This document summarizes a study on the welfare effects of Poland's 1999 pension reform, which introduced a three-pillar pension system including a notional defined contribution scheme and a fully funded defined contribution scheme. The study uses an overlapping generations model to assess the aggregate efficiency of the reform, the effects across generations, and the importance of different fiscal closure approaches used to finance the transition. The results show that the reform improved welfare and most gains came from reduced pension benefits rather than pre-funding. The choice of fiscal closure, such as using public debt, also significantly impacted welfare and the distribution of costs across generations.

1. Welfare Effects of the Pension Reform in Poland
Welfare Effects of the Pension Reform in Poland
(with Marcin Bielecki, Jan Hagemejer, Krzysztof Makarski and Joanna Tyrowicz)
Karolina Goraus
Faculty of Economics, University of Warsaw
WIEM 2014
12 July 2014

2. Welfare Effects of the Pension Reform in Poland
Table of contents
1 Motivation
2 Model setup
3 Calibration and baseline
4 Results

3. Welfare Effects of the Pension Reform in Poland
Motivation
Broad picture
A scientific project at the University of Warsaw
OLG modeling of the pension system reform in Poland
Questions
Aggregate efficiency of the reform?
Effects across generations?
The importance of fiscal closure?

4. Welfare Effects of the Pension Reform in Poland
Motivation
Pension reform
Common propositions
fiscal side: raising contributions rates, contribution base and/or lowering
benefits
demographic side: fertility or immigration fostering policies
Polish case (reform of 1999)
the original system was a DB PAYG scheme
then introduction of a three pillar system
1 notional defined contribution (NDC) scheme ⇒ managed by Social
Insurance Fund (SIF)
2 fully funded DC (FDC) scheme ⇒ managed by Open Pension Funds (OPFs)
3 voluntary pension schemes

5. Welfare Effects of the Pension Reform in Poland
Motivation
Highlights
1 Assesing the aggregate efficiency ⇒ reform was welfare enhancing
2 Decomposing the welfare effects to the part attributable to changing the
way pensions are financed (PAYG → pre-funding) and to changing the way
pensions are computed (DB → DC) ⇒ the majority of the welfare effects
comes from the downward adjustment of pensions and not from
establishing the pre-funded capital pillar
3 Assesing the impact of fiscal closure on welfare assessment ⇒
approximately 15-20% of the overall welfare effect
4 Comparing main types of fiscal closures ⇒ financing the gap with public
debt allows more intergenerational equality

6. Welfare Effects of the Pension Reform in Poland
Model setup
1 Motivation
2 Model setup
3 Calibration and baseline
4 Results

7. Welfare Effects of the Pension Reform in Poland
Model setup
Model overview
OLG model with endogenous labor and savings
Heterogeneity across cohorts (mortality and labor productivity)
No heterogeneity within cohorts
Agents might have time inconsistent preferences
Exogenous retirement age and demographics
Competitive producers with CD production function
Pension system + pension system reform
Inter-generational transfers + utility to compare welfare across time with
changing demographics
Different fiscal closures (to do fiscal rules)
Calibrated to the Polish economy

8. Welfare Effects of the Pension Reform in Poland
Model setup
Model structure - consumer I
is ”born” at age J = 20 and lives up to J = 100
optimizes lifetime utility derived from leisure and consumption:
Uj (cj,t , lj,t ) = uj (cj,t , lj,t ) + β
J−j
s=1
δs πj+s,t+s
πj,t
u (cj+s,t+s , lj+s,t+s ) (1)
where β is the time inconsistency parameter, δ is the time discounting
factor and πj,t denotes the unconditional probability of a household of
having survived from birth to age j at time period t.
The instantaneous utility function:
u(c, l) = φ log(c) + (1 − φ) log(1 − l), (2)

9. Welfare Effects of the Pension Reform in Poland
Model setup
Model structure - consumer II
is paid a market clearing wage for labor supplied and receives market
clearing interest on private savings
is free to choose how much to work, but only until retirement age ¯J
(forced to retire)
The budget constraint of agent j in period t is given by:
(1 + τc,t )cj,t + sj,t + Υt = (1 − τι
j,t − τl,t )wj,t lj,t ← labor income (3)
+ (1 + rt (1 − τk,t ))sj,t−1 ← capital income
+ (1 − τl,t )pj,t + bj,t ← pensions and bequests

10. Welfare Effects of the Pension Reform in Poland
Model setup
Model structure - government
collects social security contributions and pays out pensions of DB and
NDC system
subsidyt = τt · wt Lt −
J
j=¯J
pj,t πj,t Nt−j (4)
collects taxes on earnings, interest and consumption + spends GDP fixed amount
of money on unproductive (but necessary) stuff + services debt
Tt = τl,t wt Lt +
J
j=¯J
pj,t πj,t Nt−j + τc,t ct + τk,t rt sj,t−1
J
j=1
πj,t Nt−j (5)
Γt = Gt + (1 + rg
t )Dt−1 − Dt + subsidyt (6)
wants to maintain long run debt/GDP ratio fixed

11. Welfare Effects of the Pension Reform in Poland
Model setup
Pension system I
Baseline scenario:
PAYG Defined Benefit (DB) → constructed by imposing a mandatory
exogenous contribution rate τ and an exogenous replacement rate ρ
pDB
j,t =
ρt wj−1,t−1, for j = ¯Jt
κt pDB
j−1,t−1, for j > ¯Jt
(7)
Reform scenario:
Defined Contribution → constructed by imposing a mandatory exogenous
contribution rate τ and actuarially fair individual accounts in two pillars
NDC + FDC

12. Welfare Effects of the Pension Reform in Poland
Model setup
Pension system II
NDC = contributions indexed with growth of payroll + benefit actuarially
fair + post retirement indexation with 25% of payroll growth
pNDC
j,t =



¯Jt −1
i=1
Πi
s=1(1+rI
t−i+s−1) τNDC
¯Jt −i,t−i
w¯Jt −i,t−i l¯Jt −i,t−i
J
s=¯Jt
πs,t
, for j = ¯Jt
κt pNDC
j−1,t−1, for j > ¯Jt
(8)
FDC = contributions earn interest + benefit actuarially fair + post
retirement also earn interest
pFDC
j,t =



¯Jt −1
i=1
Πi
s=1(1+rt−i+s−1) τFDC
¯Jt −i,t−i
w¯Jt −i,t−i l¯Jt −i,t−i
J
s=¯Jt
πs,t
, for j = ¯Jt
(1 + rt )pFDC
j−1,t−1, for j > ¯Jt
(9)

13. Welfare Effects of the Pension Reform in Poland
Model setup
What we do not know before simulations?
1999 reform: DB PAYG ⇒ NDC + FDC = partially funded DC
part of contributions stay in the PAYG system (SIF)
part of contributions shifted away (OPFs) + fiscal tension today
lower replacement rates + ease fiscal tension in future
comparing the steady states is not enough - transitory welfare effects
BUT SIF gap needs to be financed ⇒ possible fiscal closures with own
welfare effects
five closures: lump sum, labor tax, consumption tax, debt + labor tax, debt
+ consumption tax
we cannot tell ex ante
which fiscal closure is more efficient?
what are the effects for different cohorts?

14. Welfare Effects of the Pension Reform in Poland
Model setup
What happens within each experiment?
Welfare analysis - like Nishiyama & Smetters (2007)
1 Run the no policy change scenario ⇒ baseline
2 Run the policy change scenario ⇒ reform
3 For each cohort compare utility, compensate the losers from the winners
4 If net effect positive ⇒ reform efficient
Robustness checks
with and without time inconsistency
alternative age-productivity patterns (flat and according to Deaton, 1997)

15. Welfare Effects of the Pension Reform in Poland
Calibration and baseline
1 Motivation
2 Model setup
3 Calibration and baseline
4 Results

16. Welfare Effects of the Pension Reform in Poland
Calibration and baseline
Demographics
No of 20-year-olds arriving in the model in each period (left) and mortality
rates across time for a selected cohort (right).
Source: EUROSTAT demographic forecast until 2060.

17. Welfare Effects of the Pension Reform in Poland
Calibration and baseline
Productivity growth and retirement age
Labor augmenting productivity growth rate projection (left) and actual
retirement age in economy, past values and forecasts (right).
Source: European Commission. Effective retirement age based on SIF annual reports, own projection

18. Welfare Effects of the Pension Reform in Poland
Calibration and baseline
Calibrated parameters
β = 1 β = 0.9
ω = 1 ω - D97 ω = 1 ω - D97
α capital share 0.31 0.31 0.31 0.31
τl labor tax 0.11 0.11 0.11 0.11
φ preference for leisure 0.532 0.564 0.534 0.567
δ discounting rate 0.983 1.004 0.988 1.008
d depreciation rate 0.06 0.06 0.06 0.06
τ total soc. security contr. 0.061 0.061 0.061 0.061
ρ replacement rate 0.253 0.152 0.255 0.153
resulting
∆kt /yt investment rate 21.6 21.4 21.4 21.1
r interest rate 7.2 7.3 7.3 7.5

19. Welfare Effects of the Pension Reform in Poland
Calibration and baseline
Fiscal burden of the pension system
Pension share in GDP and cumulated changes in SIF balance in the baseline
scenario of no policy change (with no time inconsistency).

20. Welfare Effects of the Pension Reform in Poland
Results
1 Motivation
2 Model setup
3 Calibration and baseline
4 Results

21. Welfare Effects of the Pension Reform in Poland
Results
Welfare effects of various fiscal closures
Consumption equivalents (in % terms of permanent consumption) under the
parametrization of β = 1 and productivity following Deaton (1997).
Fiscal closure Fiscal closure in reform min − max
in baseline Υ τc debt + τc τl debt + τl (in %)
Υ 2.586 2.439 2.576 2.791 2.900 18.8
τc 2.442 2.338 2.505 2.682 2.793 19.4
debt + τc 2.444 2.345 2.383 2.683 2.682 14.4
τl 2.393 2.299 2.440 2.601 2.729 18.7
debt + τl 2.387 2.280 2.391 2.589 2.624 15.1

22. Welfare Effects of the Pension Reform in Poland
Results
Decomposition of welfare effects I
lump sum tax

23. Welfare Effects of the Pension Reform in Poland
Results
Decomposition of welfare effects II
consumption tax (left) and debt with consumption tax (right)

24. Welfare Effects of the Pension Reform in Poland
Results
Decomposition of welfare effects III
labor tax (left) and debt with labor tax (right)

25. Welfare Effects of the Pension Reform in Poland
Results
Changes to taxes and debt share
Changes to taxes and debt share (lump sum tax in baseline scenario).

26. Welfare Effects of the Pension Reform in Poland
Results
Alternative scenarios
time inconsistent preferences
Uj (cj,t , lj,t ) = uj (cj,t , lj,t ) + β
J−j
s=1
δs πj+s,t+s
πj,t
u (cj+s,t+s , lj+s,t+s ) (10)
age-productivity profile according to Deaton (1997)

27. Welfare Effects of the Pension Reform in Poland
Results
Welfare effects in alternative scenarios
Consumption equivalents (in % terms of permanent consumption). In the
baseline scenario fiscal closure given by lump sum taxation.
Fiscal closure β = 1 β = 0.9
in reform scenario ω = 1 ω - D97 ω = 1 ω - D97
Υ 2.79 2.59 1.94 1.78
τc 3.01 2.44 2.17 1.75
debt + τc 3.11 2.58 2.24 1.84
τl 3.28 2.79 2.36 1.97
debt + τl 3.37 2.90 2.42 2.06

28. Welfare Effects of the Pension Reform in Poland
Results
Conclusions
Pension reform in Poland was welfare enhancing and the majority of the
welfare effects comes from the downward adjustment of pensions (not
from establishing the pre-funded capital pillar).
Fiscal closure itself can contribute/deduct up to app. 15-20% of the
overall welfare effect of the pension system reform.
Financing the reform with public debt allows to spread the costs of
establishing the pre-funded pillar fairly across all generations.
Results are robust to a number of parametric choices (time inconsistency
and life cycle productivity patterns).

29. Welfare Effects of the Pension Reform in Poland
Results
Questions or suggestions?
Thank you!