Stayin' Alive

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Olof Björlin and Sepp Sigulla offer an intriguing glimpse into Europe's future. Although they have never met, Björlin and Sigulla are part of the most significant lifestyle trend in centuries. Both men are retired, among the swelling ranks of Europeans enjoying comfortable lives on generous pensions provided entirely by the welfare state. Sigulla, 69, a former union representative in Maintal, a suburb of Frankfurt, owns his own four-story apartment building and earns more on his old-age pension than he did in salary. Björlin, 71, a retired lawyer in Stockholm, regularly flees the Nordic cold for vacations in sunny Italy. "I'm quite happy," says Björlin. "I'm living well."

They are members of the first generation in modern times to enjoy their golden years in such comfort. Unfortunately, it's probably the last as well. In another 30 years, as the number of retired workers like Björlin and Sigulla multiply thanks to the aging of the baby boom generation, Europe will face an unprecedented financial crisis. The number of pensioners is rising sharply, and the number of workers is shrinking. It's a demographic time bomb. When it goes off, the European system of state pensions faces drastic choices: either cut benefits sharply or make people work far longer than they do today. Or both.

Björlin and Sigulla also illustrate how differently European countries have responded to the looming crisis. Sweden, where Björlin has been drawing a pension for six years, started planning for the geriatric explosion in 1992, finally putting into place a complete overhaul of its pensions system last year. The new arrangement, employing a new way of treating pension contributions, is designed to encourage people to work longer to help guarantee a sound financial footing for the pension system. Germany, where Sigulla retired seven years ago and where the proportion of people over 65 is growing faster than anywhere in the world — by 2040, the number of the country's over-65s is expected to almost double to 30 million people, up from 16 million today — has yet to adopt or even begin to develop a political consensus to reform the deficit-ridden state pension system.

Germany isn't alone. Both France and Italy face a budget crunch to finance generous state pensions. Rail workers and firemen in France can retire at the still vibrant age of 50. Until a loophole was closed recently, women in Italy with state jobs could retire with as little as 15 years in the job. Yet both countries have dodged a timely overhaul of their pension systems for political reasons. In France, Prime Minister Lionel Jospin has delayed reforming costly civil service pensions, apparently out of fear of damaging his chances as a presidential candidate in 2002. In Italy, the government was even more cynical, adopting a far-reaching pension reform program similar to Sweden's in many respects, but implementing it so gradually that it shifts the burden of paying the lion's share of the costs from today's workers to the generation that begins to retire in 2040. "They're going to realize how much they're paying for my generation, and what lousy pensions they themselves are going to have," says 58-year-old Giuseppe Pennisi, an economics professor in Rome.

The U.S. financial firm Merrill Lynch concluded in a recent study that the effect on public pension spending could be extremely negative as the population of retirees grows. Not only do states have to pay for the pensions, but there will be sharply higher health care costs as well. Social security costs in Germany, for example, are expected to rise from 30.8% of GDP in 1980 to 47.4% in 2040, while France's social costs will rise from 28.3% to 37.4% of GDP. As a recent European Commission study concluded, the large increase in the proportion of the economy that must be spent on retirement "raises concerns regarding the long-term sustainability of pay-as-you-go pension systems."

How could Europe get in such a mess? After all, when the state pension was invented in Germany a century ago by Otto von Bismarck the retirement age was set at 65, far above the average life expectancy at the time. And the primary goal was to insure against old-age indigence. But when European governments began redesigning their pension systems after two world wars and the longest depression in history, most decided in the 1950s to offer pension systems that went way beyond the idea of simply shielding the oldest members of society against poverty.

Instead, the new pensions aimed to guarantee that workers' living standards would not decline after they retired. Unlike some plans in the U.S. and Switzerland that forced workers to save for a rainy day, most of the new European systems paid benefits out of annual payroll deductions or tax rolls, the so-called pay-as-you-go system. The first generation of retirees collected generous pensions without ever having contributed a franc. The system survived because there were lots of young workers and relatively few elderly.

A sharply falling birthrate in Europe is gradually turning that system upside down and making it untenable. According to a study by the European Commission, the ratio of people 65 and over to the working population is expected to rise from 85% in 1995 to 124% in 2050. Richard Disney, an economist at Britain's Nottingham University, pointed out recently that the present system, in which the financing of gradually accumulating pension liabilities is left to future generations, "bears much the same character as the schemes of Charles Ponzi, an originator of the use of chain letters to raise money."

Two other statistics make the picture even bleaker. First, the actual age of retirement has been steadily falling because of early retirement programs designed to combat unemployment and because of easy-to-get medical pensions for the allegedly infirm. In Germany, for example, the legal retirement age is 65 — the same set by Bismarck in the 1880s. But the average age when people retire has fallen to 59.

The second factor is that people are living longer. While medical breakthroughs extend life expectancy, pension programs have to pay out far longer than anticipated. Peter Hicks, administrator of the social policy division at the Organization for Economic Cooperation and Development (O.E.C.D.) in Paris, says one statistic summarizes Europe's problem: in 1960 a European worker lived an average 68 years, with 50 of them spent working. The other 18 years went first in schooling, then in a couple of years of retirement. Today, the average worker lives 76 years, with only half the time in paid employment and almost two decades in retirement. "The most dramatic demographic change one can conceive of has happened in only four decades," says Hicks.

This daunting actuarial calculus helps explain why Germany has avoided grappling with a solution to its pension problem. Even today, when the number of workers is still relatively high, payroll deductions cover only two-thirds of Germany's annual pension obligations of $193 billion, with the rest made up by value added taxes, levies on gasoline and transfers from the general budget. With pension insurance already claiming 19.3% of a worker's wages, Germany doesn't have much room for maneuver. One private study suggested that contributions will have to rise to between 23% and 24% by 2030. Germany already has a crushing income tax burden. The Bundesbank, the German Central bank, says the only logical answer is to cut benefits. But when the government of Chancellor Gerhard Schröder proposed last year to merely slow the rise in benefits, his party lost five straight state and local elections.

The French government has succeeded in pushing the retirement age in the private sector to over 60 by increasing the minimum time at work to qualify for a full state pension to 40 years. But a landmark 1999 study of the French pension system by economist Jean-Michel Charpin warned that unless further reforms are made, pension payments will balloon from 11.6% of GDP to 16% in the year 2040. Charpin proposed an increase in the pension qualification period to 42.5 years worked, and its application to France's 4.5 million public sector employees — who currently work just 37.5 years to qualify for state pensions representing 75% of their final pay.

Successive Italian governments treated the state pension system as a pork barrel, with most employees able to retire in their mid-50s with 35 years service, and state workers getting a pension after only 19 years in the job, until the rules were changed early this year. The minimum was further reduced by military service, college, even maternity leave. "A women with a college degree, a government job and a couple of kids could have the right to a pension after seven or eight years," complained Giulio de Caprariis, deputy director of the research center of Confindustria, the Italian employers' association.

With evidence of the demographic change abundantly available for two decades, why has it taken European governments so long to respond? The answer is a lack of political will to take away one of the most popular government benefits. Few politicians have forgotten the massive protests and strikes that convulsed Paris in 1995. "By failing to react immediately," warned French President Jacques Chirac in September 1999, "we're accepting the question will be treated at the last minute by brutal increases in taxes, reduction of pension payments, or both at once."

Most experts recommend that governments adopt a "multi-pillar" approach to pension reform using a combination of the traditional pay-as-you-go state pension and so-called funded pensions, in which workers save by contributing to a retirement account. Some degree of self-funding gives incentive to work longer, and helps bolster a country's financial markets by creating a large pool of invested savings. An example of how a multi-pillar system works can be found in Hungary, where three years ago the post-communist government found it had no choice but to scrap the old system (see box).

But apart from Switzerland, which has a mandatory private pension system, Britain is the only West European country that has tried to move away from dependency on a state pension. Successive British governments, beginning with Margaret Thatcher's, have guaranteed only a minimum retirement benefit. It now stands at $430 a month, compared to $492 in France. Additional options allow people to select from an occupational state pension scheme, a pension provided at work, and a private pension plan such as an insurance policy or investment account. Overall, the average monthly pension in the U.K. stands at $850.

This means Britain is not facing the same financial crisis confronting Continental nations. Another benefit is the impact on financial markets: pension fund assets are over 75% of GDP in Britain, but a mere 6% in Germany and just 1% in Austria. Countries that encourage private pension funds tend to have more money available to finance new companies, helping expand economic growth.

In spite of the demographic and fiscal pressures facing them, for most European countries a switch to a largely private system is ruled out for ideological reasons. In France, they call state pensions "generational solidarity" and the idea is broadly popular in most other countries. When Sweden began working on pension reform, for example, privatization was never given serious consideration. Perhaps for this reason, Swedish political parties, from nearly all points of the political spectrum, were able to agree on the terms of the reform, which is being phased in over 20 years. It's probably the most far-reaching change yet implemented in Europe.

The Swedish plan increases the tax burden: to pay for it, pension contributions rose from 13% of wages to 18.5%. What is revolutionary, at least for Europe, is how those contributions will be handled. The first 16 percentage points of the pension contribution will be used to finance the existing pay-as-you-go system. But while funding stays the same as under the old system, contributions will be recorded as if they were financing an individual account of a funded pension system. This mathematical conjuring, known as a notional account, will encourage people to stay in the job longer by offering bigger pensions for each extra year of work. The rest of the contributions will be placed in an investment account for each individual, who will have more than 500 mutual funds to choose from. "We got it right, it's a very sound system," boasts Anna Hedborg, director of Sweden's national social insurance board.

Italy was an early convert to the Swedish system of notional accounts. But unlike the Swedes, the Italians adopted a very long transition period and built in a deficit to their new pension, almost ensuring a financial crisis later on. Germany has embraced the idea of putting a mandatory 2.5% of wages into individual savings accounts as the foundation of a funded system. Unlike the Swedes, the Germans haven't yet admitted that the other pension contributions will also have to rise. A pension summit of all political parties is scheduled to be held in Berlin next month to try to reach a compromise that will allow reform to get off the ground next year.

Because the real crunch is two or more decades away, it's tempting to leave the problem for another government and another day. As the Swedish example has shown, there will be pain in the transition. Yet it also shows that for the next few years a non-radical, gradual solution is still possible, one that that makes the system fairer and more transparent. But if politicians in countries like Germany and France remain too scared of voters to bite the bullet on pensions, then when the final reckoning inevitably arrives, it will be more painful — and the political fallout far worse. The time bomb is ticking louder by the day. — With reporting by Greg Burke/Rome, Bruce Crumley/ Paris and Jennie James/London