The Italian pension system: reforms and the change
in the future composition of pension income
Zeno Mayr
MSc Finance Thesis
Supervisor
Anders Grosen
Department of Business Studies
Aarhus School of Business and Social Sciences,
Aarhus University
January 2013
CONTENTS
Contents
List of Figures
List of Tables
1. Introduction ................................................................................................ 1
1.1
Problem statement ................................................................................ 2
1.2
Structure................................................................................................ 3
2. The Pension System .................................................................................. 4
2.1
Functions of pension systems ............................................................... 4
2.2
Types of pension systems ..................................................................... 5
2.2.1
Organization and Financing of pension systems ............................ 5
2.2.2
Relation between contributions and benefits .................................. 7
2.3
Economic considerations ...................................................................... 9
2.4
Challenges to pension systems ........................................................... 10
2.5
Pension reforms .................................................................................. 11
3. The Italian Pension System .................................................................... 13
3.1
The crisis of the italian pension system ............................................... 13
3.1.1
Demographic crisis ....................................................................... 14
3.1.2
Crisis in the labor market .............................................................. 16
3.1.3
Crisis of public finances ................................................................ 18
3.2
Pension reforms in the last twenty years ............................................. 21
3.2.1
Public pension (pillar I) ................................................................. 22
3.2.2
Private complementary pension (pillar II) ...................................... 25
3.2.3
Individual pension integration (pillar III) ........................................ 26
3.3
Different public pension payment systems .......................................... 27
3.3.1
Old defined benefit scheme .......................................................... 28
3.3.2
Notional defined contribution scheme ........................................... 29
3.4
Complementary pension schemes ...................................................... 31
3.4.1
Product Types............................................................................... 32
3.4.2
Market development ..................................................................... 33
ii
4. Analysis .................................................................................................... 37
4.1
The simulation ..................................................................................... 39
4.1.1
Simulation 1: retiring in 2012 (Defined Benefit Scenario) ............. 40
4.1.2
Simulation 2: retiring in 2025 (Mixed Scenario) ............................ 45
4.1.3
Simulation 3: retiring in 2035 (NDC) ............................................. 48
4.1.4
Simulation 4: private pension provision ........................................ 50
5. Final considerations and reflections...................................................... 52
5.1.1
Advantages and challenges for the NDC ...................................... 53
5.1.2
The challenges for complementary pension provision .................. 54
Literature ......................................................................................................... 57
iii
LIST OF FIGURES
Figure 1: Intergenerational allocation ................................................................. 6
Figure 2: Development old-age dependency ratio ............................................ 10
Figure 3: Population pyramid, year 1901 .......................................................... 14
Figure 4: Population pyramid, year 2011 .......................................................... 15
Figure 5: Population pyramid, predictions 2050 ............................................... 15
Figure 6: Demographic pressure and public pension expenditure in 1990 ....... 19
Figure 7: Demographic and public pension expenditure in 2007 ...................... 20
Figure 8: Pension assets as a share of GDP (2011) ........................................ 34
Figure 9: Development of Assets to GDP fraction from 2001 to 2010 .............. 34
Figure 10: Development of enrolled members and assets under management 36
Figure 11: Three different pensioning cases .................................................... 38
Figure 12: Growth of gross wages (1997 – 2011) ............................................ 40
Figure 13: Public pension income and replacement rates in 2012 ................... 45
Figure 14: Nominal GDP growth ....................................................................... 46
Figure 15: Pension income and replacement rates in 2025 ............................. 48
Figure 16: Replacement rates for pensioning at age 66 and 70 years ............. 49
Figure 17: Replacement rates from private and public pension in 2035 ........... 51
Figure 18: Replacement rates in 2013, 2025 and 2035 from public pension .... 52
iv
LIST OF TABLES
Table 1: Three pillar structure after reforms ..................................................... 12
Table 2: Old-age dependency ratio .................................................................. 18
Table 3: Active pension payment systems in 2012 ........................................... 28
Table 4: Transformation coefficients ................................................................ 31
Table 5: Salary categories in Euro ................................................................... 39
Table 6: Revaluation coefficients for quote A and B ......................................... 41
Table 7: Defined benefit scheme – calculation of quote A ................................ 43
Table 8: Defined benefit scheme – calculation of quote B ................................ 44
Table 9: Notional defined contribution scheme................................................. 47
v
1. INTRODUCTION
At the beginning of the 1990’s Italy’s high pressure of the pension system on
the budget and GDP as well as the increasing old age dependency ratio
required a deep structural reform of the pension system. Throughout the last
two decades the Italian pension system underwent a series of reforms. In 1992
(Amato reform) and 1995 (Dini reform) two main reforms were introduced which
caused a change of the public old age pension system from a defined benefit to
a notional defined contribution system. A comparable total system change will
take decades to be fully implemented. The further reforms of the current Prime
Minister Mario Monti currently try to speed up the realization of the process.
The past reforms of Dini and Amato designed the "new" pension as a sum of
three pillars:
1) The public pension (Pillar I)
2) Employer sponsored or private mandatory programs (Pillar II)
3) Additional voluntary programs (Pillar III)
With the introduction of the "new" pension system and the recent decision of the
Monti government, the private pension provision will become more and more
important. For the population it is inevitable to invest in pension products of the
2nd and 3rd pillar in order to reach a certain level of pension benefit.
Within these two pillars different product types are distinguished:
- Fondi pensione aperti - open pension funds (FPA)
- Fondi pensione negoziali/aperti – closed pension funds (FPN)
- Piani individuali previdenziali - Individual insurance saving plans (PIP)
Furthermore, Italian employees receive a severance indemnity from the
Trattamento di fine rapporto (Tfr), which for employees in the private sector is
equal to the cumulative total of 7.41% of earnings each year. It is paid by
employers and is retained in a fund that the employers manage directly. Since
1
the 1st of July 2007 each employee is able to decide where and how this Tfr
should be invested.
1.1 PROBLEM STATEMENT
During the last decade numerous pension products for the 2nd and 3rd pillars
were sponsored by banks and financial intermediaries, employer and employee
associations in order to face the increasing demand of a retirement pension
supplement. Current statistics, however, show that the private pension market
in Italy compared to other important OECD countries is still underdeveloped. As
already mentioned in the introduction, recent reforms from the Monti
government accelerate the implementation of the notional defined contribution
system. On the one hand this implicates a revision of public finances and an
improved fairness of the pension system and on the other hand it leads towards
a decreasing public (Pillar I) replacement rate between pension and last salary
for future pensioners.
The main purpose of the thesis is
the analysis of the way the replacement rate will develop for different income
segments in Italy from 2012 to 2035 given the already introduced reforms.
This involves a breakdown of the analysis into the three different pension
payment systems, which are currently active in Italy, and their respective impact
on the pension income for different salary classes. In this context, the main
characteristics of the Italian private pension system will be described. The
additional calculation of the replacement rate coming from private pension
products serves to simulate the future composition of pension income. In
addition, the challenges and problems for the private pension, which could
directly influence the development of the replacement rate, will be analyzed.
2
1.2 STRUCTURE
In addressing the problem statement the thesis consists of several chapters that
in continuation of each other help the reader to understand how and why the
future composition of pension income in Italy will experience significant
changes.
Chapter 2 gives an introduction to the general concepts and functions of
pension systems. The chapter describes the different possibilities of how
pension systems are financed and which types of relations between
contributions and benefits exist. Additionally the main challenges, which
pension systems have to face and the necessary associated reforms are
explained.
Chapter 3 addresses the Italian pension system. After a short historical
introduction the crisis of the Italian pension which occurred due to the
demographical changes, the problems with public finances and further issues in
the labor market is described. Going further the chapter gives an overview of
the main reforms and decisions taken in order to solve the mentioned problems.
Chapter 4, the main part of the assignment analyzes the impact of the
undertaken reforms on the future composition on pension income. In the
analysis different scenarios and calculation methods are explained by means of
numerical examples.
Chapter 5 reflects on the content presented in the previous chapters. This
includes critiques as well as the potentials for the future development of the
Italian pension system.
3
2. THE PENSION SYSTEM
Before starting to examine the Italian pension system, its change during the
time and the current reforms, it is important to investigate the general concepts
and functions of pension systems.
2.1 FUNCTIONS OF PENSION SYSTEMS
In general, pension systems consist of three fundamental functions (Passini,
2004, p. 11):
 Firstly, a pension system incorporates a preventive function which should
guarantee the same living standard as during the employment period
also after retirement to the retired population. Old aged retired people do
otherwise not possess the necessary means to maintain a same level of
wealth for themselves and their families.
 Secondly, the pension system has an auxiliary character: it tries to
relieve poverty (Barr and Diamond, 2008, p. 25). This function includes
the financial support of people unable to work because of age or
disability. A minimum amount of income should be guaranteed to those
people even though they haven’t paid the necessary level of contribution
yet to get the respective minimum benefit.
 Thirdly, a pension system contains a social-economic function since the
accumulated pension contributions can be invested in favor of a
country’s economic development and be returned to the employees in a
later period in time in form of poverty relief or regular pension income
distribution.
From the above mentioned functions it is apparent that an intervention by the
state regarding the pension system and an obligation for employees to
contribute to the system is needed. Without the mandatory pension programs
applied by the state and with a system based on a voluntary contribution
4
scheme only young employees could never save enough money to satisfy their
future pension income. A system based on volunteers would bear the following
risk: the potential development could result in a huge auxiliary support payment
from the state, which going further would load even more on the public finances.
According to Passini the same risk could be caused if the pension provision was
assigned to the private sector only. Pension managers could become unable to
guarantee future pension income due to different reasons like market
downturns.
2.2 TYPES OF PENSION SYSTEMS
Pension systems can be categorized according to the way they are financed
and according to the different relation schemes between contributions and
benefits.
2.2.1 ORGANIZATION AND FINANCING OF PENSION SYSTEMS
Pension systems can be financed through two main methods. One method is
the pay-as-you-go scheme, where pension are paid out to old-age pensioners
using the contributions from active employees. The other method instead, the
fully funded scheme, uses the paid-in contributions from the pensioner to payoff his/her individual pension.
Pay-as-you-go (PAYG) systems
PAYG systems are mainly managed by the state. In such schemes the wealth is
transferred from one generation, the active employees, to another, the
pensioners. Potential variances between proceeds and expenses are filled by
the state.
This type of system is like an intergenerational contract, where one generation
provides the pension needs of another generation, the already retired
generation. The following graph shows this concept the young, the active and
the retired generation.
5
Figure 1: Intergenerational allocation
0
A
30
B
60
0
D
30
A
60
B
90
0
E
30
D
60
A
90
C
90
Period 1:
Period 2:
Period 3:
Young generation
Active generation
Retired generation
Source: A. Grosen
The advantages of PAYG schemes are the lower management costs, an
attractive pension system for young and growing populations and the
uncomplicated method to pay out full benefits straight away in comparison to
funded systems (World Bank Pension Reform, 2002).
A PAYG scheme works well as long as an equilibrium between benefits and
contributions exists. Miani (2002, p. 11) shows this concept with the following
simple formula.
p = average dispersed pension
P = number of pensioners
c = fraction of pension contribution
w = average wage
L = number of workers
The system is in equilibrium when dispersed benefits (pP) are equal to collected
contributions (cwL):
pP = c w L
From this follows
c=pP/wL
p/w is the average replacement rate between pension and wage and indicates
the incidence per cent of the average pension in respect to average salary. The
concept of replacement rate will be used later in thesis.
6
P/L is the dependency ratio between pensioners and active workers. This ratio
depends mainly on demographic phenomena, like the dynamics of the retired
population and active population, the unemployment rate and statutory
provisions.
In general, the ratio tends to decrease if the retirement age will be lowered or
the average life expectancy is extended. The higher the dependency ratio, the
higher the fraction of pension contribution needs to be in order to fulfill an
equalized system.
Fully funded schemes
Fully funded schemes are systems where the contributions paid from each
single employee are available to pay off his own pension. The contributions are
invested year over year to form a capital stock, which will be used directly or as
life annuity at the moment when the worker is going to retire. In this pension
regime every individual creates a specific pension scheme through the savings
according to the individual insurance approach. The fully funded scheme
distributes the savings between different phases of the lifetime of an individual.
(Barr and Diamond, 2006)
The main risks of such a system are basically related to market-financial risk
and inflation risk, which could reduce the accumulated contributions in the
course of the years.
2.2.2 RELATION BETWEEN CONTRIBUTIONS AND BENEFITS
The calculation of the pension can be based on different payment schemes. In
the following section an explanation of three different methods is given. The
schemes differ according to the relation between contributions and benefits.
Defined benefit schemes
In a defined benefit pension plan, the future pension income of an employee is
quantified in relation to his individual number of years of service and the wage
history. (Barr and Diamond, 2006) For the calculation of the pensions in the
past various types of benefit formulas have evolved. Career-average and final-
7
pay plans are typical calculation types. In a career-average scheme, the
average overall lifetime service salary is multiplied by the years of service. This
amount is multiplied by a fractional pension benefit, usually 1.5%. The final-pay
plan, which today is the most common one, multiplies the number of years of
service by the average salary over the last 3-5 years and then multiplies again
by a fractional benefit. (Logue and Rader, 1998)
Defined contribution schemes
In a defined contribution pension plan, a worker pays a certain percentage of
the salary into a pension account. The contributions are invested in different
types of assets in order to generate returns. At retirement the pension can be
either paid off directly or paid off as annuity. (Logue and Rader, 1998)
In the above described defined benefit scheme the pension is obtained as
percentage of salary and depends on the number of years of service only and is
independent from every type of contribution. In contrast, in a defined
contribution system the pension depends on the amount of contributions
transferred to a pension account during the working lifetime. A common
characteristic of both schemes is that the pension income is reduced if an
individual decides to retire early: in the defined benefits case because a minor
number of years of service can be used for the determination of the pension, in
the defined contribution case because a minor amount of contribution is
transferred to a pension account. (Cazzola, 2008)
Notional defined contribution schemes
A notional defined contribution scheme works similar to a defined contribution
plan. The main difference lies in the fact that contributions are directed to a
notional account and not to an account where the accumulated capital is
invested in assets. The accumulation of the accounts is “virtual” and almost
unfunded and therefore pay-as-you-go. The individual accounts are notional
accounts and indexed to a nominal interest rate chosen by the state. Typical
nominal interest rates are the growth rate of average wages, price inflation and
8
GDP growth. Upon retirement the notional accumulation of contributions is
distributed in form of annuities. (Barr and Diamond, 2008)
2.3 ECONOMIC CONSIDERATIONS
At the beginning of this chapter the different functions of pension system were
presented. Besides the functional view of a pension system it is also possible to
take a macro and micro perspective of a pension system. According to a macro
perspective, a pension system is no more than a mechanism, which allocates
current GDP into a part held by the working generation and a part kept by the
retired generation. This scheme reflects the concept of the intergenerational
contract, explained in the precedent section. Taking it from the micro - individual
perspective, a pension system divides the personal income over the entire life
time by planning life cycle consumption. During their active working career,
workers acquire rights (pension claims), which will be sold in a later stage once
they will retire. (Grosen, 2011)
An interesting analysis about the economics of pension systems is also given in
the article “The Economics of Pensions”, from Barr and Diamonds (2006).
According to Barr and Diamond is the output, the economic growth of a state,
that matters independent of the type of pension system. All types of pension
systems, e.g. pay-as-you-go and fully funded have something in common. The
general goal of pension systems is to give pensioners an appropriate amount of
pension income in order to continue consumption. In a PAYG system this claim
is reached by the promise from the government or employer that the pensioner
will get his benefits after having stopped to work. In a fully funded scheme this
claim is achieved by the accumulation of assets, which after retirement are used
to pay off the pension needs.
9
2.4 CHALLENGES TO PENSION SYSTEMS
Pension systems in practice worldwide today face a series of challenges.
Looking at all challenges, two main problems caused the instability of the social
security mechanism in the world and especially in Europe.
Demographic change
The first challenge is the demographic change within the population. The world
population is aging. According to the data from the United Nations and
Organization for Economic Cooperation and Development (OECD) the old-age
dependency ratio, the fraction between the population aged over 65 and the
working population between 20-64 years, will double over the next 40 years.
However, when looking at the following chart some differences have to be taken
into account.
Figure 2: Development old-age dependency ratio
60%
50%
OECD-Europe
OECD
40%
World
30%
20%
10%
0%
1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 2050
Source: OECD and United Nations
While in 2010 the ratio in the whole world amounted to about 12%, in Europe
the fraction was already at the level of around 28%, a higher than projected
value for the overall world of 26% in 2050. The phenomenon of old-aging
dependency is clearly more distinctive in member countries of the OECD.
Projections for the year 2050 estimated dependency ratios within the OECD of
10
more than 50%. These numbers indicate that most pension systems in the
industrialized countries will enter a crisis or even worse are already in a crisis.
The aspect of an increasing old-age dependency ratio of a population does not
only depend on the increasing longevity but also on the decreasing fertility rates
around the world. In the quinquennium 1975 – 1980 the world average fertility
rate was 3.8, the OECD average 2.3. During the past period from 2005 to 2010
the value declined to 2.5 for the world and to 1.7 for OECD. For the period 2025
– 2030 projections expect levels of 2.3 for the world and around 1.7 for OECD.
These numbers put further pressure on the problem of an increasing old-age
dependency.
Structural – fundamental challenge
The second challenge concerns the structure of pension systems in
industrialized countries. In many countries like Germany and France public
pension schemes are unfunded and based on the pay-as-you-go mechanism.
As already mentioned in section 2.2 a PAYG system works good as long as
there exists an equilibrium between contributions and benefits. Pay-as-you-go
schemes worked pretty well back in the 60’s and 70’s of the last century when
old-age dependency amounted to levels around 18% in Europe. At that time a
ratio of 7:1, meaning seven workers for each pensioner was normal. Today the
ratio decreased to four workers for each pensioner and according to further
projections in 2040 this ratio will be 1:1. A consequence of this development is
that states have to increase pension contributions, payroll taxes or issue new
debt in order to maintain the pension systems. However this brings the negative
effect of financial instability of countries and slowed economic growth. (KMPG,
2011)
2.5 PENSION REFORMS
An alternative or better said the only way out of this misery is the adoption of
reforms and the structural change of pension schemes. The implementation of a
pension system based on a sound three pillar structure offers a possibility to
11
overcome the challenges explained above. Governments are required to
establish pension systems, where the pension benefits of retirees does not only
come from public schemes but also from mandatory private and voluntary
programs.
The table below shows the conception of a three pillar pension system after the
implementation of reforms. An important step in such a process is the passage
from a defined benefit scheme to defined contribution or notional defined
contribution scheme within pillar I.
Table 1: Three pillar structure after reforms
I
State
II
Employer
III
Individual
Publicly founded
schemes, social security
schemes
Employer-sponsored
schemes or private
mandatory programs
Additional voluntary
arrangements
Unfunded
(PAYGO)
Funded
Funded
DB
NDC
DB
DC
DC
Source: A. Grosen
Examples for the successful restructuring of pension system are Chile and
Poland. In both countries the government was able to implement a more
balanced scheme by giving more importance and weight to mandatory and
voluntary complementary pension schemes. The next chapter analysis in detail
the case of Italy: challenges and problems, and the reforms implemented to
rebalance the pension system.
12
3. THE ITALIAN PENSION SYSTEM
The beginnings of the Italian pension system date back to the end of the 19thcentury. At that time a first type of pension was introduced on a voluntary basis.
Over the next twenty years the pension provision became mandatory and in
1919 the institution INPS 1 (Istituto nazionale per la previdenza sociale) was
established. The fixing of the pension was based on a fully funded scheme.
In the postwar period inflation and destruction prevailed. The accumulated
pension capital lost all of its purchasing power and a change to a pay-as-you-go
scheme was decided. The implementation of the new pension scheme lasted
until 1970, when the fully funded scheme was completely abolished. (Cesari,
2007, p. 28) During this period Italy experienced a strong demographic and
economic growth. At the same time the expenditure for social security was
expanded to broader occupational categories and the level of pension provision
was also increased. It was during the 70s and 80s when Italy accumulated huge
liabilities for pension expenditure. These liabilities are still a burden on the
public finances today.
The following chapter analyses the different reforms and changes applied to this
three pillar structure over the past twenty years. The importance of the
contribution of the three pillars changed significantly in the past and is going to
change also in the future as the following sections will demonstrate.
3.1 THE CRISIS OF THE ITALIAN PENSION SYSTEM
A pension mechanism based on the pay-as-you-go concept works well as long
as there is equilibrium between the employed and retired population. If such an
equilibrium is no longer active, this type of pension scheme will enter a crisis.
1
The INPS in Italy is the main institution for social security today. In Europe it
ranks as one the biggest institutions as most of Italian employees are
obligatorily insured through the INPS.
13
The explained disequilibrium occurred in Italy at the beginning of the 90’s as
conditions have changed at that time. The increase of life expectancy,
decreasing birth-rates, the change in labor markets and the uncontrolled
increase of public spending for social security caused the crisis of the Italian
pension system.
3.1.1 DEMOGRAPHIC CRISIS
In the context of analyzing the reasons for the Italian pension system crisis, the
examination of the demographic evolution plays an essential role as it is closely
linked to pension spending.
Today the Italian demographic evolution is characterized by two important
phenomena (Cesari, 2007, p. 32):
 A decreasing fertility rate, conditioned by the passage from agricultural to
an industrial society, the increasing emancipation and the development
of contraception
 An increasing life expectancy, contingent by the improved economic and
humanitarian conditions and the progress in medicine
Both phenomena are reflected in the following figures known as the population
pyramid. Figure 3 shows the composition of the Italian population at the
beginning of the last century. In 1901 the Italian population of 32 million people
had a so called pyramid shape, which means that the amount of male and
female people decreased with their increasing age.
Figure 3: Population pyramid, year 1901
14
Figure 4: Population pyramid, year 2011
Source: Istat
In 2011, after more than 100 years, the population increased to 60 million
people. As figure 4 shows, the two above mentioned criteria have transformed
the shape of the pyramid to a kind of rhombus. Today, the majority of the
population is reflected by the adult generation of around 40 years. Young-aged
people decreased in absolute as well as in relative terms. Depending on the
assumptions, scenarios and models can differ slightly, but they remain the
same in their basic message: The ratio of older people to people of working age
has increased steadily and will in the future change even more to the detriment
of the younger generation. This trend requires reforms that target either funding
or benefits.
Figure 5: Population pyramid, predictions 2050
15
According to the latest projections for the period until year 2050 the Italian
population will stay stable at its recent levels. But the distributions of different
age classes within the population will change significantly. In 2050 old-age
retired people above 65 years will exhibit the biggest share of Italian’s
population (figure 5).
The preceding figures underlined the problem of equilibrium between
contributions and benefits in a pay-as-you-go scheme. To avoid the equilibrium
problem, Italian politics used more and more public finances in order to maintain
the pension system and in order to react to the mentioned changes and
challenges. However, at the beginning of the 90’s it was unavoidable to reform
the pension system and to prevent a collapse of the system. (Botta, 2012, p. 33)
3.1.2 CRISIS IN THE LABOR MARKET
Besides the challenges for the pension system resulting from the demographic
evolution, the crisis in the labor market also negatively impacts the pension
schemes.
Cesari (2007, p. 35) explains this problem with the use of a simple equation.
Benefits
=
Pensioners
Contributions
Income
Income
Workers
Benefits
Worker Populatio n Contributions
Old age >65 Pensioners
Population Old age >65
The equation shows that the pension benefit in the pay-as-you-go scheme
depends on six factors: the benefit increases
 with the rate of contributions, given by the fraction contributions/income
 with productivity of labor, defined as a ratio of income and number of
workers
 with employment rate, given by the fraction of workers/population
 with the intervention of the fiscal system to balance the fraction between
benefits and contributions
16
The benefit diminishes with the increase:
 of the old-age dependency ratio given by the fraction between people
aged over 65 and the total population
 of the excess of pensioners relative to old age people conditioned by the
Italian phenomena of old-age pensioning
Considering the increasing old age dependency, the decline of benefits can be
avoided in four ways: with the increase of employees generating higher
contributions, with the enhancement of productivity, with increase of aliquots
and with reduction of old-age pensioning. The other two factors can only be
changed through a legal intervention.
In theory, these concepts appear to be logical, but in practice it is different. Over
the last 30 years, the dynamics in the Italian labor market were unfavorable for
the pension system. New technologies and restructuring in production caused
an increase of the unemployment rate from 6% at the end of the 70’s to 12% at
the end of the 80’s.
Furthermore, new types of contracts, such as part-time contracts, distorted the
equilibrium in the pension system. This kind of contracts involved minor costs
for companies, as the pension contributions were inferior than for regular
contracts. As a consequence, a smaller amount of contributions accrued the
pension finances.
The increase of the old-age dependency ratio is a phenomenon, which didn’t
affect Italy only, but also the majority of other industrialized countries. However,
the dimension and level of the Italian ratio were tremendous. The following table
compares the old-age dependency ratios of Italy, Germany, OECD-Europe and
the United States.
17
Table 2: Old-age dependency ratio
1970
2010
2050
Italy
15.9
33.4
66.4
Germany
24.3
33.7
61.3
OECD Europe
21.1
28.7
55.7
United States
18.7
21.6
37.3
Source: OECD, Pensions at Glance 2009
The data indicates that back in the 70’s Italy didn’t face the problem of a high
old-age dependency. However, over the last 40 years things have changed
drastically and Italy exhibits one of the highest ratios today. The projections for
the year 2050 map an even worse scenario, which suggests that Italy will rate at
the top of all old-age dependency ratios.
Yet another big problem puts pressure on the Italian pension system: illegal
employment. This phenomenon, very widespread throughout the country
causes heavy damages to public finances, firstly by missing contributions
flowing to the state and secondly by the increased expenditures for poverty
relief as illicit employees are registered as unemployed.
3.1.3 CRISIS OF PUBLIC FINANCES
Beginning in the mid 70’s, the Italian pension system entered a stage of
continued deficit accumulation. Besides the regular function to guarantee
income after retirement, the Italian pension system also invested in the
expansion of the concept of the welfare state. This decision implicated a
growing disequilibrium between contributions and benefits and resulted in a
missing intervention from the state to change something in the system.
The public deficit had a remarkable increase, especially at the beginning of the
90’s, when the criteria for entering the European monetary union were decided.
With a public deficit of around 10% Italy was far away from the originally
required 3% by the Maastricht criteria. (Botta, 2012, 36)
18
High pressure of pension expenditure on the GDP
The following two charts illustrate the precarious situation of the pension system
in Italy in 1990 and 2007. In both charts Italy (the red spot) is situated in the
upper right corner, which indicates a high old-age dependency ratio as well as a
high impact of pension spending on the gross-domestic-product. In 1990, before
the introduction of first pension reforms by the government, the cost for
pensions added up to 10.1% of the GDP. More than 15 years later, in 2007,
Italy shifted even more to the corner, exhibiting a fraction of Public pension
expenditure/GDP of about 14%.The shift along the axis of old-age dependency
is based on the reason already explained in the previous section.
Figure 6: Demographic pressure and public pension expenditure in 1990
Source: OECD, Pensions at Glance 2011
19
Figure 7: Demographic and public pension expenditure in 2007
Source: OECD, Pensions at Glance 2011
Despite the numerous interventions during the 90’s, the situation in the Italian
pension system has not been and is still not stable today as the second graph
shows. A series of new and future reforms have to be undertaken in order to
stabilize the public finances. Before describing the recent changes introduced
by the Monti government, a thorough analysis of the reforms from the 90’s and
their impact on the pension system needs to be carried out.
20
3.2 PENSION REFORMS IN THE LAST TWENTY YEARS
During the 90’s, the Italian pension system underwent a series of reforms,
which dramatically changed the structure of the pension scheme. Up to that
time period the Italian pension system basically consisted of two pillars: The
old-age pensioning and age of service pension based on a defined benefit
calculus scheme.
Old-age pensioning was reached at the age of 55 years for women and of 60
years for men and a minimum of 15 years of contributions needed to be paid.
Age of service pensioning instead was obtained, independently of age, after 35
years of contributing.
The Italian pension system of that time resulted to be inappropriate for the
Italian society and public finances as explained in previous sections. Therefore
the pension reforms of the last twenty years designed a new structure of the
Italian pension system. (Botta, 2012, p. 38)
The Italian pension system in its current shape is the result of a reconfiguration
and reform process based on the models already introduced in other states like
United States, Great Britain or even Chile. The Italian pension system is
characterized by three main pillars, which should guarantee the pension income
of the retired population. (Liera, 2005, p. 11)
 The first pillar represents the public and mandatory pension determined
by a Notional Defined Contribution scheme, which guarantees a
minimum of pension benefit
 The second pillar constitutes the private mandatory pension provision in
form of occupational pension funds
 The third pillar represents the additional private voluntary pension
supplement in form of life-insurance contracts and private pension funds
In order to get a better understanding of the changes implemented to the
pension system, the reforms are analyzed chronologically pillar by pillar in the
following.
21
3.2.1 PUBLIC PENSION (PILLAR I)
Amato reform 1992
The past pension reforms mainly affected the public pillar I scheme. The first big
reform was passed in 1992 by the Amato government as a consequence of the
big deficit. The decree-law n.503/1992 implemented the following directives.
The pensionable age was raised gradually to 60 years for women and 65 years
for men within the timeframe from 1993 to 2000.In order to make use of the old
age pensioning concept a minimum of 20 years of contributions was requested
compared to the earlier 15 years. The reference period for the calculation of
pension benefits was changed from the last 5 years to the last 10 years of
remuneration. This was introduced for employees with more than 15 years of
contributions. For the ones with less than 15 years or even for new entrants the
reference period related to the entire working career. In addition, pension
benefits were not indexed any longer to real wages and prices but only adjusted
to price increases. (Liera, 2005, p. 17)
Dini reform 1995 – a structural change
Only three years after the adoption of the Amato reform it was realized that the
implemented changes had not been enough to guarantee the future stability of
public finances. The demographic change and the increasing disequilibrium
between contributions and benefits made it necessary to review the entire
structure of the pension system.
With the adoption of law n. 335/1995 the most important structural change in
the Italian pension system was executed: the shift from a defined benefit to a
notional defined contribution scheme. The main goal of this reform was to
create a fairer pension scheme. The pension benefits still paid off by the INPS
were now linked to the contributions from each single employee and not to the
individual salary anymore. The new pension scheme was implemented
gradually depending on the years of service accumulated up to the 31st
December 1995. An exact explanation of the new system will follow in the next
section, when the calculation of pension benefits under different schemes will
be analyzed.
22
Additionally, other rules were implemented. The reform changed the scheme for
age of service pensioning by adding a minimum age to the 35 years of
contributions. Initially the age was fixed at 53 years. The Dini reform also tried
to reward workers with different incentives if they decided to retire at a later
point of time. The pensioner with a higher age of retirement than defined would
benefit from a higher amount of pension as these were calculated based on the
contributions paid. A further harmonization and standardization for the same
treatment of public and private employees was also attempted to be reached.
(Liera, 2005, p. 19)
In 1997, an additional reform was undertaken by the government of the Prime
Minister Romano Prodi. The reforms tried to harmonize and accelerate the
measures and targets implemented by reforms from the years 1992 and 1995.
A main objective of the reforms was also the adjustment of the Italian public
finances in order to allow access to the European monetary union.
Maroni reform 2004
The adoption of law n. 243/2004 was aiming at gradually increment the pension
age for age of service pensioning and to increase the importance of
complementary pension schemes. The former was fixed to 60 years starting in
2008, 61 years in 2010 and 62 years in 2014.
Trattamento di fine rapporto – Severance indemnity
Another very important objective of the Maroni reform was the development of
complementary pension schemes. For the development of such schemes a
change in destination of the country specific severance indemnity or so called
Trattamento di fine rapporto (Tfr) was decided.
The Trattamento di fine rapporto (Tfr) is a form of deferred remuneration, which
is paid to employees at the moment when the employment contract ends for
reasons like pensioning or dismissal. In economic terms this severance
indemnity is a form of loan from the employee to the employer. The Tfr is
calculated by dividing the yearly gross salary by a fixed parameter of 13.5,
which yields 7.41% of the remuneration. 6.91% are destined to the employee
and 0.5% to a guarantee fund managed by the INPS, which intervenes in case
the employer/ the company becomes insolvent.
23
The Tfr is revaluated on a compounded basis year over year with 1.5% + 75%
of the inflation rate and determined by the Istat. The Tfr concept is reserved to
employees from the private sector only, employees from the public sector are
subject to a different scheme. (Cesari, 2007, p. 14)
According to the civil code (art. 2120) an employee has the opportunity, under
certain circumstances, to ask for an anticipation of max 70% of the Tfr.
The decree-law n. 252/2005 introduced a new scheme for the severance
indemnity. Within the 30th june 2007 all employees of the private sector had to
decide what to do with their respective Trattamento di fine rapporto. The new
scheme offered four different options:
 to maintain the Tfr within the company
 to transfer the Tfr to one of the different product types for complementary
pensions
 to join an occupational complementary pension scheme
 to do nothing and the Tfr will be transferred by the employer to a pension
fund referring to the contract type of the employee
All four options contained risks and chances for the employees. (Cazzola, 2008,
p. 138)
Monti reform 2011
In order to rebalance the public budget during summer 2011 the minister of
economic affairs Tremonti introduced several further reforms. The decisions
included the suspension of pension revaluation during 2011-2013, a further
increase of the pensionable age and an extra taxation for pension income
higher than Euro 90,000.
By the end of 2011, Italy was in a very bad shape and a political change was
unavoidable. The new Prime Minister Mario Monti and his minister of welfare
Elsa Fornero enacted a decisive change in the Italian pension scheme with the
adoption of decree law n. 6/2011. The goal of the new disposition consisted of
guaranteeing the respect of international commitments and of balancing
requirements, of guaranteeing an economic-financial stability and of enforcing
the sustainability of the Italian pension scheme for the long term in terms of
impact on the Italian gross domestic product. (Botta, 2012, p. 65) All reforms
24
should be enacted under the concept of fairness and adequateness in the
sense of the welfare state.
It was agreed that, starting from 1st of January 2012 the respective pension
benefit of each individual is going to be calculated according to a notional
defined contribution scheme. In practice, the scheme in place simply
accelerates the 1995 Dini reform by abolishing the gradual implementation of
the NDC scheme. The exact explanation will be given in the next sections. For
the minister Fornero it was an important part to implement a system involving
the same treatment for everyone.
Furthermore, with the Monti reform the age of service pension concept was
abolished. Instead, an early retirement pension scheme was introduced.
According to that scheme the possibility of pensioning depends on the number
of years of contribution payments made .Starting from 2012 a minimum of 42
years and 1 month for men and 41 years and 1 month for women will be
required in order to receive a pension. This level is set to increase over the
years in relation to the increasing life expectancy.
Regarding the old-age pensioning the age level is increased to 66 years for
men and women. This target will be reached gradually in 2018, when the old
age pensioning age will be the same for men and women from the private and
public sector underlining again the concept of fairness.
Another innovative aspect of the pension reform is represented by the fact that
age of pensioning has become flexible. Each employee has the liberty to decide
the time of his or her retirement up to an age of 70 years. The person who
decides to work longer than an old age of 66 years will receive a higher pension
due to a higher amount of contributions paid into the pension account overall.
(Carli & Micardi, 2012, p. 10)
3.2.2 PRIVATE COMPLEMENTARY PENSION (PILLAR II)
The pension reforms of the past twenty years tried not to limit the pension
income solely to the public pension. With the reform of 1992, the Prime Minister
Amato introduced the first steps of complementary pension schemes. In 1993,
the first pension funds (private and occupational) were born. The goal was to
25
enable pensioners higher levels of pension benefit. The introduction of pension
funds in a certain way was like a step back in the past as the “old” scheme of
funding was reintroduced.
In order to better develop the complementary pension schemes in the year
2000 a reform (Decree law n.47/2000) for the taxation of complementary
pension products was decided. The reform introduced a taxation of 11% on
coupons, dividends and capital gains resulting from pension funds compared to
the 12.5% taxation for normal investment products. The small difference
between the taxation percentages did not present a big advantage to make this
kind of investment more attractive. Regarding the taxation of investment
products in summer 2011 the Italian government changed the percentage from
12.5% to 20%, which should make pension products with a percentage of 11%
more attractive now. (Decree law n. 138/2011).Furthermore, the concept of a
yearly deductible amount of 5,164.57 Euros of voluntary complementary
pension contribution tried to make private pension investments also more
interesting.
3.2.3 INDIVIDUAL PENSION INTEGRATION (PILLAR III)
The third pillar is similar to the second one as it uses the same financial
mechanisms and the concept of funding to generate future pension benefits.
The peculiarity of pillar III is the individual initiative to use the fiscal advantages
for pension products. Typical pension products used within this pillar are open
pension funds and individual saving plans, e.g. life insurance contracts. For the
development of this pillar the fiscal changes of the year 2000 and 2011 were of
great relevance. For self-employed workers who do not dispose of collective
treatments, pillar III represented the same function as pillar II.
The last section (section 3.4) of this chapter analyses the characteristics,
importance and market development of complementary pension schemes (Pillar
II and Pillar III) in Italy in more detail.
26
3.3 DIFFERENT PUBLIC PENSION PAYMENT SYSTEMS
After a series of reforms during the past twenty years, the methods for the
calculation of pension benefits appear to be complex. The reform of Dini in 1995
divided the employees into two categories: Employees registered at the INPS
before the 31st December 1995 and those registered for the first time starting
from the 1st January 1996. The main distinction between those categories of
workers resided in the different methods for the calculation of pension benefits
(Il sole 24 ore, 2012, p. 13), which will be demonstrated in the following cases.
Public pension benefit according to the Dini reform (1995)
Case 1: The defined benefit scheme will be applied to those employees, who
had a minimum of 18 years of service at the 31st of December 1995.
Case 2: The notional defined contribution scheme will be used for employees,
who started to work from the 1st of January 1996 going forward.
Case 3: A mixed scheme will be used for those workers, who had less than 18
years of contributions at the 31st of December 1995. The defined benefit
mechanism will be used for the years up to the end of 1995 and the notional
defined contribution scheme for the years after the 1st January 1996. (Botta,
2012, p. 43)
Public pension benefit according to the Monti reform (2011)
As already mentioned in the last section, the Monti reform tried to accelerate the
Dini reform of 1995. In contrast to the Dini reform (Case 1), now under the new
scheme employees, who had accumulated more than 18 years of contributions
up to the end of 1995 will pass to the less favorable notional defined
contribution scheme for all the pension payments made after the 31st December
2011. Today, in 2012, the Italian public pension systems, consists of the
schemes shown in the following table.
27
Table 3: Active pension payment systems in 2012
Employee profile
Pension system applied
Case 1
Minimum 18 years of
contributions at 31st
December 1995
Defined benefit for the years until
31stDecember 2011 and NDC
from 1stJanuary 2012
Case 2
Less than 18 years of
contributions at 31st
December 1995
Defined benefit for the years until
31stDecember 1995 and NDC
from 1stJanuary 1996
Case 3
0 years of contributions at
1stJanuary 1996
NDC starting from 1stJanuary
1996
In chapter 1 theoretical descriptions of the defined benefit and notional defined
contribution pension systems were already given. Using the theory, an
explanation of both schemes within the Italian pension system will follow in this
section.
3.3.1 OLD DEFINED BENEFIT SCHEME
As it can be seen from the table above, the defined benefit scheme is still in use
for the calculation of the mixed cases 1 and 2. The defined benefit scheme is
based on three main elements (INPS 1):
 Years of contribution: the total amount of contributions up to a maximum
of 40 years, which a worker can assert at the moment of pensioning.
 Pensionable income: the average remuneration obtained during the last
years of work. Previous remuneration is revaluated according to
indicators from the Italian National Institute for Statistics (Istat). The
indicator used for this revaluation is the FOI Index – the national
consumer price index for families of regular workmen and employees.
 Rate of return: it is equal to 2% for an income within a limit of Euro
44,204 (dated 2011). For higher income levels, the rate of return is
decreasing respectively to 1.5%, 1.25% and 1%. The return rates are
also updated yearly by the Istat.
28
The calculation of the pension benefit is given by the following formula:
Years of contribution x rate of return (2%) x revaluated pensionable income
Calculated with the above shown formula, an employee obtained nearly 80% of
the average of the last five years of remuneration for forty years of contribution.
The amount of the pension decreases with a higher level of income. The
pension income also decreases due to the different treatment of years of
contribution aggregated before the 31stof December 1992. In this context a so
called quote A and quote B are taken into account while calculating the pension
income.
Quote A is determined according to the years of contribution with due date
31stof December 1992 and the average remuneration of the last five years or
the last 260 weeks of contribution for regular employees and 10 years (520
weeks) for self-employed people.
Quote B relates to the years of contribution starting from 1stof January 1993 and
the average remuneration of the last 10 years (520 weeks) for regular
employees and 15 years for self-employed people. (Martorelli, 2011, p. 4)
In the last chapter a detailed explanation (only for regular employees) of the old
defined benefit scheme follows by using numerical examples and a simulation.
3.3.2 NOTIONAL DEFINED CONTRIBUTION SCHEME
The NDC calculation method was introduced with the reform of 1995 by the
Prime Minister Dini. The “new” pension scheme refers to all employees, who
either did not accumulate 18 years of contribution at the end of the year 1995 or
are new employees starting from the 1stof January 2012.
In the notional defined contribution system the annual pension income is
calculated in the following way
Individual amount of contributions x transformation coefficient relative to the
age at the moment of pensioning.
29
The individual amount of contributions
The individual amount of contributions is the sum of all contributions paid by the
employee from the beginning of his/her working career until the beginning of the
pension career. The yearly contributions correspond to the product between the
annual salary and the pension contribution rate. For regular employees this rate
is fixed at 33% and for self-employed workers at 20%.
At the end of every year the contributions are revaluated with a capitalization
rate. This system is similar to the concept used for the determination of the
severance indemnity explained in the precedent section. In Italy the
capitalization rate applied, corresponds to the five year average nominal growth
rate of the gross domestic product.
The yearly contributions can only be calculated up to a maximum salary ceiling
of Euro 96,149. Above this level the salary is not subject to pension contribution
and therefore not revaluated. (INPS 2)
Transformation coefficient
The transformation coefficient is the second important element for the
calculation of the pension income under the notional defined contribution
scheme. This parameter (starting from 57 years up to 65 years) is fixed in
relation to the age of the employee at retirement and also to the life expectancy:
a higher age corresponds to a higher transformation coefficient. According to
the previous law nr. 335/1995 the coefficients were updated on a ten years
basis only. (Martorelli, 2011, p. 8). With the Monti-Fornero pension reform the
treatment of transformation coefficients experienced a significant change in
order to adapt them to the ongoing macroeconomic and demographic change.
Starting from 2012 the coefficients are updated on a three years basis.
Furthermore, the age range was extended to 70 years. The extension to 70
years should offer employees the possibilities to continue working longer and
benefit from higher coefficients. In the last chapter the advantage of working
until an age of 70 years instead of 66 years will be shown.
The following table shows the current coefficients after the update made in May
2012. The table indicates that from 1996 until 2012 transformation coefficients
experienced a great diminishment due to demographic change and the above
mentioned factors. Looking at the last column a significant negative variation for
30
an age of 65 between the coefficients fixed in 1995 and the once fixed in 2012
can be observed. The penultimate column shows the positive impact of
extending the coefficient to a higher age.
Table 4: Transformation coefficients
Source: INPS, Siulpmarche
3.4 COMPLEMENTARY PENSION SCHEMES
As already implied in section 3.2 the first complementary pension schemes
were introduced with the decree law n. 124/1993 by the Amato government.
The decree established the legal framework for first complementary pension
schemes, in form of closed pension funds, only for collective agreements
between employees and their respective labor unions. The adoption of decree
law n. 47/2000 instead opened the complementary pension scheme also to
each individual in form of open pension funds and individual saving plans – life
insurance contracts.
31
The Italian complementary pension product range, besides open and closed
pension funds and life insurance contracts, comprises also the so called fondi
pensione preesistenti, preexistent pension funds.
An important and necessary step in the evolution of the Italian private pension
market was the reform for severance indemnity in 2004, implemented later by
decree law n. 252/2005.The reforms introduced starting from 1993 produced a
fairly modest success of the private pension provision. The main objective of
this further legal action was to energize the development of the complementary
pension scheme and to guarantee a solid pillar II and pillar III structure within
the Italian pension system.
3.4.1 PRODUCT TYPES
Before analyzing in more detail the market development for private pension
schemes, it is relevant to describe the different product types within the
complementary pension scheme (Cannata & Settimo, 2007, p. 8)
Closed pension funds
Closed pension funds are collective agreements between employees and
employers. This category of funds addresses employees from a same
occupational area, e.g. employees from the same company or group of
companies or employees from the same geographic area. A closed pension
fund is a legal entity consisting of different legal elements such as meeting of
members, administration and control entities and the fund responsible. Certain
services and activities are assigned to external advisors. For example, the
management of the financial assets is assigned to specialized companies such
as banks, asset managers or insurance companies. The business activity of
closed pension funds is supervised by the Covip, the Italian supervisory
commission for pension funds.
Open pension funds
Open pension funds are directly established by banks, insurance companies
and asset management companies. This type of pension funds can be joined by
32
individuals or also on a collective basis. The business activity of open pension
funds is supervised by the Covip.
Individual savings plans (Piani individuali pensionistici - Pip)
Individual savings plans are life insurance contracts with characteristics which
are similar to pension funds. The admission to Pip’s is reserved to individuals
only and cannot be entered by collective agreements as for open and closed
pension funds. Individual savings plans are also regulated by the Covip.
Preexistent pension funds
Preexistent pension funds were introduced before the reform of 1993 and are
regulated by art. 2117 of the civil code. Preexistent pension funds were
established within the environment of large companies e.g. Fiat or Unicredit
already back in the 1970’s. These funds also underlie the supervision of the
Covip.
3.4.2 M ARKET DEVELOPMENT
The last sections explained the regulatory framework and different reforms
implemented for the development of private pension provision in Italy. The
following section analyses the evolutionary process of the complementary
pension scheme during the past 10 years.
The Italian market for private pension provision reached a level of about 99
billion euro of financial assets under management, equal to about 5.8% of the
Italian gross domestic product, at end of 2012. When comparing this value to
other countries such as United Kingdom, United States, Switzerland or even the
Netherlands it turns out that Italy exhibits a fairly low fraction between financial
asset and GDP. The difference is more restrained if the comparison is
conducted with other big member countries (France, Germany and Spain) of the
European Union.
33
Figure 8: Pension assets as a share of GDP (2011)
140%
Assets / GDP
120%
100%
80%
60%
40%
20%
0%
Source: OECD statistic database, 2012
Figure 9 shows the growth of the fraction assets to GDP throughout the past ten
years in Italy. The chart makes clear that after the severance indemnity reform
enacted in 2007 the market for private pension provision experienced a higher
growth compared to precedent years.
Figure 9: Development of Assets to GDP fraction from 2001 to 2010
Source: OECD statistic database, 2012
34
Besides the overall observation it is also relevant to take a look at the absolute
numbers of members enrolled in complementary pension schemes and also at
the distribution of assets between the different private pension products.
Before the implementation of the Maroni reform in 2007, the complementary
pension scheme in Italy at the end of 2006 registered about 3.3 million
members enrolled in private pension programs and about 51 billion euro in
assets under management. In terms of enrolled members closed and open
pension funds counted around 1.7 million members, which represent more than
50% of all employees registered to a private pension scheme. With the
introduction of the Tfr-reform in 2007 the number of employees enrolled jumped
by around 43% equal to 1.4 million to 4.7 million within one year only. This jump
occurred mainly due to the obligation for employees to decide where to invest
the severance indemnity. The assets under management grew by more than 6
billion euro to 57.7 billion euro. At the end of 2007 closed and open pension
funds recorded the highest growth rates compared to other pension products.
However, from 2008 to 2012, the situation changed. The growth of new
members enrolled diminished to an average annual rate of 4.7% so below to the
pre-reform 8.4% level between 2003 and 2006. It is interesting that the
allocation of members between the different product types changed
significantly. While closed pension funds registered a zero level growth,
individual savings plans grew by more than 12% every year and resulted to
have the most members enrolled by the end of the year 2012. At the end of
2012 a total of 5.9 million employees were registered to a private pension
scheme with about 99 billion Euro invested.
According to the Istat around 22 million people worked in Italy at the end of
2011, of which 16 million as dependent employees (with severance indemnity
payments) and 6 million as self-employed. The comparison of the enrolled
members and the overall number of employees reveals that only one fourth of
all Italian employees are registered to a complementary pension scheme so far.
Regarding the assets under management estimations from the government
predict that the annual flows from the severance indemnity amount to about 19
billion euro. During the past three years, however, only around 5 billion euro on
average per year of severance indemnity flowed into the complementary
35
pension schemes. As these numbers show, the market for private pension
provision contains a high potential for growth.
Figure 10: Development of enrolled members and assets under management
Source: Covip – Annual reports
36
4. ANALYSIS
This chapter talks about the primary topic of thesis: the change in the future
composition of pension income in Italy. The idea of this section is to simulate
the change in replacement rates, so the ratio between pension income and last
salary, coming from public pension schemes and private pension provision.
As already mentioned in section 3.3, the Italian pension system designs three
different cases for the calculation of public pension income since the last
reforms of the Monti government. The application of those schemes on the
different employee profiles entails a change in replacement rates. The
replacement rates show how much a retiree receives in pension income in
relation to his/her last salary.
In order to have a better understanding for the following simulation of
replacement rates a short recap of the different calculation cases will be given.
Case 1: this scenario refers to employees, who had a minimum of 18 years of
contribution before the 31st of December 1995. In this case the pension income
is calculated based on the defined benefit scheme until the 31 stof January 2011.
For employees starting to retire from the 1stof January 2012, the pension
income is fully calculated on the defined benefit base. For e.g. for employees
retiring from the 1stof January 2013, the last year of contribution (2012) is
already calculated based on the notional defined contribution scheme.
Case 2: the second mixed scenario refers to employees, who had less than 18
years of contributionat the 31st of December 1995. In this case the pension
income is determined by the defined benefit scheme for the years until 31 stof
December 1995. For all years of contribution after that date the notional defined
contribution scheme is used for the calculation of pension income.
Case 3: the third case relates to workers, who started to work after the 1 st
january 1996. In this case the entire pension income is fully based on the
notional defined contribution scheme.
37
Figure 11: Three different pensioning cases
Replacement rates
In the context of pension schemes, the replacement rate is simply defined as
the ratio between the first annual pension income and the level of the last
annual salary. Hence, this ratio indicates the change of income in the passage
from active worker to retiree.
In general two types of replacement rates exist: gross and net replacements
rates. Gross replacement rates are basically composed dividing the gross
pension income by the last gross salary. For the calculation of net replacement
rates, instead, the net salary, including taxes and social security contributions
and the net pension income, where only taxes are deducted, is used. The
taxation of personal income is characterized by its progressiveness, in pratice
the tax rate increases as the taxable salary increases.
Gross replacement rates are always lower than net replacement rates as in the
fraction for net replacement rates the denominator is reduced more than the
numerator, which furthermore leads to a higher percentage level for the net
replacement rate. (La Republicca, 2008)
The following simulations use the gross replacement rate for the composition of
the analysis. The main reason for this choice is that the calculation of the net
replacement rate mostly depends on the income taxation of each individual. In
order to reach comparable results based on net replacement rates, the anaylsis
would need to be based on the single characteristics of the Italian income
taxation, which is not intended in the present analysis.
38
4.1 THE SIMULATION
The model simulates the replacement rates according to the different
calculation types for pension income. All simulations are based on common
assumptions. The model assumes that employees will work for 40 years and
retire at an age of 66 years in line with new rules from the Monti reform.
Furthermore, in each simulation the calculation of replacement rates will be
conducted for ten different income categories. This differentiation helps to
analyze how and if the relation between last salary and pension income
changes according to the level of salary. The ten salary categories try to
illustrate different employee profiles (employees and managers).The first
category shows the profile of the Italian average employee with a final yearly
salary of around 32,000 Euro. The last category stands for the final yearly
salary of a senior manager with an amount of 130,000 Euro. The salary
categories 2 to 9 show the income profile for the employee profiles in between.
Table 5: Salary categories in Euro
Source: own calculations
For the development of salaries, the 40 years of contribution are divided in four
decades. Each decade is combined with a different growth rate for salaries. The
model assumes that salaries during the first two decades of work grow at higher
rates than during the last two decades. Normally an employee experiences the
greatest salary increase between year 10 and 30 of his/her career.
The growth rates are based on historical salary increases published by the Istat.
The 10 year average for this data series is 2.6% while the 15 year average is
2.15%. The salary growth rates for the four different decades are based on
these numbers. Therefore, the simulation assumes the following rates: decade
1-10 assumes a growth rate of 2%, decade 11-20 2.5%, decade 21-30 2% and
decade 31-40 a growth rate of 1.5%.
39
Figure 12: Growth of gross wages (1997 – 2011)
5,00%
4,00%
3,00%
2,00%
1,00%
0,00%
-1,00%
-2,00%
Source: Istat, Bloomberg
The first simulation (denominated as DB – Defined benefit) is done for
employees retiring in 2012 and therefore are fully linked to a defined benefit
calculation.
The second simulation (denominated as Mixed – DB and NDC) projects the
replacement rate for employees retiring 2025. In this case the ten years of
contribution before the 1stof January 1996 are calculated according to the
defined benefit scheme and the 30 years after that point of time according to the
notional defined contribution scheme.
The third simulation (NDC – notional defined contribution) calculates the
replacement rate for employees retiring in 2035 who are fully subject to the
notional defined contribution scheme.
The fourth simulation (denominated as private) projects the replacement rates
coming from private pension provision programs.
The following sections show how each of these simulations was calculated and
what the main outcomes were.
4.1.1 SIMULATION 1: RETIRING IN 2012 (DEFINED BENEFIT SCENARIO)
In section 3.3.1. a short description for the calculation of pensions under the
defined benefit scheme was already given. The determination of the
pensionable income under this scheme is the main component and more
40
difficult to calculate compared to the pensionable income in the notional defined
benefit scheme. In order to eliminate the loss of purchasing power of money,
the law (D.Lgs. 30 dicembre 1992, n. 503) designs the revaluation of all
incomes for the years of work preceding the pensioning. For this purpose, the
Istat provides revaluation coefficients, calculated on the basis of the FOI index.
As mentioned earlier the pensionable income is composed of two quotes: a first
quote A, based on the aggregated years of work until the end of 1992 and a
second quote B, determined by the years of contribution after the 1stof
January1993. The revaluation coefficients for the income are slightly different
for quote A and quote B. In difference to quote A, the revaluation coefficients for
quote B are increased by one percentage point as a bonus. The following table
illustrates the coefficients valid for 2012.
Table 6: Revaluation coefficients for quote A and B
th
Source: INPS (Msg. nr. 6167, April 6 2012)
How to determine the monthly pensionable income for quote A?
Quote A is given by the following formula:
A (years of contribution) x B (average weekly salary) x 0.0015384
“A” are the years of contribution, indicated in weeks, aggregated until the 31stof
December 1992, “B” is the average weekly salary (revaluated accordingly to the
above shown coefficients) calculated on the last 260 weeks of work, 0.0015384
(see section 3.3.1 rate of return of 2% divided by 13 – number of monthly
41
payments) is a fixed coefficient to be applied to an average weekly salary lower
than Euro 850.08 (equal to an annual salary of Euro 44,204).
If the annual salary exceeds the ceiling of Euro 44,204, the calculation and the
coefficients need to be adjusted. The ceiling is adjusted every year and
published by the INPS. For the year 2012 the following ranges are effective
(INPS 2, cir. Nr. 21 february 9th 2012).

0.0015384 (2%) - until Euro 850.08 (44,204)

0.0011538 (1.5%) – for the range exceeding the 33% - between 850.08
(44,204) and 1,130.6 (58,791)

0.000961538 (1.25%) – for the range between 33% and 66% - between
1,130.6 (58,791) and 1,411.13 (73,379)

0.00076923 (1%) – for the range exceeding the 90% - higher than
1,615.15 (83,988)
The calculation for quote B follows the same logic with some minor changes.
A1 (years of contribution) x B1 (average weekly salary) x 0.0015384
“A1” are the years of contribution, indicated in weeks, aggregated after the 1stof
January 1993, “B1” is the average weekly salary (revaluated accordingly to
coefficients in table 5) calculated on the last 520 weeks of work, 0.0015384 (see
section 3.3.1 rate of return of 2% divided by 13 – number of monthly payments)
is a fixed coefficient to be applied to a average weekly salary lower than Euro
850.08 (equal to an annual salary of Euro 44,204).
Also for the calculation of quote B, in case the revaluated weekly salary is
higher than Euro 850.08, the multiplicators decrease when increasing the
pension income as follows:

0.00123076 (1.60%) – for the range exceeding the 33% - between
850.08 (44,204) and 1,130.6 (58,791)

0.00103846 (1.35%) – for the range between 33% and 66% - between
1,130.6 (58,791) and 1,411.13 (73,379)
42

0.000846154 (1.10%) – for the range between 66% and 90% - between
1,411.13 (73,379) and 1,615.15 (83,988)

0.000692308 (0.90%) - for the range exceeding the 90% - higher than
1,615.15 (83,988)
The gross pension paid by the INPS (13 monthly payments) is equal to the sum
of quote A and quote B.
The following numerical examples assume regular employees, who had
aggregated 1,092 weeks of pension contribution until the end of 1992, and 988
weeks of contribution after the 1stof January 1993. In total they contributed
2,080 weeks equal to 40 years of work.
The calculation is done according to the above explained scheme and for an
employee with salary category 4, so an initial salary of Euro 30,000 and final
salary of nearly Euro 65,000.
Table 7: Defined benefit scheme – calculation of quote A
43
Table 8: Defined benefit scheme – calculation of quote B
So the monthly gross pension consists of the sum of quote A and quote B,
equal to Euro 3,703. Multiplied by 13 (number of payments) results in a yearly
pension salary of Euro 48,139.
The next step of the simulation leads to the main wanted outcome, the
replacement rate. The gross replacement is simply obtained dividing the
pension salary by the last salary before pensioning. In this case 48,139 / 64,927
= 74%. The retiree gets 74% of his last salary as pension income.
The same simulation was done for all salary categories, from 1 to 10. The
following chart shows the different replacement rates for such salary ranges.
44
Figure 13: Public pension income and replacement rates in 2012
Source: own calculations
For salary category 1 to 2 the gross pension replacement rate is nearly 80%.
This is because the income is revaluated at the highest rate of return of 2%.
From category 3 to 10 the replacement rates decrease while salaries increase.
The replacement rate diminshes from 71% for category 5 to 57% for category
10. The main driver is the different revaluation of salaries.
4.1.2 SIMULATION 2: RETIRING IN 2025 (MIXED SCENARIO)
The calculation of replacement rates for employees retiring in 2025 is more
complicated as those employees underlie two different pension schemes: the
old defined benefit system and the new notional defined contribution scheme.
The theoretical framework was already given at the beginning of this section
and for the notional defined contribution system in section 3.3.2. Before starting
to show the numerical examples some parameters, which are fundamental for
the determination of replacement rates, need to be defined.
In the mixed scenario the retirement is assumed to happen in 2025, so Quote A
and Quote B, which are necessary for the calculation of the old defined part
need to be included. The models assumes to use the same coefficients, as the
once published by the Istat for the year 2012.
45
The pension amount for the years of work after the 1stof January 1996 are
based on the notional defined contribution systems. For that scheme the growth
of the gross domestic products is relevant. The following graph shows the
yearly growth rates over the last 15 years.
Figure 14: Nominal GDP growth
Source: Istat, Bloomberg
The 5 year average, the red line, is used as capitalization rate for pension
contributions. For the years between 2012 and 2025 it is assumed that the
economy will recover and turn back to higher growth rates. The 5 year average
should move from currently 0.72% to 1.3% in 2015 and furhter to 1.5% in 2025.
In table 9 a short abstract for the calculation of notional defined contribution part
based on salary category 1 is illustrated. The main number in the table is on the
bottom right, the annual pension income. It is obtained in the following way:
every year (from 1996 up to 2025) 33% of the annual salary is contributed to the
pension scheme. This amount is capitalized by the 5 year average of the GDP
growth. This procedure is done until the age of pensioning. The total sum of all
capitalized contributions is then multiplied by the transformation coeffcients. As
the pensioning will happen in 2025 the transformation coeffcients published in
table 4 and valid from 2012 until 2015 shouldn’t be valid anymore for the year
46
2025. For this reason the coeffcients were adjusted using a decreasing variation
of 6%. So e.g. the coeffcient for age 66, passed from 5.624% to 5.287%.
In order to get annual pension amount the total sum of contributions is
multiplied by the transformation coeffcient. In shown example 315.124 x 5.287%
= 16.659.
Table 9: Notional defined contribution scheme
For the 10 years of work from 1985 to 1996, the pension amount is calculated
accordingly to the defined benefit scheme. This is done in the exact same way
as for simulation 1 in the previous section. The only difference are the number
of weeks before and after the 1stof January 1993. Following the same
framework an annual pension income of Euro 6,507 results. Dividing the sum of
16,659 (NDC part) and 6,507 (DB part) by the last salary 32,463 gives a gross
pension replacement rate of 71%.
In the simulation the same process was done for all other salaries categories.
The outcome of the simulation can be observed in the following chart.
47
Figure 15: Pension income and replacement rates in 2025
Source: own calculations
4.1.3 SIMULATION 3: RETIRING IN 2035 (NDC)
The third simulation (“NDC – notional defined contribution”) calculates the
replacement rate for employees retiring in 2035 and who are fully subject to the
notional defined contribution scheme. It is the scheme which is currently active
for all employees, who started to work after the 1stof January 1996. In the
simulation for retiring in 2035 an adjustment for the transformation coeffcients
(table 4) was done. The coeffcients were adjusted downwards by using an
simplified average of the variation between the period 2009-2013 and 20102013.
In order to better understand the outcomes of the simulation, an important point
of this scheme should be emphasized: the maximum salary ceiling for pension
contributions. The yearly pension contribution amounting to 33% of the annual
salary can only be taken into account to a maximum of Euro 96,149 for the year
2012. This contribution cap was introduced with the implementation of the new
pension scheme in 1996 (Art. 2, law nr. 335, 8.8.1995). The ceiling needs to be
revaluated every year in line with the FOI Index, published by the Istat.
As a consequence of this regulation the ratio between pension contributions
and salary is not the same for all salary categories. As the relation between
48
pension contribution (33%) and salary is linear for all incomes up to maximum
of 96,149 the replacement rate is the same for category 1 to 7 at a level of 65%.
Starting from category 8,however, the gross replacement rate is decreasing
down to a level of 60% for category 10.
Working until 70 years
As already mentioned in section 3.2.2, the pension reforms from the Monti
government reward working until an age of 70 years. In May 2012, the
transformation coeffcients were extented up to 70 years for this purpose. In
order to observe the advantages of working until a higher age, the same
simulation for notional defined contribution schemes was conducted by
changing the year of pensioning.
The following chart shows the differences between pensioning at an age of 66
years and at an age of 70 years.
Figure 16: Replacement rates for pensioning at age 66 and 70 years
Source: own calculations
This picture clearly states that there is a huge advantage of pensioning at a
higher age. By deciding to retire at 66 years, a pensioner gets around 65% of
replacement rate. A regular employee, instead, remaining active until 70 years
of age, gets nearly 19% more of pension income, which results in a total of 84%
of his last salary.
49
4.1.4 SIMULATION 4: PRIVATE PENSION PROVISION
The last simulation analyzes the development of private pension provision and
the respective impact on pension income and replacement rates. The focus are
the contributions resulting from the severance indemnity (trattamento di fine
rapporto).
The simulation assumes that 6.91% of the yearly gross salary is invested in a
form of complementary pension provision. The framework used for the
computation of replacement resulting from the private pension scheme is nearly
the same as the one used in the notional defined contribution scheme and the
mixed scheme. Exclusively the yearly amount of contribution (6.91% instead of
33%) and the yearly capitalization rate are different. In the private pension
scheme the contributions are actually invested in real assets compared to the
notional defined contribution scheme, where contributions are charged to a
notional fictive account. The simulation model assumes an investment in a
pension fund with a defensive portfolio allocation of 70% in bonds and 30% in
equities. Bonds on average should yield 1.75% and equity investments 4%
above inflation, after tax and costs (data used from Covip), so a portfolio
performance of 2.43% per annum. The invested amounts are capitalized at this
rate. The final amount with 40 years of contribution capitalized at an average
rate
of
2.43%
is then
multiplied
with
the
transformation
coefficient
corresponding to the age of retirement. As the complementary pension scheme
does not contain any restrictions and ceilings for contributions, the replacement
rate is the same for all salary categories. The replacement rate obtained from
the simulation is 15%.
50
Figure 17: Replacement rates from private and public pension in 2035
Source: own calculations
The graph shows that in combination with complementary pension schemes the
replacement rate is nearly the same as in the case when working until an age of
70 years. At this point it deserves to be mentioned that the foregoing simulation
was carried out for the minimum of contributions to a private pension scheme
only. Employees are of course not detained to dedicate a higher percentage of
their salary to complementary pension provisions. In the simulation a second
scenario was also computed, where employees pay 10% of their gross salary
into the private pension contribution. By investing 10% of the gross salary for
the entire working lifetime results in a replacement rate of around 22% coming
private pension provision. The yearly contribution rate can be increased by each
individual in accordance to his/her financial possiblities.
51
5. FINAL CONSIDERATIONS AND REFLECTIONS
Figure 18: Replacement rates in 2013, 2025 and 2035 from public pension
Source: own calculations
Figure 18 summarizes the future development of the Italian pension system.
The blue colored bars illustrate the replacement rate for retirement in 2012
under the framework of the old defined benefit system. The green colored bars
show the level of replacement rates when retiring in 2025 and linked to the
mixed scheme. The red bars describe the replacement rate for workers retiring
under the notional defined contribution scheme in 2035.
Workers retiring in 2012 are the last ones to profit from the advantage of the old
defined beneft system. When taking a closer look it turns out that the
distribution of replacement rates is fairly unequal for the old defined benefit
scheme. The difference in replacement rates between category 1 and 10 is
nearly 24%.
The mixed scheme comprises more equal replacement rates. The difference
between the lowest and highest salary category is around 14%. This is mainly
due to a greater part of pension income which is determined by the notional
defined contribution scheme.
Looking at the red bars, the level from category 1 to category 10 is nearly the
same. The difference is around 5%. The notional defined contribution scheme
52
treats pension incomes of all individuals in a more equal way. The amount an
employee contributes during his entire worklife is paid out once the decision to
retire is made. In simple terms: what is paid in, is paid out a later point of time.
For this reason the replacement rates stay at almost the same level for all
salary categories. The decrease in replacement rates for higher salary
categories is due to the cap on pension contributions already explained in the
previous analysis.
The graph could also be analyzed along the different salary categories. Workers
from salary category 1 experience the biggest declines in pension income
between pensioning in 2012 and 2035. The drop from the defined benefit
directive to the notional defined contribution schemes amounts to about 16%.
This means that a retiree with a final salary of Euro 32,000 in the year 2035 will
get 16% less of pension income compared to a pensioner with the same profile
retiring in 2012.The drop in replacement rates between the different frameworks
starts to evened out for higher salary categories. Interesting to observe is also
the fact that for categories 7 to 10 the replacement in 2035 is in fact higher than
2012. The reason is that in the notional defined contribution scheme, which
follows a more equal treatment, higher salaries are not that much limited.
Furthemore, it can be concluded that employees retiring in 2012 with salary
profile 1 to 5 actually receive more pension income than contributed into the
pension system. This is one of the crucial aspects why a deep structural
pension reform was needed.
5.1.1 ADVANTAGES AND CHALLENGES FOR THE NDC
To sum it up, the introduction of the notional defined contribution system led to
a more equal treatment between pension contributions and pension incomes.
The new pension scheme does not burden on public expenses as it is in line
with economic growth of the country. Furthermore with the determination of
transformation coefficients the system adapts to the demographic change within
the population of a state. But there is one risk that should not be forgotten: as
the determination of certain parameters of the NDC framework is linked to
economic growth there is a risk that certain projections will not persist. During
53
2008 and 2009 Italy experienced negative growth rates for the GDP, which
implicated a 5 year average around levels of 1%. For this purpose the italian
government confirmed positive capitalization rates of 1-1.5% for the next years,
as the negative years were considered anomalous due to the economic crisis. If
a sustained economic recovery does not happen, the growth rates close to zero
will impact the calculation of pension income negatively.
In addition a weak point of the system is also the following: in the context for the
calculation methods of the notional defined contribution scheme it needs to be
clarified that there are actually no real amounts of money, which are
accumulated and destinated to an active financial portfolio as it is done for
complementary pension schemes.
With the introduction of the last pension reforms the financing of pension
benefits has not been revised. Current pensions are still guaranteed along the
pay-as-you-go mechanism. Basically, the contributions paid by active workers
are used to pay the pension income of new retirees. This mechanism does not
guarantee a perfect consistency between paid-in contributions and paid out
benefits. The unstableness of this mechanism should decrease the longer the
notional defined contribution scheme is active and the less pensioners subject
to the old defined benefit scheme will be in the public pension provision.
5.1.2 THE CHALLENGES FOR COMPLEMENTARY PENSION PROVISION
Due to the changes in the public pension schemes the complementary pension
provision has become more important than ever. The laws passed in the past
years have reduced the public pension scheme and as a consequence
increased the relevance of complementary pension schemes. Nevertheless the
diffusion of the private pension provision is still at low levels and unsatifying in
relation to the expectations. Out of the 22 million working population only
around 6 million people (dated December 2012, Covip) are enrolled to one of
the forms for complementary pension schemes.
There are various reasons for this constellation. The simulation tends to prove
that in the short term replacement rates and pension income will remain at
moderate levels, in the long term instead it shows that they will undergo a
54
radical change. Yet, in reality, a broad part of the population is still not aware of
the tendency of reducedpension benefits.
Today, three out of four employees do not enter the system for private pension
provision. The participation of young people is dramatically lower: only 18% of
all emloyees aged below 35 years are enrolled in complementary pension
schemes. Equally the number of those, who actually decide to suspend the
payment of contributions is increasing.
But why is this the case?
To begin with, one part of the population is effectively not aware of their
respective personal provision needs and does not understand the possibilities
offered due to their complexity. In order to counteract this issue it is necessary
to improve the information flow and foster information exchange as well as
transparency for employees. Overall awareness of the structural changes within
the Italian social security needs to be raised and communication should be a
strategic part of every pension initiative in order to ensure that employees are
suffiently educated and are able to recognize the value of the pension schemes.
Then again, another part of the population, in contrast, is aware of the changing
environment. What prevents them from entering complementary schemes are
on the one hand a lack of trust in the system and on the other hand missing
economical possibilites. In the aftermath of the financial crisis, the attitude of
employees towards financial institutions like banks, insurance companies and
pension provision institutions has changed significantly. A lot of employees
critized the opacity of complementary pension products and the increased cost
structure of those products. The target should be to overcome these negative
sentiments, to rebuild the trust of employees, to encourage them to invest in
private pension provisionand to make them responsible for building their future
retirement income.
The other problem mentioned above, the missing economical capacity of
employees and especially young employees is a problem of higher complexity.
In this context the weak persisting contracts for employment are a big issue.
The majority of young Italian employees get only temporary contracts during
their first years of work. These contracts avoid planning reliability for employees
and furthermore don’t facilitate the development of private pension provision.
55
Another issue to bear in mind which could affect the weak development of the
complementary pension market is the destination of the severance indemnity.
After the reform in 2007 a high number of employees still decided to maintain
the indemnity within the company. The core business of the Italian economy
consists ofsmall and medium sized businesses, which means companies with
10 – 50 employees. The indemnities kept within these small companies were
seen as a loan financing between the employee and the employer. With the
introduction of the new regulation certain employees had and still have the
sensation that shifting their compensation outside of the company could weaken
their position with regard to their employer.
To conclude, the problem of guaranteeing an adequate pension for everyone is
still unsolved. Solutions for better integrating private and public contribution
schemes are suggested by multiple institutions and are discussed vividly.
In any case it will be important to change the fiscal treatment for private pension
accumulation, for example it is necessary to tax realized returns and not to tax
accrued returns as it is done so far. This procedure could increase the available
capital at maturity. It also should not be forgotten, that several other countries
worldwide ask their employees for mandatory contributions to private pensions
schemes in order to improve their coverage rates, contrary to the voluntary
sytem in Italy. A mutual exchange of best practices and learnings with other
countries and finally the common approach for a sustainable solution should
definitely be considered by Italy.
To sum up, we may say that the investment in complementary pension
schemes is of undeniable importance, because the earlier someone starts to
individually take care of his/her personal provision the more flexible he/she will
be able to react to demographic, social, financial and economic tendencies and
the less he/she will depend on political decisions. Similarly, policy makers
should set the expansion of private pension provision rates as their main policy
target for the future, because simple solutions like the increase of retirement
ages and the promotion to work rather to retire have stopped being useful and
further efforts seem to be needed in order to address the challenges explained
in this work.
56
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