Italy: Doomed to Work?


The phrase comes from Morgan Stanley's Vicenzo Gizzo, not from me. Here he gives the first part of an extremely informative breakdown and analysis of the Italian pensions reform.

On October 3, the Italian government passed a draft for the reform of the pension system. This document will now be submitted to Parliament and amend a previous proposal that had been sitting in the Senate for months. We believe this is the most serious structural reform effort in several years. The unions have called a half-day general strike for October 24, but the chances of the reform succeeding are high, in our view...........

The new reform implies a two-stage process. In the first stage, from 2004 until 2007, the employees who intend to stay at work for longer, beyond the age of 57, will obtain a 32.7% tax-free bonus, equivalent to the standard social contribution rate currently paid by employers and employees. The beneficiaries will have the option of cashing in the bonus, depositing it in their social security accounts, or channelling it into private schemes. In a second stage, from 2008 onwards, the number of years that will give access to seniority pensions will be raised from 35 to 40. Up to the year 2015, pensions for those employees who still want to retire after 35 years of contribution will be heavily penalized.

This is not the first attempt to reform Italy’s generous pension system. It is probably worth reminding our readers that up until the early nineties Italian civil servants could retire with 20 years of contributions and receive a pension equivalent to the compensation of their last year at work. Two major restructuring efforts were delivered during the Nineties. In 1992, Giuliano Amato raised the legal retirement age from 60 to 65 for men and from 55 to 60 for women. That reform lengthened the reference period on which benefits were computed from five to ten years, raised the minimum number of years of contribution to 35, reduced the disparities between private and public sector employees, and replaced wage with consumer price indexation mechanisms. A second significant step was taken by Lamberto Dini in 1995. That reform linked pension benefits to a stream of work-life contributions rather than a reference compensation period.

The impact of the two reforms is clear. Data from the Department of Welfare (Nucleo di Valutazione della Spesa Previdenziale, Gli Andamenti Finanziari del Sistema Pensionistico Obbligatorio, June 2002) show that the annual growth rate of pension spending came down from 12.2% in 1990-92 to 7.3% in 1993-97, and dropped further to 3.4% in 1998-2001. Yet over the same period, pension spending rose in nominal terms from around €70 billion in 1989 to nearly €160 billion in 2001, i.e., from around 11.5% to almost 14% of GDP, at an annual average growth rate of 7.3%. Today, at 13.8%, Italy still shows one of the highest pension expenditure-to-GDP ratios among the industrial countries. The transition from defined benefits to defined contributions took place in an extremely gradual fashion. The defined-contribution system was fully effective only for the new entrants into the labour market in 1996. It was applied on a proportional basis, pro-rata, for those who had been at work for less than 18 years. In contrast, the reform kept the status quo for those who had worked for more than 18 years. It will take until the year 2035 for Italy to shift to a full defined-contribution system.

The baseline scenario assumes an increase in life expectancy of around five years from here until 2050, a slight rise in the fertility rate from the current 1.3 to just above 1.4, and net immigration inflows of around 120,000 a year. The model rests on an eight-percentage-point rise in the activity rate to 72% mainly on a higher female participation rate and a five point drop in the unemployment rate to 4.5% by the end of the reference period. This progress limits the drop in the employment rate to only 14 percentage points over the next 50 years, or 0.25% a year, despite a 28% fall in the working age population. A strong productivity growth rate of 1.7% keeps real GDP on track for an average growth rate of 1.5%. While labour force participation has gone up in the recent past at a pace of more than one-half a percentage point a year, this progress has led to a marked deceleration in productivity growth rates. The combination of higher participation rates and strong productivity, as implied by the RGS model, is an aggressive assumption, in our view, and may hide risks of an even more unpleasant spending dynamic.

Yet, even under such favorable assumptions, the pension expenditure-to-GDP ratio, after some initial stability, goes up rapidly from the current 13.8% to a peak of 16% around 2035 before easing back to 13.6% in 2050. The ratio of pension expenditure to GDP could be conveniently decomposed into the product of a ‘legal-institutional ratio’, given by the average pension to the productivity per employee; and a ‘demographic ratio’, given by the number of pensions to the number of employees. This second ratio could be further broken down into (1) a dependency ratio -- the over-65 population to the working-age population, aged 20-65; (2) an eligibility ratio -- the number of pensions to the over-65 population; and (3) the inverse of the participation rate, which we label here the employment ratio.

In the 2006-15 decade, the dynamic in pension expenditure to GDP is likely to be almost entirely driven by demographics, as the baby-boom generation kicks in. Note that benefits paid during this period are still mainly linked to average earnings, due to the long transition phase imposed by the Dini reform. In other words, expenditure goes up with the number of pensions, while the average pension fails to decelerate quickly enough to offset the boom in retirements. When we move towards the middle of the forecasting period, pension schemes become less expensive as a larger number of employees whose pension is computed on defined contribution retires. This trend extends well into the final part of the reference period when it is also coupled with end of the impact of the baby boomers.
Source: Vincenzo Guzzo, Morgan Stanley Global Economic Forum
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