Economic Survey of Norway 2005: Long term sustainability of the pension and welfare system

 

The following OECD assessment and recommendations summarise Chapter 3 of the Economic Survey of Norway 2005 published on 8 August 2005.

Are welfare programmes blunting the incentives to work?

Norwegians live comparatively long and healthy lives; the official retirement age for men and women is, at 67, above the OECD norm; and participation rates are very high at all ages for both sexes. Over their working lives, Norwegian citizens probably furnish on average at least as much work effort as the average OECD citizen.  But on a typical working day, a well above average number of those of working age are on sick leave or claiming a disability pension, and around half of those over 62 have withdrawn from the labour force, often benefiting from subsidised early retirement on the AFP scheme. Trends in early retirement, disability, and, (until very recently) sick leave, have been strongly upwards and levels are very high by international comparison. The cost to society of these schemes is also very high in terms of lost output. New policies, or strengthened policies, are needed to arrest these upward trends in non-activity, and if possible reverse them. In addition, recent proposals that would shorten the standard working week, or make the labour market less flexible, should be resisted.

Number of sickness days per employee and unemployment in Norway

1. Dotted line corresponds to interpolated years which are 1985 and 1986.

Source: Ministry of Labour and Social Affairs, OECD Analytical Database.

Analysis show that the economic incentives to reduce or curtail work effort through these schemes are substantial: eligibility criteria are not strict, replacement rates are high, and the impact on eventual public pension benefits of leaving the workforce to profit from one or other of these schemes can be quite small. It is revealing that a recent reform, by which doctors must assess capacity to work within 8 weeks on sick leave, was accompanied by a dramatic fall in total sick leave. This suggests that gate-keeping as well as economic incentives and health status are important drivers in this area, and probably also in the area of disability pensions.  A reform of the disability pension scheme, splitting it into a permanent scheme and a temporary one entailing rehabilitation has not so far had much impact on either inflows into disability, or outflows into work. Indeed, there has been a marked inflow of younger workers into temporary disability. If the results continue to disappoint, then more effort should be given to assessing work capacity at an early stage, and encouraging a timely return to the workplace, as work skills erode after prolonged absence. In the pension reform, incentives to move into disability rather than a flexible early retirement scheme should be removed, by adapting the disability scheme accordingly.

Inactivity because of illness or disability in selected OECD countries

In 2003, as a percentage of population in each age group

Source: OECD estimates based on labour force surveys.

The AFP scheme covering early retirement is a private agreement between employers and representatives of employees, financed entirely by the employer in the public sector, entirely by the employer before the age of 64 in the private sector, and 60/40 by employers and the government after that age. The scheme was introduced in 1989 in the private sector with the laudable aim of providing a decent retirement income as from age 65 for people who had left school comparatively young, and who had worked ever since, often in arduous jobs, and whose life expectancy at 65 was probably lower than the average. Over the years, though, its coverage has greatly expanded, and age at entry to the scheme is now down to 62 years. Around three-quarters of older workers now qualify for AFP pensions, and a large proportion of those who do qualify actually claim them.  A particularity of the AFP is that entry to it has almost no impact on the size of the eventual public old-age pension at age 67. The average age at retirement has thus dropped precipitously, reducing output and tax revenues, and raising public spending. The government should therefore curtail the inflow into such schemes by reducing its subsidies, and ensure that they are targeted at those groups for which they were originally intended.

Average effective retirement age in Norway(1)
 

1. Average age of withdrawal from the labour force for individuals older than 40 based on changes in participation rates by five-year age cohorts over five-year intervals.
Source: OECD (2004b).

How important is pension reform?

The current Norwegian public pension system is still maturing, and together with the very high participation rates this means that most Norwegians will be able to claim full pensions, that are indexed to wages and are taxed favourably. With life expectancy continuously increasing, spending could more than double as a percentage of mainland GDP by 2050 if a reform is not carried out.  Public sector occupational pension schemes for central government employees (including teachers and some other groups) are unfunded and will also entail a significant rise in the future public spending burden, especially as the expansion of public sector employment is relatively recent.

Broad agreement was reached in the Norwegian Parliament on the proposed pension reforms in May 2005, but important elements are still under discussion. The Parliament supported the introduction of a benefit adjustment factor to account for changes in life expectancies at age of retirement. A minimum pension would be paid to those who had earned low incomes or with less than complete work histories, and there would be an effective ceiling on benefits for high earners. Benefits would be indexed to the average of wages and prices. It is officially estimated that the impact of less favourable indexation treatment, the benefit adjustment factor and the positive impact on labour supply of older workers of actuarial fairness would lead to savings of around 3% of GDP in public spending over the next few decades. However, these effects depend on the final design of the flexible retirement scheme and the link between pension earnings and pension benefits.

The government was asked to submit new proposals incorporating a stronger redistribution element, which would weaken the link between lifetime earnings, and pension benefits, and hence also weaken work incentives. The government was also asked to submit an alternative proposal favouring early retirement. It is very important that the authorities pursue a reform that strengthens work incentives and thus helps to ensure the sustainability of the scheme. Consideration should be given to a more direct and transparent linkage between actual contributions and actual benefits for those between the pension floor and ceiling whatever their age at retirement. The period of transition to the reformed system should be kept short.

To top up NIS pension benefits many larger companies operate funded occupational pension schemes for their employees, mostly of the defined benefit type. They attract favourable tax treatment provided that the benefits cannot be claimed before 67 years. The schemes cover about one third of private-sector employees, they are firm-specific, and portability between different firms is complex.  There is no portability into, or from, the public-sector pay-as-you-go (central administration) or funded (local government) occupational pension schemes which cover all employees there. Combined with the AFP scheme, the public-sector occupational schemes guarantee gross replacement of at least two-thirds of final pay at age 65. The 2004 White Paper proposed mandatory occupational pensions for all in the private sector, starting as early as January 2006, and coherence between the provisions of the public-sector schemes and the reformed NIS old-age pension system. Because many complex issues of creating new schemes in the private sector remain to be resolved, and because operating such schemes may be very costly for small companies if introduced suddenly, their introduction on a mandatory basis should be phased in gradually. Rules allowing portability of occupational pensions between the public and private sectors should be considered, and the two-thirds guarantee in the public sector phased out over time.

How can long-run fiscal sustainability be assured?

The oil wealth and the sensible proposals for pension reform should not be allowed to obscure the basic fact that neither the one nor the other, nor even both in combination, will obviate the need for hard choices for public spending in the years to come. The latest OECD estimates suggest that total old-age-related public spending (on both pensions and health) could rise by around 13 percentage points of GDP over the next few decades, assuming that the pension reform proposals are accepted as they stand and that they have their officially-estimated impact.  Most of the increase would still be on public pensions, and it would come about as a result of demographic developments and because the system is still maturing, not because its generosity is excessive. Indeed, if the old-age pension "accounts" were separated out from the general budget, they would certainly show that the system would be in surplus at present at a notional contribution rate of 17½ per cent of salaries, as proposed in the reform package. Spending of oil revenue is currently about 5% of mainland GDP and it could rise to 7-8% at its peak given adherence to the fiscal rule, and gradually shrinking thereafter. Even with an early return to the strict fiscal rule, it is clear that rising oil-related fiscal revenues would be quite insufficient to finance such foreseeable spending increases. Spending the capital of the Fund to close the gap would merely pass on the problem in magnified form to the children of the current working generation.

Accrued pension liabilities and the Pension Fund
% of mainland GDP

 

Source: Ministry of Finance.

The inevitable conclusion is that there will have to be substantial public spending cuts relative to GDP in other areas and/or a rise in the tax burden. Spending cuts and/or tax increases should preferably be designed to encourage work effort. It would be as well to prepare suitable measures while income from oil-related activities remains high, so that they can be phased in gradually, reducing pressure on the exchange rate during a period when the economy is still likely to be prospering. This would guard against the need to take disruptive measures at a later stage that would threaten the sustained growth of national income.

Return to the Economic Survey of Norway 2005 homepage

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A printer-friendly Policy Brief (pdf format) can also be downloaded. It contains the OECD assessment and recommendations, but not all of the charts included on the above pages.

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