projections for the year 2050 map an even worse scenario, which suggests that Italy will rate at the top of all old-age dependency ratios. Yet another big problem puts pressure on the Italian pension system: illegal employment. This phenomenon, very widespread throughout the country causes heavy damages to public finances, firstly by missing contributions flowing to the state and secondly by the increased expenditures for poverty relief as illicit employees are registered as unemployed CRISIS OF PUBLIC FINANCES Beginning in the mid 70 s, the Italian pension system entered a stage of continued deficit accumulation. Besides the regular function to guarantee income after retirement, the Italian pension system also invested in the expansion of the concept of the welfare state. This decision implicated a growing disequilibrium between contributions and benefits and resulted in a missing intervention from the state to change something in the system. The public deficit had a remarkable increase, especially at the beginning of the 90 s, when the criteria for entering the European monetary union were decided. With a public deficit of around 10% Italy was far away from the originally required 3% by the Maastricht criteria. (Botta, 2012, 36) 18

24 High pressure of pension expenditure on the GDP The following two charts illustrate the precarious situation of the pension system in Italy in 1990 and In both charts Italy (the red spot) is situated in the upper right corner, which indicates a high old-age dependency ratio as well as a high impact of pension spending on the gross-domestic-product. In 1990, before the introduction of first pension reforms by the government, the cost for pensions added up to 10.1% of the GDP. More than 15 years later, in 2007, Italy shifted even more to the corner, exhibiting a fraction of Public pension expenditure/gdp of about 14%.The shift along the axis of old-age dependency is based on the reason already explained in the previous section. Figure 6: Demographic pressure and public pension expenditure in 1990 Source: OECD, Pensions at Glance

25 Figure 7: Demographic and public pension expenditure in 2007 Source: OECD, Pensions at Glance 2011 Despite the numerous interventions during the 90 s, the situation in the Italian pension system has not been and is still not stable today as the second graph shows. A series of new and future reforms have to be undertaken in order to stabilize the public finances. Before describing the recent changes introduced by the Monti government, a thorough analysis of the reforms from the 90 s and their impact on the pension system needs to be carried out. 20

26 3.2 PENSION REFORMS IN THE LAST TWENTY YEARS During the 90 s, the Italian pension system underwent a series of reforms, which dramatically changed the structure of the pension scheme. Up to that time period the Italian pension system basically consisted of two pillars: The old-age pensioning and age of service pension based on a defined benefit calculus scheme. Old-age pensioning was reached at the age of 55 years for women and of 60 years for men and a minimum of 15 years of contributions needed to be paid. Age of service pensioning instead was obtained, independently of age, after 35 years of contributing. The Italian pension system of that time resulted to be inappropriate for the Italian society and public finances as explained in previous sections. Therefore the pension reforms of the last twenty years designed a new structure of the Italian pension system. (Botta, 2012, p. 38) The Italian pension system in its current shape is the result of a reconfiguration and reform process based on the models already introduced in other states like United States, Great Britain or even Chile. The Italian pension system is characterized by three main pillars, which should guarantee the pension income of the retired population. (Liera, 2005, p. 11) The first pillar represents the public and mandatory pension determined by a Notional Defined Contribution scheme, which guarantees a minimum of pension benefit The second pillar constitutes the private mandatory pension provision in form of occupational pension funds The third pillar represents the additional private voluntary pension supplement in form of life-insurance contracts and private pension funds In order to get a better understanding of the changes implemented to the pension system, the reforms are analyzed chronologically pillar by pillar in the following. 21

27 3.2.1 PUBLIC PENSION (PILLAR I) Amato reform 1992 The past pension reforms mainly affected the public pillar I scheme. The first big reform was passed in 1992 by the Amato government as a consequence of the big deficit. The decree-law n.503/1992 implemented the following directives. The pensionable age was raised gradually to 60 years for women and 65 years for men within the timeframe from 1993 to 2000.In order to make use of the old age pensioning concept a minimum of 20 years of contributions was requested compared to the earlier 15 years. The reference period for the calculation of pension benefits was changed from the last 5 years to the last 10 years of remuneration. This was introduced for employees with more than 15 years of contributions. For the ones with less than 15 years or even for new entrants the reference period related to the entire working career. In addition, pension benefits were not indexed any longer to real wages and prices but only adjusted to price increases. (Liera, 2005, p. 17) Dini reform 1995 a structural change Only three years after the adoption of the Amato reform it was realized that the implemented changes had not been enough to guarantee the future stability of public finances. The demographic change and the increasing disequilibrium between contributions and benefits made it necessary to review the entire structure of the pension system. With the adoption of law n. 335/1995 the most important structural change in the Italian pension system was executed: the shift from a defined benefit to a notional defined contribution scheme. The main goal of this reform was to create a fairer pension scheme. The pension benefits still paid off by the INPS were now linked to the contributions from each single employee and not to the individual salary anymore. The new pension scheme was implemented gradually depending on the years of service accumulated up to the 31 st December An exact explanation of the new system will follow in the next section, when the calculation of pension benefits under different schemes will be analyzed. 22

28 Additionally, other rules were implemented. The reform changed the scheme for age of service pensioning by adding a minimum age to the 35 years of contributions. Initially the age was fixed at 53 years. The Dini reform also tried to reward workers with different incentives if they decided to retire at a later point of time. The pensioner with a higher age of retirement than defined would benefit from a higher amount of pension as these were calculated based on the contributions paid. A further harmonization and standardization for the same treatment of public and private employees was also attempted to be reached. (Liera, 2005, p. 19) In 1997, an additional reform was undertaken by the government of the Prime Minister Romano Prodi. The reforms tried to harmonize and accelerate the measures and targets implemented by reforms from the years 1992 and A main objective of the reforms was also the adjustment of the Italian public finances in order to allow access to the European monetary union. Maroni reform 2004 The adoption of law n. 243/2004 was aiming at gradually increment the pension age for age of service pensioning and to increase the importance of complementary pension schemes. The former was fixed to 60 years starting in 2008, 61 years in 2010 and 62 years in Trattamento di fine rapporto Severance indemnity Another very important objective of the Maroni reform was the development of complementary pension schemes. For the development of such schemes a change in destination of the country specific severance indemnity or so called Trattamento di fine rapporto (Tfr) was decided. The Trattamento di fine rapporto (Tfr) is a form of deferred remuneration, which is paid to employees at the moment when the employment contract ends for reasons like pensioning or dismissal. In economic terms this severance indemnity is a form of loan from the employee to the employer. The Tfr is calculated by dividing the yearly gross salary by a fixed parameter of 13.5, which yields 7.41% of the remuneration. 6.91% are destined to the employee and 0.5% to a guarantee fund managed by the INPS, which intervenes in case the employer/ the company becomes insolvent. 23

29 The Tfr is revaluated on a compounded basis year over year with 1.5% + 75% of the inflation rate and determined by the Istat. The Tfr concept is reserved to employees from the private sector only, employees from the public sector are subject to a different scheme. (Cesari, 2007, p. 14) According to the civil code (art. 2120) an employee has the opportunity, under certain circumstances, to ask for an anticipation of max 70% of the Tfr. The decree-law n. 252/2005 introduced a new scheme for the severance indemnity. Within the 30 th june 2007 all employees of the private sector had to decide what to do with their respective Trattamento di fine rapporto. The new scheme offered four different options: to maintain the Tfr within the company to transfer the Tfr to one of the different product types for complementary pensions to join an occupational complementary pension scheme to do nothing and the Tfr will be transferred by the employer to a pension fund referring to the contract type of the employee All four options contained risks and chances for the employees. (Cazzola, 2008, p. 138) Monti reform 2011 In order to rebalance the public budget during summer 2011 the minister of economic affairs Tremonti introduced several further reforms. The decisions included the suspension of pension revaluation during , a further increase of the pensionable age and an extra taxation for pension income higher than Euro 90,000. By the end of 2011, Italy was in a very bad shape and a political change was unavoidable. The new Prime Minister Mario Monti and his minister of welfare Elsa Fornero enacted a decisive change in the Italian pension scheme with the adoption of decree law n. 6/2011. The goal of the new disposition consisted of guaranteeing the respect of international commitments and of balancing requirements, of guaranteeing an economic-financial stability and of enforcing the sustainability of the Italian pension scheme for the long term in terms of impact on the Italian gross domestic product. (Botta, 2012, p. 65) All reforms 24

30 should be enacted under the concept of fairness and adequateness in the sense of the welfare state. It was agreed that, starting from 1 st of January 2012 the respective pension benefit of each individual is going to be calculated according to a notional defined contribution scheme. In practice, the scheme in place simply accelerates the 1995 Dini reform by abolishing the gradual implementation of the NDC scheme. The exact explanation will be given in the next sections. For the minister Fornero it was an important part to implement a system involving the same treatment for everyone. Furthermore, with the Monti reform the age of service pension concept was abolished. Instead, an early retirement pension scheme was introduced. According to that scheme the possibility of pensioning depends on the number of years of contribution payments made.starting from 2012 a minimum of 42 years and 1 month for men and 41 years and 1 month for women will be required in order to receive a pension. This level is set to increase over the years in relation to the increasing life expectancy. Regarding the old-age pensioning the age level is increased to 66 years for men and women. This target will be reached gradually in 2018, when the old age pensioning age will be the same for men and women from the private and public sector underlining again the concept of fairness. Another innovative aspect of the pension reform is represented by the fact that age of pensioning has become flexible. Each employee has the liberty to decide the time of his or her retirement up to an age of 70 years. The person who decides to work longer than an old age of 66 years will receive a higher pension due to a higher amount of contributions paid into the pension account overall. (Carli & Micardi, 2012, p. 10) PRIVATE COMPLEMENTARY PENSION (PILLAR II) The pension reforms of the past twenty years tried not to limit the pension income solely to the public pension. With the reform of 1992, the Prime Minister Amato introduced the first steps of complementary pension schemes. In 1993, the first pension funds (private and occupational) were born. The goal was to 25

31 enable pensioners higher levels of pension benefit. The introduction of pension funds in a certain way was like a step back in the past as the old scheme of funding was reintroduced. In order to better develop the complementary pension schemes in the year 2000 a reform (Decree law n.47/2000) for the taxation of complementary pension products was decided. The reform introduced a taxation of 11% on coupons, dividends and capital gains resulting from pension funds compared to the 12.5% taxation for normal investment products. The small difference between the taxation percentages did not present a big advantage to make this kind of investment more attractive. Regarding the taxation of investment products in summer 2011 the Italian government changed the percentage from 12.5% to 20%, which should make pension products with a percentage of 11% more attractive now. (Decree law n. 138/2011).Furthermore, the concept of a yearly deductible amount of 5, Euros of voluntary complementary pension contribution tried to make private pension investments also more interesting INDIVIDUAL PENSION INTEGRATION (PILLAR III) The third pillar is similar to the second one as it uses the same financial mechanisms and the concept of funding to generate future pension benefits. The peculiarity of pillar III is the individual initiative to use the fiscal advantages for pension products. Typical pension products used within this pillar are open pension funds and individual saving plans, e.g. life insurance contracts. For the development of this pillar the fiscal changes of the year 2000 and 2011 were of great relevance. For self-employed workers who do not dispose of collective treatments, pillar III represented the same function as pillar II. The last section (section 3.4) of this chapter analyses the characteristics, importance and market development of complementary pension schemes (Pillar II and Pillar III) in Italy in more detail. 26

32 3.3 DIFFERENT PUBLIC PENSION PAYMENT SYSTEMS After a series of reforms during the past twenty years, the methods for the calculation of pension benefits appear to be complex. The reform of Dini in 1995 divided the employees into two categories: Employees registered at the INPS before the 31 st December 1995 and those registered for the first time starting from the 1 st January The main distinction between those categories of workers resided in the different methods for the calculation of pension benefits (Il sole 24 ore, 2012, p. 13), which will be demonstrated in the following cases. Public pension benefit according to the Dini reform (1995) Case 1: The defined benefit scheme will be applied to those employees, who had a minimum of 18 years of service at the 31 st of December Case 2: The notional defined contribution scheme will be used for employees, who started to work from the 1 st of January 1996 going forward. Case 3: A mixed scheme will be used for those workers, who had less than 18 years of contributions at the 31 st of December The defined benefit mechanism will be used for the years up to the end of 1995 and the notional defined contribution scheme for the years after the 1 st January (Botta, 2012, p. 43) Public pension benefit according to the Monti reform (2011) As already mentioned in the last section, the Monti reform tried to accelerate the Dini reform of In contrast to the Dini reform (Case 1), now under the new scheme employees, who had accumulated more than 18 years of contributions up to the end of 1995 will pass to the less favorable notional defined contribution scheme for all the pension payments made after the 31 st December Today, in 2012, the Italian public pension systems, consists of the schemes shown in the following table. 27

33 Table 3: Active pension payment systems in 2012 Case 1 Case 2 Employee profile Minimum 18 years of contributions at 31 st December 1995 Less than 18 years of contributions at 31 st December 1995 Pension system applied Defined benefit for the years until 31 st December 2011 and NDC from 1 st January 2012 Defined benefit for the years until 31 st December 1995 and NDC from 1 st January 1996 Case 3 0 years of contributions at 1 st January 1996 NDC starting from 1 st January 1996 In chapter 1 theoretical descriptions of the defined benefit and notional defined contribution pension systems were already given. Using the theory, an explanation of both schemes within the Italian pension system will follow in this section OLD DEFINED BENEFIT SCHEME As it can be seen from the table above, the defined benefit scheme is still in use for the calculation of the mixed cases 1 and 2. The defined benefit scheme is based on three main elements (INPS 1): Years of contribution: the total amount of contributions up to a maximum of 40 years, which a worker can assert at the moment of pensioning. Pensionable income: the average remuneration obtained during the last years of work. Previous remuneration is revaluated according to indicators from the Italian National Institute for Statistics (Istat). The indicator used for this revaluation is the FOI Index the national consumer price index for families of regular workmen and employees. Rate of return: it is equal to 2% for an income within a limit of Euro 44,204 (dated 2011). For higher income levels, the rate of return is decreasing respectively to 1.5%, 1.25% and 1%. The return rates are also updated yearly by the Istat. 28

34 The calculation of the pension benefit is given by the following formula: Years of contribution x rate of return (2%) x revaluated pensionable income Calculated with the above shown formula, an employee obtained nearly 80% of the average of the last five years of remuneration for forty years of contribution. The amount of the pension decreases with a higher level of income. The pension income also decreases due to the different treatment of years of contribution aggregated before the 31 st of December In this context a so called quote A and quote B are taken into account while calculating the pension income. Quote A is determined according to the years of contribution with due date 31 st of December 1992 and the average remuneration of the last five years or the last 260 weeks of contribution for regular employees and 10 years (520 weeks) for self-employed people. Quote B relates to the years of contribution starting from 1 st of January 1993 and the average remuneration of the last 10 years (520 weeks) for regular employees and 15 years for self-employed people. (Martorelli, 2011, p. 4) In the last chapter a detailed explanation (only for regular employees) of the old defined benefit scheme follows by using numerical examples and a simulation NOTIONAL DEFINED CONTRIBUTION SCHEME The NDC calculation method was introduced with the reform of 1995 by the Prime Minister Dini. The new pension scheme refers to all employees, who either did not accumulate 18 years of contribution at the end of the year 1995 or are new employees starting from the 1 st of January In the notional defined contribution system the annual pension income is calculated in the following way Individual amount of contributions x transformation coefficient relative to the age at the moment of pensioning. 29

35 The individual amount of contributions The individual amount of contributions is the sum of all contributions paid by the employee from the beginning of his/her working career until the beginning of the pension career. The yearly contributions correspond to the product between the annual salary and the pension contribution rate. For regular employees this rate is fixed at 33% and for self-employed workers at 20%. At the end of every year the contributions are revaluated with a capitalization rate. This system is similar to the concept used for the determination of the severance indemnity explained in the precedent section. In Italy the capitalization rate applied, corresponds to the five year average nominal growth rate of the gross domestic product. The yearly contributions can only be calculated up to a maximum salary ceiling of Euro 96,149. Above this level the salary is not subject to pension contribution and therefore not revaluated. (INPS 2) Transformation coefficient The transformation coefficient is the second important element for the calculation of the pension income under the notional defined contribution scheme. This parameter (starting from 57 years up to 65 years) is fixed in relation to the age of the employee at retirement and also to the life expectancy: a higher age corresponds to a higher transformation coefficient. According to the previous law nr. 335/1995 the coefficients were updated on a ten years basis only. (Martorelli, 2011, p. 8). With the Monti-Fornero pension reform the treatment of transformation coefficients experienced a significant change in order to adapt them to the ongoing macroeconomic and demographic change. Starting from 2012 the coefficients are updated on a three years basis. Furthermore, the age range was extended to 70 years. The extension to 70 years should offer employees the possibilities to continue working longer and benefit from higher coefficients. In the last chapter the advantage of working until an age of 70 years instead of 66 years will be shown. The following table shows the current coefficients after the update made in May The table indicates that from 1996 until 2012 transformation coefficients experienced a great diminishment due to demographic change and the above mentioned factors. Looking at the last column a significant negative variation for 30

36 an age of 65 between the coefficients fixed in 1995 and the once fixed in 2012 can be observed. The penultimate column shows the positive impact of extending the coefficient to a higher age. Table 4: Transformation coefficients Source: INPS, Siulpmarche 3.4 COMPLEMENTARY PENSION SCHEMES As already implied in section 3.2 the first complementary pension schemes were introduced with the decree law n. 124/1993 by the Amato government. The decree established the legal framework for first complementary pension schemes, in form of closed pension funds, only for collective agreements between employees and their respective labor unions. The adoption of decree law n. 47/2000 instead opened the complementary pension scheme also to each individual in form of open pension funds and individual saving plans life insurance contracts. 31

37 The Italian complementary pension product range, besides open and closed pension funds and life insurance contracts, comprises also the so called fondi pensione preesistenti, preexistent pension funds. An important and necessary step in the evolution of the Italian private pension market was the reform for severance indemnity in 2004, implemented later by decree law n. 252/2005.The reforms introduced starting from 1993 produced a fairly modest success of the private pension provision. The main objective of this further legal action was to energize the development of the complementary pension scheme and to guarantee a solid pillar II and pillar III structure within the Italian pension system PRODUCT TYPES Before analyzing in more detail the market development for private pension schemes, it is relevant to describe the different product types within the complementary pension scheme (Cannata & Settimo, 2007, p. 8) Closed pension funds Closed pension funds are collective agreements between employees and employers. This category of funds addresses employees from a same occupational area, e.g. employees from the same company or group of companies or employees from the same geographic area. A closed pension fund is a legal entity consisting of different legal elements such as meeting of members, administration and control entities and the fund responsible. Certain services and activities are assigned to external advisors. For example, the management of the financial assets is assigned to specialized companies such as banks, asset managers or insurance companies. The business activity of closed pension funds is supervised by the Covip, the Italian supervisory commission for pension funds. Open pension funds Open pension funds are directly established by banks, insurance companies and asset management companies. This type of pension funds can be joined by 32

38 individuals or also on a collective basis. The business activity of open pension funds is supervised by the Covip. Individual savings plans (Piani individuali pensionistici - Pip) Individual savings plans are life insurance contracts with characteristics which are similar to pension funds. The admission to Pip s is reserved to individuals only and cannot be entered by collective agreements as for open and closed pension funds. Individual savings plans are also regulated by the Covip. Preexistent pension funds Preexistent pension funds were introduced before the reform of 1993 and are regulated by art of the civil code. Preexistent pension funds were established within the environment of large companies e.g. Fiat or Unicredit already back in the 1970 s. These funds also underlie the supervision of the Covip MARKET DEVELOPMENT The last sections explained the regulatory framework and different reforms implemented for the development of private pension provision in Italy. The following section analyses the evolutionary process of the complementary pension scheme during the past 10 years. The Italian market for private pension provision reached a level of about 99 billion euro of financial assets under management, equal to about 5.8% of the Italian gross domestic product, at end of When comparing this value to other countries such as United Kingdom, United States, Switzerland or even the Netherlands it turns out that Italy exhibits a fairly low fraction between financial asset and GDP. The difference is more restrained if the comparison is conducted with other big member countries (France, Germany and Spain) of the European Union. 33

39 Assets / GDP Figure 8: Pension assets as a share of GDP (2011) 140% 120% 100% 80% 60% 40% 20% 0% Source: OECD statistic database, 2012 Figure 9 shows the growth of the fraction assets to GDP throughout the past ten years in Italy. The chart makes clear that after the severance indemnity reform enacted in 2007 the market for private pension provision experienced a higher growth compared to precedent years. Figure 9: Development of Assets to GDP fraction from 2001 to 2010 Source: OECD statistic database,

40 Besides the overall observation it is also relevant to take a look at the absolute numbers of members enrolled in complementary pension schemes and also at the distribution of assets between the different private pension products. Before the implementation of the Maroni reform in 2007, the complementary pension scheme in Italy at the end of 2006 registered about 3.3 million members enrolled in private pension programs and about 51 billion euro in assets under management. In terms of enrolled members closed and open pension funds counted around 1.7 million members, which represent more than 50% of all employees registered to a private pension scheme. With the introduction of the Tfr-reform in 2007 the number of employees enrolled jumped by around 43% equal to 1.4 million to 4.7 million within one year only. This jump occurred mainly due to the obligation for employees to decide where to invest the severance indemnity. The assets under management grew by more than 6 billion euro to 57.7 billion euro. At the end of 2007 closed and open pension funds recorded the highest growth rates compared to other pension products. However, from 2008 to 2012, the situation changed. The growth of new members enrolled diminished to an average annual rate of 4.7% so below to the pre-reform 8.4% level between 2003 and It is interesting that the allocation of members between the different product types changed significantly. While closed pension funds registered a zero level growth, individual savings plans grew by more than 12% every year and resulted to have the most members enrolled by the end of the year At the end of 2012 a total of 5.9 million employees were registered to a private pension scheme with about 99 billion Euro invested. According to the Istat around 22 million people worked in Italy at the end of 2011, of which 16 million as dependent employees (with severance indemnity payments) and 6 million as self-employed. The comparison of the enrolled members and the overall number of employees reveals that only one fourth of all Italian employees are registered to a complementary pension scheme so far. Regarding the assets under management estimations from the government predict that the annual flows from the severance indemnity amount to about 19 billion euro. During the past three years, however, only around 5 billion euro on average per year of severance indemnity flowed into the complementary 35

41 pension schemes. As these numbers show, the market for private pension provision contains a high potential for growth. Figure 10: Development of enrolled members and assets under management Source: Covip Annual reports 36

42 4. ANALYSIS This chapter talks about the primary topic of thesis: the change in the future composition of pension income in Italy. The idea of this section is to simulate the change in replacement rates, so the ratio between pension income and last salary, coming from public pension schemes and private pension provision. As already mentioned in section 3.3, the Italian pension system designs three different cases for the calculation of public pension income since the last reforms of the Monti government. The application of those schemes on the different employee profiles entails a change in replacement rates. The replacement rates show how much a retiree receives in pension income in relation to his/her last salary. In order to have a better understanding for the following simulation of replacement rates a short recap of the different calculation cases will be given. Case 1: this scenario refers to employees, who had a minimum of 18 years of contribution before the 31 st of December In this case the pension income is calculated based on the defined benefit scheme until the 31 st of January For employees starting to retire from the 1 st of January 2012, the pension income is fully calculated on the defined benefit base. For e.g. for employees retiring from the 1 st of January 2013, the last year of contribution (2012) is already calculated based on the notional defined contribution scheme. Case 2: the second mixed scenario refers to employees, who had less than 18 years of contributionat the 31 st of December In this case the pension income is determined by the defined benefit scheme for the years until 31 st of December For all years of contribution after that date the notional defined contribution scheme is used for the calculation of pension income. Case 3: the third case relates to workers, who started to work after the 1 st january In this case the entire pension income is fully based on the notional defined contribution scheme. 37

43 Figure 11: Three different pensioning cases Replacement rates In the context of pension schemes, the replacement rate is simply defined as the ratio between the first annual pension income and the level of the last annual salary. Hence, this ratio indicates the change of income in the passage from active worker to retiree. In general two types of replacement rates exist: gross and net replacements rates. Gross replacement rates are basically composed dividing the gross pension income by the last gross salary. For the calculation of net replacement rates, instead, the net salary, including taxes and social security contributions and the net pension income, where only taxes are deducted, is used. The taxation of personal income is characterized by its progressiveness, in pratice the tax rate increases as the taxable salary increases. Gross replacement rates are always lower than net replacement rates as in the fraction for net replacement rates the denominator is reduced more than the numerator, which furthermore leads to a higher percentage level for the net replacement rate. (La Republicca, 2008) The following simulations use the gross replacement rate for the composition of the analysis. The main reason for this choice is that the calculation of the net replacement rate mostly depends on the income taxation of each individual. In order to reach comparable results based on net replacement rates, the anaylsis would need to be based on the single characteristics of the Italian income taxation, which is not intended in the present analysis. 38

44 4.1 THE SIMULATION The model simulates the replacement rates according to the different calculation types for pension income. All simulations are based on common assumptions. The model assumes that employees will work for 40 years and retire at an age of 66 years in line with new rules from the Monti reform. Furthermore, in each simulation the calculation of replacement rates will be conducted for ten different income categories. This differentiation helps to analyze how and if the relation between last salary and pension income changes according to the level of salary. The ten salary categories try to illustrate different employee profiles (employees and managers).the first category shows the profile of the Italian average employee with a final yearly salary of around 32,000 Euro. The last category stands for the final yearly salary of a senior manager with an amount of 130,000 Euro. The salary categories 2 to 9 show the income profile for the employee profiles in between. Table 5: Salary categories in Euro Source: own calculations For the development of salaries, the 40 years of contribution are divided in four decades. Each decade is combined with a different growth rate for salaries. The model assumes that salaries during the first two decades of work grow at higher rates than during the last two decades. Normally an employee experiences the greatest salary increase between year 10 and 30 of his/her career. The growth rates are based on historical salary increases published by the Istat. The 10 year average for this data series is 2.6% while the 15 year average is 2.15%. The salary growth rates for the four different decades are based on these numbers. Therefore, the simulation assumes the following rates: decade 1-10 assumes a growth rate of 2%, decade %, decade % and decade a growth rate of 1.5%. 39

45 Figure 12: Growth of gross wages ( ) 5,00% 4,00% 3,00% 2,00% 1,00% 0,00% -1,00% -2,00% Source: Istat, Bloomberg The first simulation (denominated as DB Defined benefit) is done for employees retiring in 2012 and therefore are fully linked to a defined benefit calculation. The second simulation (denominated as Mixed DB and NDC) projects the replacement rate for employees retiring In this case the ten years of contribution before the 1 st of January 1996 are calculated according to the defined benefit scheme and the 30 years after that point of time according to the notional defined contribution scheme. The third simulation (NDC notional defined contribution) calculates the replacement rate for employees retiring in 2035 who are fully subject to the notional defined contribution scheme. The fourth simulation (denominated as private) projects the replacement rates coming from private pension provision programs. The following sections show how each of these simulations was calculated and what the main outcomes were SIMULATION 1: RETIRING IN 2012 (DEFINED BENEFIT SCENARIO) In section a short description for the calculation of pensions under the defined benefit scheme was already given. The determination of the pensionable income under this scheme is the main component and more 40

46 difficult to calculate compared to the pensionable income in the notional defined benefit scheme. In order to eliminate the loss of purchasing power of money, the law (D.Lgs. 30 dicembre 1992, n. 503) designs the revaluation of all incomes for the years of work preceding the pensioning. For this purpose, the Istat provides revaluation coefficients, calculated on the basis of the FOI index. As mentioned earlier the pensionable income is composed of two quotes: a first quote A, based on the aggregated years of work until the end of 1992 and a second quote B, determined by the years of contribution after the 1 st of January1993. The revaluation coefficients for the income are slightly different for quote A and quote B. In difference to quote A, the revaluation coefficients for quote B are increased by one percentage point as a bonus. The following table illustrates the coefficients valid for Table 6: Revaluation coefficients for quote A and B Source: INPS (Msg. nr. 6167, April 6 th 2012) How to determine the monthly pensionable income for quote A? Quote A is given by the following formula: A (years of contribution) x B (average weekly salary) x A are the years of contribution, indicated in weeks, aggregated until the 31 st of December 1992, B is the average weekly salary (revaluated accordingly to the above shown coefficients) calculated on the last 260 weeks of work, (see section rate of return of 2% divided by 13 number of monthly 41

47 payments) is a fixed coefficient to be applied to an average weekly salary lower than Euro (equal to an annual salary of Euro 44,204). If the annual salary exceeds the ceiling of Euro 44,204, the calculation and the coefficients need to be adjusted. The ceiling is adjusted every year and published by the INPS. For the year 2012 the following ranges are effective (INPS 2, cir. Nr. 21 february 9 th 2012) (2%) - until Euro (44,204) (1.5%) for the range exceeding the 33% - between (44,204) and 1,130.6 (58,791) (1.25%) for the range between 33% and 66% - between 1,130.6 (58,791) and 1, (73,379) (1%) for the range exceeding the 90% - higher than 1, (83,988) The calculation for quote B follows the same logic with some minor changes. A1 (years of contribution) x B1 (average weekly salary) x A1 are the years of contribution, indicated in weeks, aggregated after the 1 st of January 1993, B1 is the average weekly salary (revaluated accordingly to coefficients in table 5) calculated on the last 520 weeks of work, (see section rate of return of 2% divided by 13 number of monthly payments) is a fixed coefficient to be applied to a average weekly salary lower than Euro (equal to an annual salary of Euro 44,204). Also for the calculation of quote B, in case the revaluated weekly salary is higher than Euro , the multiplicators decrease when increasing the pension income as follows: (1.60%) for the range exceeding the 33% - between (44,204) and 1,130.6 (58,791) (1.35%) for the range between 33% and 66% - between 1,130.6 (58,791) and 1, (73,379) 42

48 (1.10%) for the range between 66% and 90% - between 1, (73,379) and 1, (83,988) (0.90%) - for the range exceeding the 90% - higher than 1, (83,988) The gross pension paid by the INPS (13 monthly payments) is equal to the sum of quote A and quote B. The following numerical examples assume regular employees, who had aggregated 1,092 weeks of pension contribution until the end of 1992, and 988 weeks of contribution after the 1 st of January In total they contributed 2,080 weeks equal to 40 years of work. The calculation is done according to the above explained scheme and for an employee with salary category 4, so an initial salary of Euro 30,000 and final salary of nearly Euro 65,000. Table 7: Defined benefit scheme calculation of quote A 43

49 Table 8: Defined benefit scheme calculation of quote B So the monthly gross pension consists of the sum of quote A and quote B, equal to Euro 3,703. Multiplied by 13 (number of payments) results in a yearly pension salary of Euro 48,139. The next step of the simulation leads to the main wanted outcome, the replacement rate. The gross replacement is simply obtained dividing the pension salary by the last salary before pensioning. In this case 48,139 / 64,927 = 74%. The retiree gets 74% of his last salary as pension income. The same simulation was done for all salary categories, from 1 to 10. The following chart shows the different replacement rates for such salary ranges. 44

50 Figure 13: Public pension income and replacement rates in 2012 Source: own calculations For salary category 1 to 2 the gross pension replacement rate is nearly 80%. This is because the income is revaluated at the highest rate of return of 2%. From category 3 to 10 the replacement rates decrease while salaries increase. The replacement rate diminshes from 71% for category 5 to 57% for category 10. The main driver is the different revaluation of salaries SIMULATION 2: RETIRING IN 2025 (MIXED SCENARIO) The calculation of replacement rates for employees retiring in 2025 is more complicated as those employees underlie two different pension schemes: the old defined benefit system and the new notional defined contribution scheme. The theoretical framework was already given at the beginning of this section and for the notional defined contribution system in section Before starting to show the numerical examples some parameters, which are fundamental for the determination of replacement rates, need to be defined. In the mixed scenario the retirement is assumed to happen in 2025, so Quote A and Quote B, which are necessary for the calculation of the old defined part need to be included. The models assumes to use the same coefficients, as the once published by the Istat for the year

51 The pension amount for the years of work after the 1 st of January 1996 are based on the notional defined contribution systems. For that scheme the growth of the gross domestic products is relevant. The following graph shows the yearly growth rates over the last 15 years. Figure 14: Nominal GDP growth Source: Istat, Bloomberg The 5 year average, the red line, is used as capitalization rate for pension contributions. For the years between 2012 and 2025 it is assumed that the economy will recover and turn back to higher growth rates. The 5 year average should move from currently 0.72% to 1.3% in 2015 and furhter to 1.5% in In table 9 a short abstract for the calculation of notional defined contribution part based on salary category 1 is illustrated. The main number in the table is on the bottom right, the annual pension income. It is obtained in the following way: every year (from 1996 up to 2025) 33% of the annual salary is contributed to the pension scheme. This amount is capitalized by the 5 year average of the GDP growth. This procedure is done until the age of pensioning. The total sum of all capitalized contributions is then multiplied by the transformation coeffcients. As the pensioning will happen in 2025 the transformation coeffcients published in table 4 and valid from 2012 until 2015 shouldn t be valid anymore for the year 46

52 2025. For this reason the coeffcients were adjusted using a decreasing variation of 6%. So e.g. the coeffcient for age 66, passed from 5.624% to 5.287%. In order to get annual pension amount the total sum of contributions is multiplied by the transformation coeffcient. In shown example x 5.287% = Table 9: Notional defined contribution scheme For the 10 years of work from 1985 to 1996, the pension amount is calculated accordingly to the defined benefit scheme. This is done in the exact same way as for simulation 1 in the previous section. The only difference are the number of weeks before and after the 1 st of January Following the same framework an annual pension income of Euro 6,507 results. Dividing the sum of 16,659 (NDC part) and 6,507 (DB part) by the last salary 32,463 gives a gross pension replacement rate of 71%. In the simulation the same process was done for all other salaries categories. The outcome of the simulation can be observed in the following chart. 47

53 Figure 15: Pension income and replacement rates in 2025 Source: own calculations SIMULATION 3: RETIRING IN 2035 (NDC) The third simulation ( NDC notional defined contribution ) calculates the replacement rate for employees retiring in 2035 and who are fully subject to the notional defined contribution scheme. It is the scheme which is currently active for all employees, who started to work after the 1 st of January In the simulation for retiring in 2035 an adjustment for the transformation coeffcients (table 4) was done. The coeffcients were adjusted downwards by using an simplified average of the variation between the period and In order to better understand the outcomes of the simulation, an important point of this scheme should be emphasized: the maximum salary ceiling for pension contributions. The yearly pension contribution amounting to 33% of the annual salary can only be taken into account to a maximum of Euro 96,149 for the year This contribution cap was introduced with the implementation of the new pension scheme in 1996 (Art. 2, law nr. 335, ). The ceiling needs to be revaluated every year in line with the FOI Index, published by the Istat. As a consequence of this regulation the ratio between pension contributions and salary is not the same for all salary categories. As the relation between 48

54 pension contribution (33%) and salary is linear for all incomes up to maximum of 96,149 the replacement rate is the same for category 1 to 7 at a level of 65%. Starting from category 8,however, the gross replacement rate is decreasing down to a level of 60% for category 10. Working until 70 years As already mentioned in section 3.2.2, the pension reforms from the Monti government reward working until an age of 70 years. In May 2012, the transformation coeffcients were extented up to 70 years for this purpose. In order to observe the advantages of working until a higher age, the same simulation for notional defined contribution schemes was conducted by changing the year of pensioning. The following chart shows the differences between pensioning at an age of 66 years and at an age of 70 years. Figure 16: Replacement rates for pensioning at age 66 and 70 years Source: own calculations This picture clearly states that there is a huge advantage of pensioning at a higher age. By deciding to retire at 66 years, a pensioner gets around 65% of replacement rate. A regular employee, instead, remaining active until 70 years of age, gets nearly 19% more of pension income, which results in a total of 84% of his last salary. 49

55 4.1.4 SIMULATION 4: PRIVATE PENSION PROVISION The last simulation analyzes the development of private pension provision and the respective impact on pension income and replacement rates. The focus are the contributions resulting from the severance indemnity (trattamento di fine rapporto). The simulation assumes that 6.91% of the yearly gross salary is invested in a form of complementary pension provision. The framework used for the computation of replacement resulting from the private pension scheme is nearly the same as the one used in the notional defined contribution scheme and the mixed scheme. Exclusively the yearly amount of contribution (6.91% instead of 33%) and the yearly capitalization rate are different. In the private pension scheme the contributions are actually invested in real assets compared to the notional defined contribution scheme, where contributions are charged to a notional fictive account. The simulation model assumes an investment in a pension fund with a defensive portfolio allocation of 70% in bonds and 30% in equities. Bonds on average should yield 1.75% and equity investments 4% above inflation, after tax and costs (data used from Covip), so a portfolio performance of 2.43% per annum. The invested amounts are capitalized at this rate. The final amount with 40 years of contribution capitalized at an average rate of 2.43% is then multiplied with the transformation coefficient corresponding to the age of retirement. As the complementary pension scheme does not contain any restrictions and ceilings for contributions, the replacement rate is the same for all salary categories. The replacement rate obtained from the simulation is 15%. 50

56 Figure 17: Replacement rates from private and public pension in 2035 Source: own calculations The graph shows that in combination with complementary pension schemes the replacement rate is nearly the same as in the case when working until an age of 70 years. At this point it deserves to be mentioned that the foregoing simulation was carried out for the minimum of contributions to a private pension scheme only. Employees are of course not detained to dedicate a higher percentage of their salary to complementary pension provisions. In the simulation a second scenario was also computed, where employees pay 10% of their gross salary into the private pension contribution. By investing 10% of the gross salary for the entire working lifetime results in a replacement rate of around 22% coming private pension provision. The yearly contribution rate can be increased by each individual in accordance to his/her financial possiblities. 51

57 5. FINAL CONSIDERATIONS AND REFLECTIONS Figure 18: Replacement rates in 2013, 2025 and 2035 from public pension Source: own calculations Figure 18 summarizes the future development of the Italian pension system. The blue colored bars illustrate the replacement rate for retirement in 2012 under the framework of the old defined benefit system. The green colored bars show the level of replacement rates when retiring in 2025 and linked to the mixed scheme. The red bars describe the replacement rate for workers retiring under the notional defined contribution scheme in Workers retiring in 2012 are the last ones to profit from the advantage of the old defined beneft system. When taking a closer look it turns out that the distribution of replacement rates is fairly unequal for the old defined benefit scheme. The difference in replacement rates between category 1 and 10 is nearly 24%. The mixed scheme comprises more equal replacement rates. The difference between the lowest and highest salary category is around 14%. This is mainly due to a greater part of pension income which is determined by the notional defined contribution scheme. Looking at the red bars, the level from category 1 to category 10 is nearly the same. The difference is around 5%. The notional defined contribution scheme 52