Economist: Extraordinary pension hikes have caused issues with indexation

Economist Kaspar Oja explained that under the current pension indexation system, pensions may not grow at the same rate as wages. Previous extraordinary increases in pensions have led to a situation where pensions are growing faster than wages.
Economist Kaspar Oja said on the "Terevisioon" morning show Monday that indexed expenses make up only a small portion of the Estonian state budget, while the majority consists of previously agreed-upon costs.
"There's been a lot of talk about pensions, with certain wages and some subsidies also indexed. However, there are a number of expenses based on prior agreements and their relative importance is much greater," Oja said.
"I think discussions about the budget should focus more on those predetermined costs," he stated. "Indexation affects a relatively small part. That said, it is significant because it includes pensions, which admittedly form a considerable portion of the budget and are emotionally charged for many."
Host Liisu Lass noted that politicians had promised to raise pensions during the election cycle before implementing indexation.
"Yes, and that's essentially what has happened," Oja replied.
Oja explained that indexed pensions provide individuals with a sense of certainty about how much their pension will grow. "For those far from retirement, it offers a rough idea of what their pension might eventually be, assuming the rules for pension increases are followed."
The issue with indexation appears during periods when extraordinary pension increases are made instead of applying standard indexing, Oja said.
"When looking at the pension index, it depends on past wage growth and inflation — through social tax, it's tied to wage growth. The problem is that if wages grow significantly faster, pensions are calculated based on past wage growth, causing pensions to lag. Conversely, during economic downturns, pensions may grow faster than wages," he explained.
The host asked if such a situation is currently occurring.
"Considering the latest economic forecasts, real wages are expected to grow. However, since some other taxes are also increasing, net real wages might not grow after taxes. At the same time, disposable income is rising due to falling interest rates and pensions are likely growing faster than wages. We are currently seeing a situation where other forms of income are growing faster than wages," Oja said.
A few years ago, the opposite was true, according to Oja. "Wages grew more slowly in the past and pensions were raised partly to ensure they didn't lag too far behind wage growth, preventing a decline in pensioners' purchasing power. At that time, there was a social rationale for doing so."
Oja suggested that the problem with pension indexation might lie in how the index is calculated.
"For some indicators, indexation involves targeting a certain value or relative structure, followed by short-term forecasting. For example, employers and unions set the minimum wage by targeting a specific value and making short-term forecasts," he said.
"There are mainly two components," Oja continued. "One is the long-term expectation as a ratio, which is adjusted accordingly. The other is short-term growth, forecasted based on economic predictions. Perhaps if a similar approach were taken with pensions, we wouldn't have these periods requiring extraordinary pension increases, which then become permanent."
Employers have previously pointed out that the wages of public sector employees have risen faster than the economy. The host asked what component should change in the index for higher-ranking public officials' salaries.
"The issue here is that when people refer to economic growth, they often mean real growth, adjusted for inflation. However, nominal economic growth has always been fairly significant. Corporate revenues, wages and profits have grown. Pensions, being a nominal figure, should theoretically grow in line with these other nominal indicators," Oja explained.
Oja emphasized that there's nothing inherently wrong with indexation. "The issue lies in the past extraordinary increases, which have been incorporated into the pension index and never removed."
He noted that reverting past pension increases could restore the structure to its previous state. "But whether that would make sense is another question. We know that poverty in Estonia largely affects pensioners, so this is likely an area where more resources are needed."
The host asked whether Estonia might see a scenario where indexation is revised or abandoned, with pension and public officials' salary increases determined by political decisions.
"I think we may have learned from recent years that following some kind of structure could be reasonable," Oja said. "But we've somewhat disrupted that with sharp, one-time increases."
Oja explained that significant retroactive public sector wage increases have been made to compensate for years when they were not raised. "This means we didn't have a clear understanding of ongoing public sector costs. When extraordinary tax revenues came in, new permanent costs were created instead of, for example, simply raising police officers' salaries."
Pensions indexing in Estonia
Pensions grow due to indexation on April 1 each year.
Indexation serves the purpose of keeping pensions in balance with changes in wages and prices. To this end, the Government of the Republic approves a new index each year. The index is calculated as follows:
80 percent — change in receipt of the pension insurance part of social tax in the previous year;
20 percent — change in the consumer price index of the previous year.
Indexation is only applied if the aforesaid increase. But pensions will not be reduced if they decrease.
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Editor: Valner Väino, Marcus Turovski