The Impact of Introduction of Funded Pension Schemes on Intragenerational Inequality in Estonia: A Cohort Microsimulation Analysis

Abstract

This paper uses a cohort microsimulation model to analyse intragenerational distributional effects of a shift from a defined benefit pay‐as‐you‐go pension system that includes flat rate component and length of pensionable service component to a pension system with contribution based insurance components in the PAYG scheme and an additional compulsory funded pension scheme. Estonia was among the first European countries to shift partially from a pure PAYG scheme to fully funded financing in 2002. In addition, contribution points reflecting total life‐time earnings were introduced into the PAYG scheme in 1999.We use the contribution history for 1999‐2010 and information on the participation in the funded pension scheme of a full cohort of men, born in 1980, from the Estonian National Social Insurance Board to simulate the distribution of future pensions under alternative pension schemes taking into account economic and demographic changes. Our results show that in case of large inequality of labour earnings and high long‐term unemployment rates, such as in Estonia, introduction of very strong link between contributions and future pensions leads to considerably higher inequality of pensions.Simulation results suggest that the inequality of old‐age pensions more than doubles when the reforms mature. The inequality in replacement rates on the other hand decreases.