Pensions and the European debt crisis

1. PENSIONS AND THE EUROPEAN DEBT CRISIS
Jacob Vijverberg, Multi-Asset Investment Group, AEGON Asset Management
The present debt crisis in Europe requires not only actions by individual
states but also a sustainable long-term European solution. One-off
national and multinational solutions need to be embedded in a more
transparent and disciplined approach to national debt in Europe; one that
better takes into account the costs of ageing and the bold policy reforms
undertaken by member states. In this article, we identify four scenarios for
resolving the debt crisis and how these may affect pensions.
Key points
The debt crisis poses a substantial risk to both funded and unfunded pension systems
Implicit liabilities like pension systems should also be taken into account
European politicians need to take actions in order to restore confidence and contain the
debt crisis
Structural reforms are needed and budget deficits will have to be reduced.
Sowing the seeds of crisis
Like many financial crises, the seeds for the current debt crisis in Europe were sown years ago.
There are two primary underlying causes for the current crisis. The first was the steady build-up of
excessive national debts across Europe. Although the European Stability and Growth Pact was
intended to keep this debt below a critical level within the euro zone, the limit on budget deficits was
effectively ignored, as a number of countries, including Germany and France, were allowed to
continue to breach the limits. The second underlying reason for the crisis was that labour costs rose
much more quickly than productivity in many southern European countries. This resulted in unit
labour costs that exceeded those in northern Europe, making it very difficult to compete. 1
Underlying the present crisis is an additional factor that will continue to present a structural challenge
long after the present problems recede: the progressive ageing of European society. Not only is
Europe faced with a mountain of debt but there will be fewer workers both to pay off the debt and to
support ever more pensioners. Attempts at European level to reform the Stability and Growth Pact
have therefore also tried to reveal the hidden costs of ageing and to move towards reforming policies
in a way that will take account of future demographic changes. It is clear that the present debt crisis
has and will have a significant impact on pensions – but it is also the case that pensions themselves
are playing a significant but less visible role in the present debt crisis.
1
High unit labour costs are not to be confused with stand-alone productivity. The popular press often mentions that these
countries are much less productive than their counterparts in the North and that these therefore can’t coexist in one currency
union. This is not necessarily the case. Countries can be less productive in the same currency union as long as their labour
costs are equally depressed.
1 June 2010

2. A brief history of the European Debt Crisis
1. Oct 2008: Banking crisis in Iceland.
2. Oct 2008: IMF supported Hungary as foreigners retreated en masse from government securities,
prompting liquidity pressures. Foreign exchange household loans added to vulnerability.
3. July 2009: Hungary raised €1 bn in Florint bonds which was sufficient to cover financing needs.
4. Oct 2009: Greece revised its budget deficit to 12.5 percent of GDP from 3.7 percent. Financial
markets lost confidence in Greece.
5. May 2010: Euro zone finance ministers and the International Monetary Fund (IMF) agreed on aid
package for Greece worth €110 billion over three years.
6. May 2010: In a bid to prop up other financially ailing member states, the EU finance ministers and
the IMF agreed a provisional safety net worth €750 billion to be in effect until 2013.
7. November 2010: Ireland asked for EU assistance. Under the safety net, the EU finance ministers
agreed a bailout package with the IMF worth more than €85 billion over three years.
8. March 2011: The European Council gave the green light to a permanent stability mechanism (ESM).
Designed to take effect as of mid-2013, the fund will be worth €700 billion.
9. April 2011: Portugal asked the EU for financial assistance.
10. June 2011: Greek parliament approved austerity measures despite large scale street protest.
11. July 2011: EU decided to implement a package of measures to assist Greece and calm markets
about contagion risks after Spain and Italy had come under pressure.
12. August 2011: Spreads on Spanish and Italian bonds widened dramatically as the market lost
confidence in debt sustainability. The ECB decided to buy Spanish and Italian bonds to prevent a
new crisis.
Turbulent times
The first euro zone country to experience severe financial difficulty was Greece in October 2009,
after it admitted reporting erroneous debt and deficit figures. Greece received a bailout package
from the IMF and the EU in the spring of 2010. Meanwhile, Ireland was experiencing a major
housing bust. As Irish banks were forced to write off huge sums, several became insolvent. The Irish
government recapitalised the banks, which is estimated as having cost almost 60% of Irish GDP.
Ireland’s debt-to-GDP ratio shot up, forcing Ireland to accept an emergency package from the IMF
and the EU in November 2010. Irish pension funds also suffered, as the Irish government introduced
an annual pension levy of 0.6% of assets.
2 September 2011

3. Portugal was the next in line for a bailout, in April 2011. Portugal’s unit labour costs had risen quickly
following the adoption of the euro. Structural inefficiencies were not addressed and the country was
running large current account deficits. Following the bailout of Portugal, by the summer of 2011,
markets shifted their attention to Spain and Italy – both in Southern Europe but with quite different
debt dynamics (see also Figure 1).
Italy has a higher debt to GDP ratio, but a lower budget deficit than Portugal. Spain has a higher
budget deficit, but a lower debt level. These two countries are also struggling with more specific
problems. Spain is in the process of reforming its local savings banks, the Cajas, which suffered
large losses in the housing crash of 2008. Italy on the other hand has structurally uncompetitive
southern provinces and the current political landscape makes it difficult to implement reforms.
Investors, however, are not only concerned about the debt figures, but also about the ability and will
of politicians – and populations – to implement reforms.
Figure 1: Debt statistics for a sample of European countries
Europe intervenes
The present debt crisis does not respect the niceties of the EU legislative timetable and Europe is
implementing a range of immediate measures to contain it. In July 2011, interest rates were lowered
and maturities extended on loans from the European Financial Stability Facility (EFSF). This fund is
now also able to recapitalise struggling banks and to buy back debt on financial markets, provided
that this is ratified by all member parliaments. Financial markets initially reacted favourably, but in
August spreads started to increase rapidly again. The US was downgraded by S&P in the same
week, worsening the negative sentiment. The ECB began buying Spanish and Italian bonds in order
to prevent the crisis from spreading.
Ideally, this action should have been taken by the EFSF, but the EFSF was not yet ratified by all
member parliaments. However, the bond purchases put the ECB in a vulnerable position, as it
cannot exert political pressure to force countries to implement austerity measures. The ECB is
currently trying to neutralise its purchases by issuing short term bills. If it were not do so, it would
effectively end up monetising government debt, which could be inflationary. Several European
3 September 2011

4. countries, including France and Italy, are now trying to balance their budgets sooner than previously
planned.
In August, Angela Merkel and Nicholas Sarkozy agreed that they would propose the formation of a
European economic government. The exact details are still unclear (as is how it will affect the
current package of reforms proposed last September.) However, both sets of proposals would
involve an increase in multilateral authority over national budgets. They also agreed to include a
clause in all constitutions obliging countries to balance their budgets. These actions were not well
received by investors, who were hoping for a more immediate solution.
Hidden debt – sustainable pensions and Europe’s Stability and Growth Pact
Europe’s Stability and Growth Pact is a collection of different measures, only some of which are
legally binding. Applying to both the euro and non-euro zones, these measures were intended to
provide a macroeconomic framework to reinforce Europe’s internal market policies. Sovereignty –
fiscal, social and otherwise – makes greater European coordination in this area extremely difficult. In
addition a lack of transparency and the lack of a common European methodology for costing
pension systems make it hard to account for the true costs of Europe’s ageing populations. The risk
is that, as the current crisis recedes, problems with the sustainability and adequacy of Europe’s
pension systems will not only continue to grow but may continue to do so largely unseen. Europe’s
pensions systems are, in fact, a largely concealed component of the debt crisis, whose full scale and
nature has yet to be made apparent.
The European Commission has tried to draw attention to the fiscal sustainability of Europe’s pension
systems in its Pensions Green Paper of 2010 and other initiatives, including the reform of the
Stability and Growth Pact. The discussion covers not only issues around state pay-as-you-go
systems but also the implicit costs of ageing that may arise if, for example, workplace or private
pensions systems fail to deliver according to expectations. The Commission’s proposals to improve
sustainability are likely to feature in its Pension White Paper later this year. Progress is not likely to
be rapid, however, as this is an area where each Member State can exercise its national veto.
Furthermore, revealing the true state of national pension systems may also provide difficult reading
for a number of EU countries who are currently not bearing the brunt of the current debt crisis.
The potential impact of pensions is highlighted by the experiences and actions of several of the
Central and Eastern European countries (CEECs). Many CEECs formed a special case under the
Stability and Growth Pact. When they joined the EU, their pension systems were undergoing
profound reform, moving away from a primary dependence on pay-as-you-go systems towards
privately managed, mandatory-funded defined contribution systems. The CEECs tried to build these
systems up very quickly by diverting part of the payroll tax away from the pay-as-you-go systems to
finance their new, funded systems. The premise behind this approach was that the resulting ‘double
payment problem’ would be tolerable as long as there was sustained, significant economic growth.2
However, the crisis revealed this expectation to be over-optimistic and a special provision in the
2
"The scale of fiscal deterioration following the crisis is equivalent to offsetting 20 years of fiscal consolidation, implying that
fiscal constraints will be very strong in the next decade. Estimates suggest that the crisis will put further pressure on public
pension spending over the long-term because economic growth is set to be considerably lower and there is great uncertainty
as to the timing of the full recovery.[...] In a number of Member States some social security contributions were diverted to
newly established mandatory funded pensions. The crisis has underscored this double payment problem and has caused a
few governments to halt or lower contributions to private pensions to improve public pension finances." European
Commission: "Green Paper - towards adequate, sustainable and safe European pension systems", COM(2010)365, 7
July 2010.
4 September 2011

5. Stability and Growth Pact to allow them a five-year breathing space proved inadequate. The reforms
were also dogged by other issues, varying across the CEECs from the existence of special
privileged pension plans for certain economic sectors that enjoyed political influence, the misuse of
disability schemes to facilitate early retirement, the behaviour of certain sector providers and a
failure to collect the appropriate level of contributions.
The European Commission’s proposals3 to reform the Stability and Growth Pact early in 2010 may
have been little-noticed by the European public (and been overwhelmed by events), but its call to
reinforce Europe’s system of economic governance seems now to have been taken up by some
European politicians. In its call for reform, the Commission not only pointed to the need to cover the
costs of bailing out the financial sector but for debt to better reflect ‘implicit liabilities, notably related
to ageing’4 and it proposed a more qualitative, forward-looking approach to assessing debt that
would also take into account the likely effects of policy reforms. This not only included the effects of
systemic pension reform but also reversals of these reforms.5 The reform package launched in
September 2010 is still working its way through the EU institutions and is not due to come into effect
until 2013.
Reducing the European debt burden
To resolve the debt crisis, both short and long-term measures will need to be taken. In the long run,
indebted countries simply have to reduce their burden of debt. In order to be able to do this, they will
need to run primary budget surpluses6 and preferably also to expand their economies.
Currently, several European countries are still a long way removed from a primary budget surplus.
They will therefore have to reduce spending, increase taxes and implement reforms. These reforms
can be summarised into three general categories. First, countries will need to reduce their unit
labour costs in order to regain competitiveness. This can be achieved by increasing productivity or
by decreasing labour costs. Secondly, many countries are struggling with an ageing population and
rising healthcare costs. Increasing both the effective as well as the statutory retirement ages would
extend the contributing lives of the workforce. Reducing statutory retirement benefits may greatly
enhance debt sustainability but the political (and social) impact places limits on this. It is therefore
necessary to ensure that people understand the need to save for their retirement and that
appropriate and reliable information is available so that they will be able to put sufficient money
aside. There is also a need for greater efficiency in addressing the costs of medical and long-term
care as an ageing population will demand more and costlier treatments. Thirdly, corruption and tax
evasion should be addressed. This differs greatly for the various countries.
In the short term, countries will not be able to reduce their deficits immediately. They will thus have
to continue to finance their current budget deficits and refinance maturing debt. The ability to do this
depends on the trust of the markets, and countries need to win this trust by demonstrating that they
are serious about reform.
3
EU Commission: "Reinforcing economic policy coordination", COM(2010) 250, 12 May 2010.
4
EU Commission: "Enhancing economic policy coordination for stability, growth and jobs – Tools for stronger EU
economic governance", COM(2010) 367/2, 30 June 2010.
5
European Commission: "Propoosal for a Council Directive on requirements for budgetary frameworks of the
Member States", COM(2010) 523, 29 September 2010.
6
A primary budget balance is the budget balance excluding interest payments on debt.
5 September 2011

6. Finding a durable European solution
In addition to the actions that individual countries need to take, it is clear that there is a European
dimension to the debt crisis which requires a durable European solution. One-off national solutions
or multinational solutions such as Euro-bonds need to rest on a more transparent and disciplined
approach to national debt in Europe, one which better takes into account the costs of ageing and
bold policy reforms undertaken by member states.
With regard to pensions in particular, profound and extremely sensitive issues of fiscal and social
sovereignty also need to be addressed. The current reform of the Stability and Growth Pact seems
to have escaped wider public attention, with press reports focussing on political positioning around
short-term responses to the crisis. The upcoming Pensions White Paper may be an opportunity for a
wider European discussion of the steps needed but real discussion about ensuring the fiscal
sustainability of our pension systems may demand thinking the unthinkable: a more European
approach to social and labour policy, at least for the euro zone countries.
The European Commission refers to introducing greater ‘conditionality’ in the award of European
support to individual countries. For example, there are also pension reform clauses in bailout
agreements to individual countries. If this is already possible under current arrangements, can
European countries take the next step towards a more multilateral approach to how they pay for their
pension systems in order to avoid cross-border pension bailouts?
European solutions need not only be about enforcing fiscal discipline and cutting back on benefits. If
we can realize an internal market in pension provision, we have the potential to increase efficiency
and to make pension contributions go further. This needs to consider workplace and non-workplace
pension provision and, in our cross-border reflections, ultimately we need to think about increasingly
mobile pensioners as well as mobile workers.
Four scenarios for resolving the debt crisis
The resolution of the European debt crisis depends on two variables: first, market confidence needs
to be regained in the short term and, second, structural reforms must be implemented in the long
term (see Figure 2). Without market confidence, countries will not be able to finance themselves.
Without wide-ranging reforms, the debt crisis will resurface in the future when debt dynamics will be
even harder to fix.
If we look at how the debt crisis may be resolved, we identify four different scenarios. Of the four
scenarios, the worst-case scenario would be if Spain and Italy were to default. This could happen if
either of these countries is unable to implement reforms or if the EU is unable to restore confidence.
Renewed market panic would damage consumer and business confidence. The Spanish and Italian
economies would fall back into recession after which their debt burden could become
unmanageable, as GDP would contract and deficits grow. Eventually this would lead to a
restructuring of their debt. The result would be a major banking crisis as many European banks hold
significant amounts of Spanish and Italian debt. This could spark a depression and a break-up of the
euro.
6 September 2011

7. Figure 2: Resolving the European debt crisis
Alternatively, the ECB could decide to monetise government debt, leading to high inflation and a
decline in the euro. This would also probably spark a recession. It is unclear whether this would be
preferable to the break-up and default scenario. Another potential scenario would be that politicians
implement credible structural reforms, but investor confidence is not restored. This could happen if
there were uncertainty about whether measures would be implemented or if the EFSF proved
incapable of dealing with a short-term market panic. In this scenario, spreads would rapidly rise;
consumer and business confidence would drop, triggering a new recession and making it more
difficult to implement structural reforms. A default of several indebted countries and a recession in
Europe would be a real possibility.
A more optimistic scenario would be if politicians were able to restore confidence, by expanding the
EFSF, for example. However, if this isn’t accompanied by the implementation of longer-term
structural reforms, debt sustainability would be unlikely to improve. In the short run, spreads could
decline as the immediate default risk recedes. In the longer term, however, debts would rise as
competitiveness and government budgets failed to improve. Eventually the debt crisis would
resurface, after which it would prove even harder to avoid sovereign defaults.
The most positive scenario would be a rapid return to growth. For this, confidence needs to be
restored and spreads to decline. Structural reforms will be required to increase GDP growth. With
increasing tax revenues, all major European economies would be able to reduce their debt-to-GDP.
The implication for public and private pensions
Looking at the outcomes of the four different scenarios above, the question is how these will affect
pensions – not only the market impact on the value of pension assets, but also the impact on
pension liabilities. In addition, how may possible government actions affect pension funds?
Looking at the worst-case scenario, pension funds would be affected in every possible way.
Declining markets would affect pension assets decline, and high inflation will affect pension
liabilities. There is also the danger that governments will move to tax or otherwise to use pension
assets to reduce their debts. In the two, sub-optimal scenarios, pension funds would also be
affected, although less severely. Pension assets would probably perform below long-term growth
7 September 2011

8. rates if no structural reforms are undertaken, and interest rates would remain depressed, resulting in
an increase in the remaining high nominal liabilities. Inflation would remain low as the economies
perform below their growth potential, meaning that real liabilities would also not increase. However,
granting indexation (where this is optional) would be difficult.
If we look at an average or base-case scenario, the impact on pensions would be lightly positive. In
this case, politicians would implement austerity measures to reduce their deficits. Any indication that
the measures are insufficient would be penalised by higher spreads. These would serve as the main
mechanism to enforce budget disciple and would also trigger pressures on the respective
government by the EU and the ECB. It would however remain a balancing act, as renewed panic on
the financial markets might be self-fulfilling. A solution would need to be found for Greece, and
further restructuring of their debt seems inevitable. Structural reforms would be a key driver for any
future growth and the recovery would in any case be slow, as government expenditure would
continue to decline. The main economies would be able to start reducing debt by 2014.
For pension funds, this base-case scenario would restore long-term growth perspectives. Interest
rates would probably remain low, keeping nominal liabilities high and leading to slowly improving
funding ratios. Inflation might increase due to monetary financing but probably not strongly, as the
European economy would still be operating in a low growth mode. This would mean that real
liabilities would increase slowly, making it difficult for pension funds to grant indexation.
However, the current crisis has made it clear that expectations about entitlements from our current
pension systems, whether funded or unfunded, are unrealistic.7 The decline in interest rates has
further reduced the funding levels of pension funds, which were already hit by losses on
investments. Those that can may well be forced to consider reducing liabilities by forgoing indexation
or reducing benefit payments directly.
The positive scenario would clearly provide the best outcome for pension funds. Pension assets
would grow and interest rates rise, resulting in lower nominal liabilities and improving funding ratios.
This would enable pension funds to provide indexation, which would probably be required as
inflation would also gradually increase.
Enabling reforms – the importance of transparency
Increased transparency about our pension systems is a precondition for meaningful public debate
and public acceptance of reform. Although over-generous state pay-as-you-go systems may look to
be the culprits from a fiscal perspective, private funded systems, whether occupational or individual,
are by no means completely future-proof. Transparency in pensions includes making clear to people
the differences between the different providers and the pension promises on offer. To do this, the
solution at European level is to ensure that prudential frameworks are capable of revealing the
similarities and differences between the variety of funded pensions on offer, as well as to encourage
an economic, risk-based approach to delivering pensions.
A reformed prudential framework for pension provision at European level should also support the
efficiencies of scale associated with a real internal market in pensions. A more efficient internal
market in pension provision could play an important role in addressing Europe’s ‘demographic time
bomb.’ In any case, transparency will enable all parties to gain a clearer view of our pension
entitlements for the future.
7
The future of public debt: prospects and implications, BIS working paper.
8 September 2011