Spain
compiled by Allianz Global Investors
Pension System Design
Spain operates a three-pillar pension system composed of a generous and dominating state pension system and voluntary occupational and private pension arrangements.
Despite the urgent need for more far-reaching reforms, reform measures to gradually lower the still generous pension level of 85% granted by the first pillar and to strengthen the second and third pillar have not yet been taken. On the contrary, effective January 2007 Spain reduced the tax incentives for voluntary occupational pension provision. With an expected old-age dependency ratio of 67% by 2050, Spain will face an immense demographic problem, and, although pension reforms are inevitable in the medium term.
Spain has a relatively small pension market, which is dominated by third pillar insurance products, we expect pension assets grow at an annual rate of 7.7% to EUR 565 billion until 2020.
Public Pensions
The main system of pension provision in Spain is the state pension system. It contributes about 90% (for low and average wages) towards pensioners’ incomes. The first pillar in its current shape was implemented in 1997 when it underwent a thorough overhaul. It now features the following components:
- A means-tested non-contributive old-age pension granted to persons aged 65 and older, who have not acquired enough pension contributions or are not entitled to a contributory old-age pension at all. It is required that the person has lived in Spain for at least 10 years after reaching the age of 16 and for five consecutive years just before claiming the pension. This pension is financed solely from tax revenues.
- An earnings-related, contributory pension system that is mandatory for all employees and self-employed persons. The assessment base is at least 15 years of earnings and contributions, with a maximum pension being attained after 35 years of contribution. For benefits under the earnings-related pension system a means-tested minimum and maximum pension applies. It is financed through contributions paid by employees (4.7%) and employers (23.6%).
Early retirement is possible at the age of 60 for those who started working before January 1, 1967, and who have paid contributions for at least 30 years. But the pension benefit is reduced by 8% for every year of retirement before the age of 65 (maximum reduction: 40%). In the event of postponing retirement after reaching the age of 65, and having accumulated 35 contribution years, two percentage points are added to the multiplier for every further year in employment. A new law passed the Congress in November 2007 that implemented stronger incentives to postpone retirement. Beginning January 2008, individuals that postpone retirement after the statutory retirement age and have at least contributed for 40 years will see an increase of the pension benefit multiplier of four percentage points instead of only two.
In order to promote an increasing employment rate among the elderly, Spain took steps providing better opportunities for flexible and gradual retirement. On the employer side, reduced social security contributions up to 100% apply, incentivising the employment of older workers.
Occupational Pensions
Traditionally, the social security system has provided a satisfactory level of benefits for most employees. Pensions are earnings-related helping the pensioner to secure a living standard similar to that achieved during the working career. The current gross replacement rate for Spain’s first pillar amounts to 85% of pensionable income.
Consequently, there has been no perceived requirement for additional benefits, and occupational pension plans have not been highly developed. In 2006 approximately 8% of the workforce had additional occupational pension coverage. However, interest in such plans is growing because the proportion of earnings replaced by a social security pension has decreased, particularly for the higher-paid.
Up to 7% of companies are at present offering some kind of retirement plan, although these are more common among larger employers and in companies with international exposure. Currently, the majority of plans are available to the entire workforce, but still about 25% of plans are reserved only for executives.
Traditionally, benefit obligations were unfunded and sometimes even paid on a pay-as-you-go basis. In 1990, it became obligatory to account for pension liabilities via book reserve accruals. In the 1995 pension legislation, the external funding of all pension obligations was required, and this was achieved on November 16, 2002. In May 2003, the government published a report concerning the results of the externalisation process. The report concludes that this process has brought about additional external funding of pension commitments of approximately EUR 17.17 billion.
Traditionally, pension plans were of the defined benefit type, providing a pension related to final salary, or average salary over the last two years’ of employment. Defined benefit plans are usually 100% financed by the employer. Defined contribution plans are gaining in popularity where, typically, the employer bears 65-80% of the total plan cost and the employees contribute the rest. Now it is becoming quite usual to link company contributions to the employee’s contribution. In this case the plan foresees different contribution levels (minimum, medium and maximum), which are available at employee’s choice.
Private pension plan legislation came into force in 1988 and introduced the tax-qualified occupational pension arrangements. Pension funds along with insurance contracts are legally recognised funding vehicles, which attract tax advantages.
1. Pension funds
Pension funds are separate legal entities created to serve as a repository for assets of one or more tax-qualifying pension plans.
New legislation enacted in November 2007 mainly brought changes to tax-qualified pension plans, which had to be implemented by December 2008. Changes were made to compliance, funding, investment and administration rules. The most notable improvement is the possibility to offer two investment strategies under one plan. Previously, only one investment strategy was allowed. The exact wording of the act leaves some room for interpretation enabling plans to either offer two sub plans each addressing a different age group or two sub plans or sub funds into which employees are invested with varying weights according to their age.
The appointment of an investment manager and a custodian is required. The choice of the investment manager is restricted in that it has to be either a registered pension fund manager, which can only be a specialist company legally domiciled in Spain, or an insurer.
There are rules regarding a minimum funding level and solvency margin for defined benefit plans. Furthermore, surpluses cannot be recovered and contribution payments are irrevocable.
Local financial entities are at present the main players on the market, with the ten leading institutions managing about 85% of all funds.
Tax treatment of contributions and benefits
Effective January 2007 the new income tax law reduced the tax incentives for occupational pension plans. The maximum combined employee/employer contribution amount that attracts tax relief now must not exceed EUR 10,000 for employees aged 50 and younger or 30% of earnings whichever is lower. For those aged 50 and over the amount was reduced to EUR 12,000 or 50% of earnings whichever is lower.
Previously, for employees up to the age of 52, contributions up to EUR 8,000 were tax-deductible for both employer and employee. The ceiling increased by EUR 1,250 for each year exceeding age 52, with a maximum annual contribution of EUR 24,250 at age 65. In addition, the company receives a further tax credit amounting to 10% of contributions relating to salaries up to EUR 27,000. The 10% tax rebate will be abolished in 2011.
Benefits are taxed as income. Until 2007 lump sum payments were tax-favoured in the way that a certain amount was received tax-free. To encourage employees to take an annuity payment instead, the tax advantage of lump sum payments was removed.
Investment regulation
In spite of comparatively liberal investment regulations, Spanish pension funds invest with a low risk profile. The cash position of 17% of the total assets is nearly as high as the equity exposure at 19%. Pension plans that invest in bonds only have a high market share and are subject to a minimum liquidity requirement of 1%. This pattern might change, as new legislation enacted in December 2007 reduced the general solvency margin from 4% to 2%.
2. Direct insurance
Direct insurance plans play an important role in the overall market, although they are subject to an adverse tax environment. Group contracts are commonly used to fund benefits for pensioners.
The 1995 insurance legislation required group insurance contracts to back pension arrangements to meet a series of requirements. The most important of these is that surpluses can be recovered by the company (policy holder) if:
- Adequate coverage of the existing pension liabilities is maintained
- Surplus relates to premiums that have not been treated as taxable income to the employees;
- The funding vehicle is changed from group insurance to a pension fund in order to integrate the provisions into the pension fund.
The tax treatment of contributions and benefits depends on the choice made by the employer who has two options:
- Contributions are tax-deductible for the company. Employee contributions are not tax-deductible, i.e. they are paid from net income. When benefits are paid, income tax is only due on the investment returns and not the original premiums. This option is hardly ever chosen.
- The prevailing option is that the company does not claim an immediate tax deduction in order to avoid taxation as imputed income for the employee. Contributions are thus not tax-deductible for the company but are not deemed to be taxable income for the employee. Premiums are not tax-deductible for the company until the time of benefit payment. Even then, the company only receives its benefit incrementally if the former employee receives the pension benefit as an annuity. The full benefit payment will be taxed as ordinary income to the employee.
Outlook
With an expected old-age dependency ratio of 67% by 2050, Spain will face an immense demographic problem, and, although pension reforms are inevitable in the medium term only small steps have been taken so far. This limits the growth potential of the Spanish pension market to a nonetheless impressive 10.4% p.a. – well above the European average of 7.6%.
Additional reforms are inescapable, even if Spain is the only country in Europe that has a social security scheme, which is expected to be in surplus until 2015. The government expressed that it wanted to strengthen occupational pensions by encouraging the development with fiscal incentives for products mainly providing annuities instead of lump-sum payments. To ensure the financial sustainability of the pension system, reforms are necessary in the medium term as the established reserve fund for social security surpluses is expected to be exhausted in 2015.