Statutory Pension in Relation to Wages

How to compare?

Pensions can be compared to wages in many different ways. The concept of ‘replacement ratio’ is usually used to compare the starting pension to the earnings received before retirement. Pensions can also be reviewed by comparing average pensions to average earnings.

The starting pension in relation to the person’s own last wage or to the average earnings in the economy changes during the retirement period. This is due to the earnings-related pension index, which is used to adjust earnings-related pensions in payment. In addition to changes in consumer prices, the index takes into consideration 20 per cent of the changes in real earnings. Therefore, in time, the replacement ratio of the pension in payment in relation to the wages paid for the same work is likely to decrease.

There are two different definitions of the replacement ratio. The gross replacement ratio means the starting pension in relation to the person’s own last wage. In this case, the ratio is calculated on the basis of the pension and the wage, from which no taxes or contributions have been deducted. Net replacement ratio refers to the pension in hand in relation to the person’s own last wage, from which taxes and contributions have been deducted.

The gross and net replacement ratios are of different size due to the progressive tax system and the different tax deductions and social security contributions of pensions and wages. The net replacement ratio is therefore nearly always higher than the gross replacement ratio.

No pension ceiling

Finland has not set a ceiling for the amount of the pension or the pensionable earnings. In addition, after the 2005 pension reform, there has been no ceiling on the targeted replacement rate.

Before 2005, according to valid regulations on how to determine the pension, the targeted replacement ratio of the private-sector earnings-related pension scheme was set at a maximum of 60 per cent (66 per cent in the public sector) of the highest pensionable wage during a person’s working life. The pension was targeted to amount to 60 per cent of the wages. It was possible to achieve level by working for slightly below 40 years.

Every earned euro affects the earnings-related pension by an amount that depends on the insured person’s age. The pension amount and its replacement ratio can be increased considerably by continuing at work past the retirement age. If the pension is drawn late, it is increased by 0.4 per cent for each month past the retirement age.

Replacement ratios in light of research

Replacement ratios can be reviewed theoretically, in terms of working life examples, or empirically, based on research data. Replacement ratios calculated on the basis of research data best describe the pension situation at the time of conducting the study and provide information on realised pension levels for many different working lives.

The most recent replacement ratio calculations based on research data performed in Finland were done in 2010 by the Finnish Centre for Pensions and the Labour Institute for Economic Research. The research data used in the joint study (available only in Finnish) Työstä eläkkeelle – tulokehitys ja korvaussuhteet (From employment to retirement – development of earnings and replacement ratios) was panel data comprising 500,000 people from Statistics Finland’s population database in 1995-2004. The actual analysis was conducted on persons who retired from work between 1999 and 2003.

According to the results, the median of the replacement ratio of retired employees in the early 2000s was approximately 60 per cent of the wage-earner’s earnings from a few years ago.

The replacement ratio describes the pension that a person receives in relation to the regular real income of that person in the last few years before retirement. In the above-mentioned study, the income was calculated as an average of the income during the previous three years. Income transfers are taken into account as part of the income prior to retirement, but capital income is excluded from the calculations.

International comparisons of the theoretical replacement ratio

Pension replacement ratios are usually based on theoretical calculations, in which the assumption is an uninterrupted working life with an average wage. The calculations aim at describing how generous the pension schemes of different countries are under certain calculation assumptions.

At regular intervals, the EU and the OECD conduct comparative studies on the level of the replacement ratio in different countries. In addition, the Nordic Social-Statistical Committee NOSOSCO performs its own calculations. The calculations have been made using slightly different assumptions, leaving the resulting replacement levels incomparable.

In the latest report (2015) published by the OECD (a report published at regular intervals), Pensions at a Glance, the gross replacement ratio for earnings-related pensions for a Finnish wage-earner with an average wage is 56 per cent. This is on the average level (53.0 per cent) within the OECD. In OECD’s calculations, people are assumed to begin working at the age of 20 and continue working without interruptions until the national retirement age, that is, until age 65  in Finland.

In the calculations of the Indicator Sub-Group (ISG) of the Social Protection Committee (SPC), the changes in pension replacement ratios between 2013 and 2053 are reviewed. The replacement ratios for Finland are estimated to decline from 62 to 51 per cent. The EU calculations assume a working life of 40 years and retirement at the age of 65.

In the NOSOSCO calculations, the pension replacement ratios settle at 65 per cent for the example person born in 1942 and 56 per cent of the gross wages for the example person born in 1962.

In light of replacement ratios, the Finnish pension system ranks in the middle in most reviews. The system’s replacement ratios are declining, as is the case in many other countries of comparison.

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Expert: Juha Knuuti