EUROPE – European Union countries that switch to defined contribution pension schemes will have lower long-term pension liabilities, Standard & Poor’s says.

“A switch to funded defined contribution state pension schemes implies a lower long-term build-up of sovereign pension liabilities compared with unfunded defined benefit systems, although the accrued improvements are not represented in the general government accounts,” S&P said.

The comments come in a report - "The Treatment of Pension Obligations in the Ratings Process For European Sovereigns" - examining how the rating agency’s analysis of countries factors DB/DC into its assessment of fiscal flexibility in the context of EU member states.

It said that several Central and East European sovereigns have in recent years implemented far-reaching pension reforms, supplementing the old pay-as-you-go scheme with a defined-contribution funded scheme.

"In a funded pension scheme, assets are amassed from contributions with the explicit aim of covering all of the related future benefits from these assets," said S&P credit analyst Remy Salters.

"As a result, we exclude all flows and stocks related to defined-contribution funded schemes from general government figures."

The agency said this leads to a near-term reduction in fiscal flexibility, as the government will need to borrow to replace the monies redirected to the defined-contribution system.

However, this treatment of government accounts did not accurately reflect the long-term fiscal benefits. On an accrual basis, the pension liability will rise less rapidly for sovereigns that have undertaken pension reforms that include defined-contribution and other funded or partially funded systems, than for those that have not.

Consequently, the reform costs are an investment that reduces accrual-based imbalances and will result in a future reduction of the government's borrowing requirement, in the form of a lower future expenditure burden on the PAYGO scheme when the relevant cohorts retire.

"This future improvement does not show in today's general government accounts, as accrued pension obligations are not included in government liabilities," said Salters.

"Nevertheless, the effects of the reform will show in subsequent no-policy-change simulations of the long-term effect of demographic change on public finances, which we publish regularly.”