Lithuania's first steps towards pension reform were taken in 1995, following a major economic crisis in the early 1990s. The first reform focused on making parametric changes to the first pillar and increasing the system's sustainability. Another two pillars were added to the system in 2004, comprising funded schemes and supplementary pension provision.

Contrary to most other CEE countries, Lithuania's second pillar is not mandatory. It is made up of individual DC accounts, but employees are free to choose whether to join or not. Acceptance of second pillar pensions has been strong and participation has increased rapidly. The third pillar is fairly underdeveloped and consists of voluntary pension funds or life insurance products. Recently, Lithuania introduced the preconditions for occupational voluntary pensions, but occupational plans have yet to be created.

In demographic terms, Lithuania will suffer from a declining and ageing population. The absolute number of Lithuanians will drop from 3.4 million today to 2.9 million in 2050. In addition to low fertility rates, negative net migration will have a serious impact. In 2004, Lithuania saw the highest rate of emigration among the EU member states that joined the same year. The dependency ratio will climb from 22.5% today to 44.9% in 2050, which is seven percentage points lower than the EU-25 average. Public pension expenditure in Lithuania will increase from 6.7% of GDP today to 8.6% in 2050. These values are roughly four percentage points lower than the corresponding values for the EU-25 average.

Assets in Lithuania's second pillar pension market total EUR 306 million and are likely to grow by at least 33% p.a. until 2015. In the third pillar, assets amount to EUR 15 million and are expected to increase by at least 25% per year.

Just like the other Baltic states, Lithuania inherited a Soviet-style pension system that was characterised by generous early retirement provisions, privileges for certain occupational groups and a weak link between contributions and benefits. When the reform process began in 1995, retirement age was gradually increased to 62.5 years for men and 60 years for women (reached in 2006). The number of contributory years required for pension benefits was also raised. Early retirement provisions were abolished, and a strong link between contributions and benefits created.

The reform implemented a two-tier system in the first pillar. Today, there is a basic flat-rate pension that depends on years of service. Benefits were increased in early 2007 and currently amount to LTU 266 (EUR 77) per month. The second part of the public system is supplemental and earnings related. It is based on a formula comprising years of service, individual wages and average income. Adjustments for the earnings-related component are made in line with average economy-wide earnings, while the basic pension is determined by the government in an ad-hoc manner.

In principle, all employees are covered by the system, but the actual coverage rate is 83% of the workforce. Some categories of the self-employed are free to join. In order to receive a full pension, 30 contributory years are required and the minimum qualifying period is 15 years. Those who do not reach the minimum qualifying period are entitled to a social assistance pension, which amounts to 90% of the basic pension.

Social contributions in Lithuania are high, amounting to 30.7% of gross wages. 23.7% of these contributions are allocated to pensions. Employers pay 21.2% of gross wages for pensions, and employees contribute 2.5%. Possibilities for early retirement were re-introduced in 2004 after having been abolished in 1995, but they only apply to people who have been unemployed for a long time. If people retire early, their pension benefits are reduced. Staying in the workforce longer than the minimum retirement age is rewarded with 8% benefit increases per extra year.

Second pillar pension funds were introduced in 2004. Discussions on whether the second pillar should be mandatory began in the mid-1990s, but no political consensus could be reached. In 2002, the decision was made to make the second pillar voluntary. Public response was extremely positive. By late 2003, 38.3% of eligible persons had decided to join, and that figure rose to 610,000 members in late 2005, more than 50%% of the labour force. Once the decision to join the voluntary system has been made, it is irreversible.

The only conditions for joining are that members are insured by the state social insurance scheme and are below the retirement age. Pension funds are established as companies. They have a supervisory board, a management board and a shareholder assembly.

Similar to mandatory second pillar systems in other Eastern European states, contributions to the second pillar are diverted from social security contributions to pension funds. In 2004, 2.5% of gross wages were redirected into the funded pillar, and this share has been gradually increased to 5.5% in 2007. Total contributions have not changed. The reduced contribution to the public system does not affect basic pension entitlement, but only the earnings-related supplementary part of first pillar pensions.

Pension plan assets must be invested in a diversified investment portfolio. This means that the assets of every pension scheme must be invested in a portfolio comprising securities, real estate, commercial bank deposits and deposit certificates issued by banks.

This portfolio is subject to the following maximum limits:

- 30% for assets of the same issuer, provided they are issued or guaranteed by the central or local governmen

- 30% for debt securities of a single issuer, with the exception government securitie

- 20% for real estate

- 25% for investments in securities issued by persons related to the pension fund

Other regulations deal mainly with limits for securities of a single issuer. With regard to international investments, Lithuania has taken a very liberal stance. There are no restrictions for foreign investments for pension funds, nor are there minimum rates of return.

Pension funds are not allowed to invest in the following financial instruments:

- Securities issued by pension funds

- Securities issued by a management enterprise with which the pension fund has concluded an asset management agreement

- Securities issued by enterprises or other organisations related to the management enterprise

- Derivative financial instruments, with the exception of instruments recognised by the Securities Commission and used for risk management

When they reach retirement, pension fund members must use their accumulated assets to buy a life annuity from a pension company. Lump sum payments or a withdrawal plan are only possible if the amount remaining in the participant's account is sufficient to buy an annuity equal to the state social insurance basic pension.

In 2006, the second pillar system counted 610,000 members. Participants can choose from 21 pension funds that are provided by six companies. The market is extremely concentrated. The largest company has a market share of 56%, and the two biggest companies have a combined market share of slightly over 90%.

Pension companies must provide one conservative fund with investments in government bonds. They are otherwise free to offer other funds with riskier portfolios. Of the 21 funds, seven are conservative funds, three have a small equity portion (up to 30%), eight have a medium equity portion (30-70%) and three offer 70-100% equity investments. Funds with medium equity exposure are the most popular, accounting for 58% of members, followed by funds with low equity exposure (27%), conservative funds (13%) and those with high equity exposure (2%).

Direct investment in shares is relatively modest in all types of pension funds; indirect investments via mutual funds are the preferred route. Pension funds with little equity exposure hold 3% in shares and 45% in mutual funds; pension funds with medium equity exposure invest 8.5% in shares and 45% in mutual funds, whereas funds with the highest equity exposure invest 39% in shares and 43% in mutual funds. Across all pension funds, assets are allocated in the following way: 43% government bonds, 39% mutual funds, 7% shares and corporate bonds and 3.6% cash and deposits. 

Employee contributions are tax deductible. If employers pay employee contributions, they are tax deductible up to a limit; employer contributions are considered as tax-free income for the employee. Pension benefits are subject to ordinary income tax.

Third pillar pensions are fairly underdeveloped in Lithuania. Private individual pensions were introduced in 2004. Individuals and their employers can contribute to voluntary pension funds. Contributions are tax-free up to 25% of annual income, and any amount above that level is taxed at a reduced rate of 15% (rather than the regular rate of 27%). At the end of 2006, 20,100 participants had joined supplementary voluntary pension funds; assets under management amounted to EUR 15 million. As is the case for second pillar funds, the market is greatly concentrated. The two leading pension providers account for 94% of total third-pillar assets. The bulk of assets is invested in mutual funds (50%), followed by government bonds (15%), equity (13%) and corporate bonds and deposits (8% each).

In 2006, the Lithuanian parliament passed a law that enables the creation of occupational pension schemes and group life contracts. This could become something of a fourth pillar in the future, but a scheme has yet to be created.

It took Lithuania almost ten years to put the basic parameters of its three-pillar pension system in place. Due to the recent introduction of voluntary occupational pensions, Lithuania could have a four-pillar system in the future. Contrary to all other CEE states with a funded second pillar, Lithuania chose not to make its second pillar mandatory. The fast take-up of second pillar pensions, which was supported by a massive advertising campaign, shows that voluntary solutions can also work.

To achieve a balanced structure, the third pillar needs to be developed further. Its development might be a question of time and rising income, but tax incentives are currently too weak to get it off the ground. Nevertheless, pension reforms in Lithuania have resulted in a much more sustainable system with a widely accepted funded element.