Spain’s state pension conundrum

The upcoming start of the retirement (as of 2025) of Spain’s baby-boom generation, which arrived 12 years later than in most other EU countries, is putting the pay-as-you-go pension system under considerable strain. Reforms, which are a condition for continuing to receive Next Generation EU funds, are aimed at making the structural deficit in pensions more sustainable, but will they?

Between 1958 and 1977 close to 14 million babies were born, 2.5 million more than in the previous 20 years and 4.5 million more than in the following 20 years. While births after World War Two surged in other European countries (between 1946 and 1964), Spanish women held back in the lean decades after their country’s 1936-39 Civil War, which claimed around 500,000 lives and forced hundreds of thousands into exile.

Social Security accounts have been in the red since 2011 when they recorded a tiny deficit of 0.06% of GDP (1.36% in 2020). The recurrent budgetary imbalance saw the Social Security reserve fund decline from €66.8 billion in 2011 to €2.1 billion at the end of 2020, impacted by the Great Recession (2008-2013) and the COVID-19 pandemic.

The system’s balance has deteriorated because of the jump in contributory pension spending, which has far outpaced the growth in revenue. While contributions accounted for 10% of GDP in 2019 (the last ‘normal’ year before the pandemic), 0.4 percentage points up on 2007, the share of contributory pensions (excluding top-ups to minimum pensions) rose from 6.9% of GDP to 10.3% over the same period. Obviously, this mismatch between revenue and spending cannot go on forever without producing a crack.

The main factors behind the deterioration are the increase in the dependency ratio (the number of pensioners divided by the population aged 16-64), a key demographic measure, and the rise in the average pension/average wage ratio. The expected increase in the weight of the elderly population relative to the population of working age will prompt a substantial rise in the ratio.

The UN population division predicted in 2020 that Spain in 2050 would have the highest percentage of old people in the world: the over-65 age group would more than double to 37% of the total population. Spain’s fertility rate of 1.18 children (below replacement level) is one of the lowest in the world and average life expectancy one of the highest (see Figure 1). The life expectancy of an individual today who has reached 65 is 21 years, up from 15 years from someone of the same age in 1975, and an OECD average of 19.7 years.

Figure 1. Key indicators: Spain

Source: OECD, Pensions at a Glance 2021.

Long-term projections, particularly regarding demographics, are, however, notoriously uncertain, as projections based on the 1991 population census proved to be. These showed Spain’s population declining from 38.8 million to 35.8 million in 2026. The population today is 47.4 million, largely because of an influx of immigrants impossible to predict.

More favourable demographic scenarios cannot be ruled out, due to a higher birth rate or greater net migration. Some experts believe Spain needs an extra 6 to 7 million workers by 2040 in order to maintain the employment rate[1]. A significant improvement in the low rate (61% as against 75% in Germany and an EU average of 67%), and hence in social security contributors, would alleviate pressures on spending. But, as Bank of Spain Governor Pablo Hernández de Cos has pointed out: ‘Uncertainty acts in both directions and, therefore, demographics might even exert greater upward pressure on pension spending, as a result, for instance, of a greater-than-projected increase in life expectancy’.

Two reforms, in 2011 by the Socialist government of José Luis Zapatero and in 2013 by the Popular Party government of Mariano Rajoy, addressed the challenge. They included delaying the retirement age, increasing the period for calculating the regulatory base, introducing a sustainability factor tying the initial pension to life expectancy and approving the pension revaluation index (PRI), linking the annual increase in benefits to the system’s structural balance, with the rise not being allowed either to be below 0.25% or higher than the change in the consumer price index plus 0.5 percentage points.

Demonstrations by pensioners at the loss of purchasing power after pensions rose by the legal minimum and the refusal of the Basque Nationalist Party (PNV) to support in parliament the 2018 national budget forced the PP government to change course and re-index pensions to inflation (reaffirmed in July 2021 by the minority left-wing government of Pedro Sánchez) and defer the entry into force of the sustainability factor, subsequently scrapped.

The consequences of these decisions for future pension spending were significant. The European Commission’s 2018 ageing report estimated that the return to pension indexing and the repeal of the sustainability factor would lead to growth in pension spending of over 4 percentage points of GDP in 2050.

Pensioners (8.8 million out of a population of 47.4 million) are a considerable voter base. Striking a fair balance between, on the one hand, making a large part of pension changes fall on the retired population, which has made decisions on the basis of certain expectations of benefits and has a limited capacity for adjustment, and, on the other, making the whole weight of reforms fall on future generations is politically complex.

Pensions will rise 2.5% next year, the largest increase in the last decade. They increased 0.9% this year, making an extra payment necessary in 2022 as inflation was much higher than expected. The government also introduced financial incentives to delay retirement and penalties to those who stop working early. The government hopes to bring the effective retirement age, which is above the OECD average, into line with the legal one, which is being gradually raised to 67.

The conditions for a full pension are loose: in Spain people who have contributed for at least 37.25 years (38.5 years from 2027) can retire at age 65 with a full pension compared with 43 years in France and 45 in Germany.

Net pension replacement rates[2] will remain high (see Figure 2). The higher rate (80% of the average wage against an OECD average of 62%) is mainly the result of a relatively high initial public pension in relation to the last wage received, but it should be borne in mind that this percentage is supplemented in some European countries, such as the UK, by private pension contributions, obligatory and voluntary alike, which are much more developed than Spain’s system introduced in 1987.

Figure 2. Spain’s retirement factors

Source: OECD, Pensions at a Glance 2021

Spain’s private pension assets represented 10.5% of GDP at the end of 2020 (excluding assets in other pension vehicles estimated at 15% of GDP) compared with the UK’s more than 90%. The maximum tax-free annual contribution for individuals has gradually dropped from €12,000 to €1,500 in 2022, discouraging saving, while that for companies has risen from €8,000 to €8,500. The government justifies the reduction in the individual tax allowance because it benefits the better off more than the lower paid.

The sustainability factor is to be replaced by an intergenerational equity mechanism (IEM) which in particular includes increasing employers’ social security contribution by 0.5 percentage points, to their fury, and that of employees by 0.1 points between 2023 and 2032 in order to build up the depleted reserve fund. If this fund is viewed in 2032 as not sufficient, further measures will be taken.

Are the measures taken so far enough to restore sustainability? The Bank of Spain’s Governor told the Senate this month they are ‘insufficient’ and either more revenue or lower pension spending will be required in order to offset a social security budget hole of between 2% and 3% of GDP (€25-€37 billion) over the next decades. He also questioned the effectiveness of transferring €22 billion from the Social Security to the state budget in order to wipe out the former’s deficit as it would increase the latter’s deficit.

The Instituto Santalucía estimates the €20 billion in revenue raised by the IEM over 10 years will not be sufficient, and the mechanism gives a false idea as it transfers most of the cost to baby boomers.

Meanwhile, a survey by the bank BBVA showed that seven out of every 10 baby boomers believe they will be worse off as a pensioner than their parents are as they will have to work more years and receive a lower pension.

Demographics is the key, but governments do not have the option of waiting to see whether projections turn out to be right or not. They have to act on the information available. Pension reforms have to be taken well in advance in order to be effective. It is rather like choosing the right moment to stop a supertanker as it takes a long time because of the huge amount of momentum they build up as they sail. Most supertankers turn off their engines about 25 km away from their dock.

Only time will tell whether the government has got it right.

[1] The ratio of people employed to the population aged 16-64.

[2] The individual net pension entitlement divided by net pre‑retirement earnings, taking account of personal income taxes and social security contributions paid by workers and pensioners.