Cyrille Schwellnus
OECD Economic Surveys: Luxembourg 2025
Abstract
Luxembourg faces rising pension costs due to the retirement of large cohorts of workers, including cross-border workers, who entered the workforce from the late 1980s. By 2070, the number of pensioners is expected to more than triple, making the current system unsustainable, despite large financial reserves accumulated in recent decades. To secure the pension system for future generations while preserving competitiveness and promoting intergenerational fairness, a comprehensive reform of the pension system is needed, combining higher pension contributions, raising the effective retirement age as life expectancy increases and gradually reducing the generosity of benefits. Phasing-in over the coming years a stable contribution rate that balances the system over 50 years to match future commitments would ease the burden on future generations by allowing today’s large working-age cohorts to contribute sufficiently, while financial returns would help the pension reserve fund to grow. Increasing the required years of contributions for those with longer periods in education and linking the legal retirement age to life expectancy would help the sustainability of the pension system and encourage people to work longer as Luxembourg has one of the lowest effective retirement ages in the OECD. Reducing the generosity of pension benefits by accelerating the transition to the benefit calculations of the 2012 pension reform and limiting pension indexation to the consumer price index rather than wages would further strengthen sustainability.
Luxembourg faces rising pension expenditure over the next decades, mainly from the retirement of the large cohorts of workers – including cross-border workers – who entered the labour market from the late 1980s. The number of pensioners will more than triple over 2024-2070, with the ratio of workers to pensioners declining from about 2½ to 1 despite an expected increase of about 190 000 of the workforce (IGSS, 2024).
While there is uncertainty around such projections, it is very unlikely that the workforce could expand enough to maintain a stable support ratio of workers to pensioners: this would require an increase in employment of about 1.2 million workers over the period, which would strain infrastructure and housing. This underlines that the existing pension system is unsustainable in the long term, despite the gradual transition of the reforms agreed in 2012 and large pension reserves accumulated over the past two decades. Pension contribution rates would have to almost double between the early 2040s and 2070 to maintain the current pension system in balance. This would impose a much larger burden on people in the labour force at that point – those born after around 1990 – than older generations by reducing their net wages and would raise businesses’ labour costs, undermining investment and employment. The foreseen demographic pressures call for the implementation of a comprehensive reform to put the pension system on a sustainable footing for the long term.
Section 2 describes the current state of the pension system in terms of characteristics, outcomes, and challenges. Section 3 outlines avenues for reform of the general pension scheme that covers private and self-employed workers, but that should equally apply to the special civil servant scheme. Given that disability and survivor pensions play a negligible role in projected increases in pension costs over the next decades (IGSS, 2024), the chapter mainly focuses on early and old-age pensions.
2.2.1. Current pension rules favour early retirement
Private sector old-age pensions in Luxembourg are based on a pay-as-you-go system, in which the current cohorts of workers finance the pensions of the current cohorts of pensioners. Mandatory pension contributions are evenly split between employers, workers, and the government, with each contributing 8% of the gross wage up to a cap of 5 times the minimum wage (Table 2.1). The statutory retirement age is 65, but early retirement from age 57 is possible for workers with careers of at least 40 years. Initial pension benefits at retirement – income replacement rates – are calculated as the sum of an earnings-related part; a part related to years of insurance; and an end-of-year allowance that is proportional to years of insurance. Benefits are indexed to real wage growth and inflation, ensuring that pension benefits grow at the same rate as workers’ nominal wages. The old-age pension system of civil servants is governed by similar qualifying rules and benefits but has different financing rules. Voluntary occupational pension schemes have developed in large businesses but are less widespread than in other European countries.
The general pension scheme covers private sector workers and self-employed workers, while the special civil servant scheme covers civil servants and workers of the national railway company. Qualifying conditions, benefits and financing of the schemes are reported in Table 2.1.
2024 values
1. The end-of-year allowance will be eliminated if the total contribution rate exceeds 24%.
Source: OECD.
People with 20 years of insurance but whose benefits would be below 90% of a reference value, which is close to the minimum wage, receive a minimum pension, while people who do not qualify for a pension are covered by social assistance.
Due to the financial incentives for early retirement built into the pension system, the effective retirement age – 60 in 2022 – is the lowest in the OECD (Figure 2.1, Panel A). While workers with 40 years of social security contributions can retire at age 57, many high-qualified workers with shorter careers can retire at age 60, since non-contributory periods of study qualify as periods of social security insurance. For instance, a person with 4 years of university studies who started working at age 24 can retire at age 60 after 36 years of career. The relatively high replacement rates in the pension system also make it possible for people to retire without achieving the full entitlement and nevertheless enjoy a relatively high income by OECD standards. Financial incentives for longer careers that were introduced with the pension reform of 2012 (see below) – a “bonus” in the accrual rate for each year of social security contributions when the sum of age and contribution years is above 95 – appear to be insufficient to maintain older people in the labour market until the statutory retirement age of 65.
Pension benefits are among the most generous in the OECD, resulting in a very high relative income of older people. The future gross replacement rate for workers with average earnings and a full career from age 22 – the ratio of pension benefits to average wages over the working life – is around 75%, among the highest in the OECD (Figure 2.1, Panel B). While the replacement rates in Greece, Italy and Spain are higher, obtaining a full pension will require working until the age of 66 in Greece, 71 in Italy and 65 in Spain, as compared to 62 years in Luxembourg. Consequently, Luxembourg is among the few countries in the OECD, where the income of older people is higher than the average income of the total population (Figure 2.1. Panel C).
1. The future replacement rate is calculated for workers with average earnings and a full career from age 22.
2. Relative income of older people is defined as the average income of people above age 65 relative to the average income of the total population. Income of older people encompasses income from public transfers, employment, self-employment capital and public transfers. In Luxembourg, public transfers account for the overwhelming part of income of older people (83.1%).
Source: OECD Pensions at a Glance database; and OECD Income Distribution Database.
2.2.2. The financing of the pension system will become increasingly challenging
Rapid employment growth over the past two decades and the associated growth in social security contributions have driven large financial surpluses of the pension system, despite the low effective retirement age and high benefit levels. Significant net immigration has helped to maintain a favourable old-age dependency ratio in the resident population, while the number of non-resident cross-border workers has more than doubled since the year 2000. This has resulted in a support ratio – the ratio of contributors to pensioners – well above the EU average and a significant financial surplus over the past decades (Figure 2.2, Panel A), with total contributions consistently exceeding total benefit payments. The surpluses have been accumulated in a pension reserve fund that reached a balance of about 34% of GDP in 2023 (Figure 2.2, Panel B), with assets amounting to more than four times annual pension expenditure, well above the legal minimum of 1.5. About 90% of assets in the pension reserve fund consist of global equities and bonds, with the remainder consisting of real estate, infrastructure, and liquidities. Despite large valuation losses in 2022 due to the decline in global equity and debt markets, the fund achieved an average nominal net rate of return of 4.3% over the period 2013-22 (OECD, 2023).
Note: Total pension reserves consist of the reserves of the National Pension Insurance Fund (CNAP, 1.4% of GDP) and the Pension Reserve Fund (FDC, 33% of GDP) in 2023.
Source: European Commission (2024) Ageing Report. Economic and Budgetary Projections for the EU Member States (2022-2070); and IGSS.
The retirement of immigrant and cross-border workers, who drove rapid employment growth from the late 1980s, poses challenges for the sustainability of Luxembourg’s pension system. The support ratio of social security contributors to pensioners is projected to decline from 2.3 in 2022 to just below 1 in 2070, one of the largest declines in the European Union. This implies that workers will have to support an increasingly large number of pensioners. The sharp decline in the projected support ratio is largely due to the retirement of the large cohorts of workers that entered the labour market from the late 1980s, who will begin to retire from the late 2020s. The gradual rise in life expectancy at retirement and the absence of any indexation of the statutory retirement age to life expectancy, which will lead to an increase in the average duration of retirement, play a more modest role. The projected decline in the projected support ratio is particularly pronounced between 2030 and 2050 before gradually tapering out between 2050 and 2070, as lower projected employment growth from the 2020s translates into smaller cohorts of pensioners (IGSS, 2024).
A pension reform in 2012 to improve the long-term sustainability of the pension system introduced: a number of semi-automatic adjustment mechanisms; reduced pension generosity; and strengthened financial incentives for older workers to remain in the labour force. A first adjustment of pension parameters will be triggered when the balance between contributions and current expenditure dips into deficit. The adjustment consists of a reduction in the extent of real wage indexation, with inflation indexation being fully maintained. A second adjustment is triggered when the periodic 10-year review of the pension system by the Social Security Institute (IGSS) – that was introduced by the 2012 reform – indicates that the balance of the pension reserve fund dips below 1½ times annual benefits over the next 10 years. When this happens, the contribution rate will be adjusted upwards to ensure that the balance of the pension reserve fund remains above the legal threshold. At the same time, the end-of-year allowance will be abolished. According to analysis in IGSS (2024), the first adjustment is likely to be triggered in 2028 and the second in 2041. The 2012 reform also reduced pension generosity by gradually reducing the income-related part, while raising the part related to years of contribution over the transition period 2012-52. The 2012 reform does not envisage any increase in the statutory and early retirement ages, but foresees a gradual increase in the bonus for long careers to strengthen incentives for older workers to remain in the labour force.
2.2.3. Past reforms will be insufficient to stem the rise in pension expenditure
Recent simulations in IGSS (2024) for the European Commission 2024 Ageing Report (European Commission, 2024) suggest that the 2012 reform is insufficient to prevent a significant rise in pension expenditure. At current policies and accounting for the 2012 reform, gross pension expenditure is projected to increase from 9.4% of GDP in 2024 to 11.2% in 2040 and 17.5% in 2070. The increase over 2024-40 is among the largest projected in the European Union, with the subsequent increase over 2040-70 larger than in any other European Union country (Figure 2.3). This mainly reflects the rapid decline in the projected support ratio, as the large cohorts of workers who entered the labour market from the late 1980s retire. These simulations rely on demographic projections by Eurostat that foresee an increase in employment of about 190 000 by 2070. According to the macroeconomic assumptions underlying the European Commission 2024 Ageing Report (European Commission, 2024), labour productivity growth is projected to gradually pick up to 1.5% in 2040 (Chapter 4). While there is some degree of uncertainty underlying these long-term simulations, they do not appear overly prudent, given constraints on labour force growth from congestion and housing and the stagnation of productivity over 2010-22. Alternative long-term simulations based on a range of scenarios recently developed by the national statistical institute (Statec) suggest that even in the most optimistic economic and demographic scenario, the support ratio would broadly halve between 2022 and 2070, declining from 2.4 to 1.1 (Everard, 2024).
% of GDP
Note: The numbers in the figure refer to the baseline scenario in European Commission (2024).
Source: European Commission (2024) Ageing Report. Economic and Budgetary Projections for the EU Member States (2022-2070).
Given that the semi-automatic adjustment mechanisms and the reduction in pension generosity foreseen by the 2012 reform will be insufficient to stem the projected increase in expenditure, balancing the pension system under existing rules will require large increases in contribution rates. Significant increases in contribution rates would not occur before the first half of the 2040s, but balancing the system thereafter would require the joint pension contribution rate of workers and employers to increase from 16% to about 30% by the mid-2060s. In terms of today’s wages, applying the required increase in contribution rates to current wage levels, the joint pension contribution for a typical worker would increase from about 9000 euros today to about 17 000 euros in 2070 (Figure 2.4). Contributions would remain constant until 2041 as the pension reserve is depleted but rapidly increase thereafter. While current workers would be protected from higher pension contributions, future cohorts of workers would bear the full brunt of the increases. Moreover, higher pension contributions on this scale would have adverse effects on businesses’ competitiveness by raising their labour costs, reducing employment and further eroding the support ratio. Even though the increase in the government’s contribution to the pension system from 8% to 15% would not have any direct impact on workers’ earnings and businesses’ price competitiveness, there would be indirect effects if the government chooses to finance higher pension expenditure through higher taxes or reductions in spending in other areas.
Annual joint employer-employee pension contribution required to balance the system under the rules of 2012 reform, based on 2022 earnings (euros)
Note: The calculations are based on the baseline scenario in European Commission (2024), assuming that projected increases in gross pension expenditure will have to be matched by proportional increases in pension contributions from 2041. For instance, projected gross pension expenditure is expected to increase by about 36% between 2022 and 2050 (from 9.2% to 12.5% of GDP), requiring a 36% increase in the joint worker and employer pension contribution rate from 16% to 22%. The nominal joint employer-employee contribution in euros is obtained by multiplying projected contribution rates by 2022 annual earnings.
Source: OECD calculations based on European Commission (2024) and Statec (2024).
A new comprehensive pension reform is needed to put the pension system on a sustainable footing and to ensure an equitable distribution of the costs of reform between current workers, pensioners and future workers, while protecting low-income workers and low-income pensioners, as well as maintaining businesses’ competitiveness. Given the scale of the challenge, balancing these objectives will require a combination of reduced pension generosity, higher contributions and increases in the effective retirement age, while exempting low-income workers and low-income pensioners from some of these measures. The pace and the extent to which these pension parameters are adjusted will determine the balance of costs borne by current workers, pensioners and future workers.
2.3.1. Extending the horizon of pension reviews
The current governance of the pension system aims to balance its finances on a medium-term basis, but the 10-year horizon is too short given the long-term nature of demographic developments. In the current framework, financial balance has to be achieved over a 10-year horizon, allowing for withdrawals from the pension reserve fund if funding exceeds what is required over this period. Any upward adjustment of contribution rates is postponed until the beginning of the 10-year coverage period during which the pension reserve fund is projected to reach its legal minimum level of 1.5 times annual pension expenditure. While this framework has a longer-term horizon than many OECD pension systems that only require a balance between contributions and payments over a few years to smooth fluctuations in income, the horizon is inappropriate for Luxembourg given the rapid projected increase in pensions claims beyond the 10-year window, creating predictable pressures on the financing of the system.
Requiring the systems to balance over a 50-year horizon or longer would ensure sustainability despite unfavourable demographic developments. This would require the social partners to reach agreement on how contributions, benefits and retirement age will be adjusted. Periodic reviews of the pension system at short intervals, for instance every 5 years, as in the current setup, would ensure that pension parameters are set according to the most up-to-date demographic and economic projections. A pension scheme that balances the system over the long-term has been successfully established in Canada (Box 2.2), which by default adjusts the contribution rates to balance the system.
Instead of sharply raising contributions from the early 2040s, when the pension reserve fund is projected to reach its legal limit, a steady-state contribution rate would be set that could be maintained over the 50-year horizon. Complementary reforms, such as a gradual increase in early and statutory retirement ages, and a shorter transition to reduced pension generosity than foreseen by the 2012 reform would allow to keep a low steady-state contribution rate. Setting a steady-state contribution rate would have the added benefit of accumulating larger assets in the pension reserve fund while the support ratio remains favourable. Financial returns on these assets could further limit the steady-state contribution rate.
The Canada Pension Plan (CPP) was created in 1966, when the support ratio of pension contributors and beneficiaries was favourable. Over time, declines in the support ratio due to demographic change that were not reflected in higher pension contribution rates drove a decline in the projected long-term balance in the CPP Fund. In 1995, the Chief Actuary report projected the CPP Fund to be depleted by 2015 (Little, 2008).
In response to the report, the Canadian government agreed to a major reform to ensure the CPP’s long-term financial sustainability. Specifically, the contribution rate would be set on a steady-state basis aiming for financial balance over a period of 75 years without any recourse to further rate increases (Carroll and Barnes, 2023).
The financial balance of the CPP is assessed every three years by computing the minimum contribution rate required to finance pensions over the subsequent 75 years, accounting for demographic changes, economic conditions and investment performance of the CPP Fund (OECD, 2021).
If the calculated minimum contribution rate exceeds the current contribution rate, a political consultation between the federal and provincial finance ministers is triggered. If ministers cannot agree on an adjustment in contribution rates, benefit levels or eligibility criteria, a safety mechanism is activated, which foresees freezing the indexation of pension benefits and increasing the contribution rate by 50% of the difference between the calculated minimum contribution rate and the current contribution rate. The safety mechanism would remain in place until the subsequent three-year review of the pension system, thus preventing excessive funding pressures to build up when a political agreement cannot be reached.
Steady-state contribution rates imply that the CPP accumulates assets while the support ratio remains relatively favourable while drawing them down as the support ratio declines. At the end of 2023, the CPP Fund had accumulated assets amounting to about 20% of GDP, with an average nominal 10-year return on assets of 9.2% (CPP, 2024).
2.3.2. Transitioning to a steady-state contribution rate
Pension contribution rates would need to be raised to achieve the long-term sustainability of the system as part of a wider package. Increases in pension contribution rates raise labour costs and reduce net wages, depending on whether businesses or workers bear the cost of the increases, which could reduce Luxembourg’s attractiveness for both businesses and workers. However, the joint contribution rate of workers and employers of 16% is currently below the OECD average and those in neighbouring countries. Moreover, increases in contribution rates will be required in most neighbouring countries to maintain the financial balance of pension systems in the face of demographic change, suggesting that moderate increases in contribution rates would not necessarily harm Luxembourg’s competitive position. Simulations by the German Council of Economic Advisors (2023), for instance, suggest that under current legislation contribution rates in Germany would have to rise by 2 percentage points by 2035 and 5 percentage points by 2080 to balance the German pension system.
Mandatory pension contribution rates for old-age and survivors, 2022
Note: Sum of employer and employee pension contributions.
Source: OECD Taxing wages 2023.
While there is room to moderately raise pension contribution rates, simulations conducted for this Economic Survey suggest that without any complementary reforms to raise the legal retirement age and to contain benefits, increases in contribution rates required to balance the system may have significant adverse effects on labour costs and net wages. Under current legislation the joint contribution rate of workers and employers would rise to 30% in 2070, 14 percentage points above the current rate (Figure 2.6). Moving to a system with a steady-state contribution rate would limit the increase, resulting in a steady-state contribution rate of 22% that would be gradually phased in by 2030. However, this would still imply an increase of 6 percentage points over the current rate over a short period, with likely significant adverse effects on labour costs and net wages. However, if growth in pension expenditure were reduced, including by increasing the effective retirement age and bringing forward the transition to the replacement rates of the 2012 pension reform from 2052 to 2037, the required steady-state contribution rate could be 18%, implying a much more limited increase of two percentage points.
Joint pension contribution rate of workers and employers
Note: The scenario “Current rules” is based on the rules of the 2012 pension reform, with real wage indexation being reduced to one-quarter in 2031 (as contributions fall below expenditure in 2028, triggering a semi-automatic adjustment) and the end-of-year allowance being abolished in 2033 (as the contribution rate is raised, triggering an automatic adjustment). The scenario “Current rules + steady-state contribution rate” assumes a gradual phase-in of a steady-state contribution rate over 2027-30 that would maintain pension reserves above 1.5 times annual expenditure over the entire period 2030-70. The scenario “Reforms + steady-state contribution rate” assumes that the transition to the replacement rates of the 2012 pension reform is brought forward from 2052 to 2037; the legal retirement age is indexed to life expectancy; periods of education are excluded from the calculation of length of careers; and pensions in payment are indexed to the consumer price index rather than nominal wages.
Source: IGSS on request of OECD.
An important consideration when raising contribution rates will be to avoid adverse impacts on the take-home pay and employment prospects of low-wage workers. The higher rates required can be introduced gradually over a few years and the government should look at other opportunities to reduce the tax burden on labour (see Chapter 1). The increase could be achieved by exempting workers at or around the minimum wage from increases in contribution rates, or by reducing personal income taxes for low-income households. If employer and employee contributions were kept constant for low-income workers, the shortfall in contributions should be offset by a higher government transfer to the pension system that could be financed by higher general tax revenues.
2.3.3. Raising the effective retirement age
Raising the effective retirement age would contribute to the sustainability of the pension system and avoid even larger increases in contribution rates. The priority should be on tightening eligibility criteria for early retirement, which, apart from raising the legal minimum age, requires excluding non-contributory periods from the calculation of total insurance years. The fact that the effective retirement age at 60 is well below the statutory retirement age of 65 implies that only a small fraction of people continue to work until the statutory retirement age. Currently, people with 40 years of contributory and non-contributory periods can retire at age 60, allowing people who studied beyond the age of 20 and who can claim study periods as non-contributory periods to retire with lengths of careers well short of 40 years. For instance, a worker with an uninterrupted career who studied four years and started working at the age of 24 can currently retire at the age of 60 despite having contributed only 36 years. Eligibility for early retirement should be tightened by excluding periods of education in the calculation of length of careers. This reform would improve intra-generational equity, since the cost would mainly be borne by highly-educated workers, who typically have higher life expectancy at retirement than lower-educated workers who start their careers early. While some high-income workers may choose to stop working despite being ineligible for an early pension, fiscal savings would nonetheless be substantial, since early retirement for these workers would be financed by private savings rather than public expenditure.
Given that the effective retirement age in Luxembourg is among the lowest in the OECD, there is room to gradually raise early and statutory retirement ages. One policy option would be to link early and statutory retirement ages to life expectancy. This would improve the sustainability of the pension system, both by avoiding further increases in the length of retirement and by raising pension contributions to the extent that people work longer. Simulations by the European Commission (2024) suggest that the expenditure-containing effects of raising legal retirement ages would outweigh expenditure-increasing effects. According to these simulations, Luxembourg would be among the countries with the largest expenditure-containing effects, given that there is currently no link between the legal retirement age and life expectancy.
Early and statutory legal retirement ages should be indexed to life expectancy, which will increase by about 6 years for men and 5 years for women over 2024-70 (IGSS, 2024). A number of countries, including Finland, the Netherlands, Portugal and Sweden, have introduced a partial link between the legal retirement age and life expectancy to keep the proportions of length of careers and time spent in retirement roughly constant. Typically, this means increasing the legal retirement age by 8 months when life expectancy increases by one year, since the proportion of adult life spent in retirement is about one-third. However, reflecting Luxembourg’s low effective retirement age, the average contributory period is currently the lowest in the European Union (European Commission, 2024) and the proportion of adult life spent in retirement around 43%, well above one-third (IGSS, 2024).To increase the very low retirement age, partial indexation of the legal retirement age to life expectancy could be preceded by a one-off set of increases in legal retirement ages to bring the proportion of adult life spent in retirement closer in line with other economies. This would put a larger burden of the costs of pension reform on current rather than future workers than indexation alone. Alternatively, if a political agreement on a one-off increase in legal retirement ages cannot be reached, the authorities should introduce full indexation of legal retirement ages to life expectancy, as is, for instance, the case in Denmark, Estonia, Greece and Italy. This would contain pension expenditure by about 2% of GDP by 2070, about one-sixth of the expenditure pressure arising from the decline in the support ratio (IGSS, 2024).
Shortening the transition period of the 2012 reform would further strengthen incentives for working longer. The 2012 reform foresees a gradual reduction in the income-proportional part of old-age pensions while increasing the part proportional to length of careers. The reform also increases the bonus for long careers, which means that when the sum of age and length of career is beyond a minimum threshold, each year of contribution will receive a higher value in the calculation of the replacement rate. Cross-country studies suggest that financial incentives to work longer have a significant impact on peoples’ choices to remain in the labour force (Boersch-Supan and Coile, 2023). Shortening the transition period of the 2052 reform, for instance by phasing it in by 2037, would strengthen incentives for workers to continue working rather than retiring early, limiting the decline in the support ratio over the next two decades.
Gradual increases in the legal retirement age and stronger financial incentives for continued work beyond the early retirement age should be complemented with measures to improve the employability of older workers and to encourage employers to hire and retain them. Better employment opportunities will ensure that older workers remain in quality jobs rather than becoming unemployed when the legal retirement age is raised. Improving the employability of older workers by preventing skill obsolescence and maintaining good health will require strengthening life-long learning; recognising skills acquired throughout working lives; and improving working conditions at all ages (OECD, 2019). There is also a need to provide training and upskilling programmes tailored to older workers, including to narrow the age gap in digital skills. Employers could be encouraged to hire and retain workers by addressing discrimination on the basis of age, including by enforcing legislation to prevent age discrimination, and ensuring that age is not a criterion in determining the level of employment protection. Good practices to manage an age-diverse workforce could be promoted, for instance by networking and mentorship programmes that facilitate opportunities for older workers to mentor younger employees, leveraging their experience and expertise while fostering intergenerational collaboration. Providing flexible schedules and more opportunities for remote work would allow adjusting work requirements to older workers’ changing capacities.
2.3.4. Adjusting benefit levels
The sustainability of the pension system could be improved by adjusting benefit levels, reducing the need to raise contributions or the legal retirement age. Shortening the transition period to the new rules for calculation of pension benefits foreseen by the 2012 pension reform by 15 years (from 2052 to 2037) would postpone the date at which the pension reserve fund reaches its legal limit. The accelerated transition to the new pension parameters would not reduce expenditure pressure in the long term, but the slower drawdown of the assets in the pension reserve fund and the associated financial returns would nonetheless allow to limit the required increases in the steady-state pension contribution.
Given high levels of benefits relative to the income of workers, pensions in payment should be indexed to inflation rather than nominal wage growth. According to current rules, the indexing of pensions in payment to nominal wage growth will be suspended when pension contributions fall below expenditure, which is projected to be the case from around 2028. However, according to the 2012 pension reform, the authorities will be able to partially index pensions in payment to real wage growth on top of inflation. Most OECD countries currently index pensions in payment to inflation, without any adjustment for real wage growth (OECD, 2023). France and Italy, for instance, switched from nominal wage indexation to inflation indexation as early as the 1990s. These changes would reduce the overall value of pensions, particularly for those living for longer periods, but the effects would be mitigated by the high initial value of pensions.
Pensions spending could also be curtailed by reducing the cap on pension benefits, which would reduce expenditure without adverse social impacts. Currently, pension contributions are capped at five times the minimum wage, which is mirrored by a roughly equivalent cap on pension benefits (Table 2.1). Reducing maximum pensions while maintaining the cap on contributions at the current level would reduce net pension expenditure, while putting a larger burden of adjustment on the highest-income workers who are best able to absorb them and engage in private pension saving.
To help relieve long-term expenditure pressures, the authorities could consider also applying a sustainability factor in the indexation of pensions in payment drawing on the one introduced in Germany in 2004. The German indexation formula contains an element that reduces the indexation of pensions when the pensioners-to-contributors ratio – the inverse of the support ratio – increases (OECD, 2021). In practice, under the current formula, when the pensioners-to-contributors ratio increases by 1% – which roughly implies an increase of 1% in pension expenditure relative to contributions – the indexation is reduced by 0.25 percentage points. This means that about one-quarter of increased expenditure pressure from demographic changes is borne by current pensioners while three-quarters are borne by current and future cohorts of workers. . Introducing a sustainability factor would have the advantage that reductions in benefits would only kick in once demographic changes become effective, reducing the reliance of current adjustments in pension calculation parameters on projections of future demographic developments. The extent of the reduction in the indexation of pensions in response to increases in the pensioners-to-contributors ratio would have to account for the overall financial sustainability of the pension system and inter-generational fairness. The burden borne by current pensioners would increase with the strength of the link between the pensioners-to-contributors ratio and reduced indexation, which may require protecting low pensions by setting a floor below which pensions cannot fall in real terms.
References
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