Surplus of Finnish Pension Institutions and the Commission’s Debt Calculation – What Happened?
The financing of Finland's statutory pensions is unique because part of the pension contribution is funded. In the national accounts, the surplus of Finland's pension institutions is considered in the financial balance of public entities. The surplus of pension institutions reduces the deficit of public entities. The European Commission recently changed its long-term debt calculations, and the surplus of pension institutions is no longer assumed to reduce public indebtedness. What is this all about?
Let’s start with the basics. The financing of private sector pensions works in such a way that a pension contribution is deducted from the salary. Part of this contribution is funded for pensions to be paid in the future. The rest of the contribution is used according to the pay-as-you-go principle, that is, part of the contribution is transferred directly to current pensioners as a pension. When retiring, the funded pension assets are liquidated, and part of the pension is paid with them. The remaining part of the pension is financed by the current working population.
Partial funding is rare as a method of financing statutory pensions. In addition to Finland, Canada is another country where statutory pensions are financed with partial funding.
A more common method is building up reserve funds. In this case, pension contributions are funded when the population structure is young. Later, when the population structure is older, the funds are liquidated. Funds are accumulated to avoid having to raise contributions when pension expenses grow, at least not as much. The funds help to balance the financial challenge caused by the size differences between successive generations. If the reserve fund can be grown large enough, investment returns can keep the contribution lower. In this case, the fund may not necessarily be liquidated.
Pensions in Finland’s public sector are backed up by reserve funds. Finland is not alone in this in the euro area, as Luxembourg also has a relatively large reserve fund for public pensions. Luxembourg’s fund has assets equivalent to more than four years of pension expenses. The change in the Commission’s debt calculation also affected Luxembourg.
What changed?
In recent weeks there has been a debate in Finland about a change in the European Commission’s long-term calculations of Finland’s debt ratio.
The Commission assesses long-term debt development based on the public sector deficit. Previously, in the Commission’s calculations, the surplus of pension institutions according to national accounts has reduced the amount of public debt in the long term. The assumption in the calculations was that the accumulated surplus would reduce public debt in the long term. However, this is not the case because the surplus of pension institutions is not used to pay off public debt. Instead, their role is to cover future pension liabilities.
The surplus is no longer considered to reduce public debt. The idea is that when the deficit calculation no longer includes factors that do not affect public debt, the debt ratio will develop more realistically in the long term.
What is the accounting surplus of pension institutions?
According to the latest forecast by the Ministry of Finance Finland, the surplus of pension institutions is about 1 per cent relative to GDP. It’s good to explain what this means. If pensions were financed through a pay-as-you-go system, no accounting surplus would be formed. Every year, pension contributions would be collected just enough to cover pension expenses. However, as mentioned before, Finnish private sector pensions are partly funded.
To put it simply, in the national accounts, the surplus of pension institutions is calculated as follows: the surplus is the sum of pension contribution income and fund capital income (about 2/3 is interest and income from dividends) minus pension expenses and costs. In the future, this accounting surplus will no longer be considered to reduce debt in the long run.
The surplus of the pension institutions in the national accounts is not fundamentally a real surplus from the perspective of pension financing. In the private sector, the liability for the funded part of the pension is paid with contributions and the returns obtained from them. In other words, investments yield returns, but the liabilities also grow over time. The surplus is used to finance future pension expenditure.
The interpretation is the same for public sector reserve funds, even though their financing method differs a bit from the private sector. The reserve funds will be used to pay pensions in the future and will not be used to finance other expenses, such as public debt.
The Commission and the Ministry of Finance Finland find that, when the surplus of pension institutions is removed from long-term debt calculations, the development of public debt is more realistic than in a calculation where the surplus would have been included.
Despite all the above, it’s clear that the existing funds will strengthen the financing of pensions in the future.
