Principles of financing earnings-related pensions
The Finnish earnings-related pension system is a defined benefit system. This means that the size of the benefit, i.e. the pension, has been agreed beforehand, and the assets needed are collected as pension contributions.
Content of this page:
- Financing of pensions
- Financing the pensions of private-sector employees
- Financing the pensions of self-employed persons
- Financing the pensions of farmers
- Financing the pensions of seafarers
- Financing the pensions in the municipal sector
- Financing the pensions of State employees
- Financing pensions in other public sectors
Financing of pensions
The financing of earnings-related pensions can be organized using the pay-as-you-go system or the fully funded system. Most Finnish earnings-related pensions are financed using a combination of the two, a partially funded system.
In the pay-as-you-go system, the sum total of the pension contributions collected annually equals the sum needed to pay pensions in that year. Thus, the working-age generation pays, in full, the pensions of generations at retirement age. In Finland, the pension systems of self-employed persons and farmers are financed by pension contributions and tax revenues, and follow the principles of the pay-as-you-go system.
In the fully funded system, the sum total of the pension contributions collected annually equals the sum needed for the future payment of the pensions earned in that year. When the fully funded system is applied, each generation saves the funds needed for its own pensions. In that case, the returns on the fund savings can also be used to pay some of the pension expenses; this reduces the contribution needed. No fully funded system is in use in Finland.
In a partially funded system, these two alternative ways of financing earnings-related pensions are combined: some of the pension contributions collected annually from employers and employees are placed into funds, i.e. saved and invested for pensions that will be paid in the future. In a partially funded system, each generation pays a portion of the pensions of the currently retired generations, but also saves a portion for its own future pension. In Finland, the pension systems of private-sector employees and seafarers operate on this partially funded principle. Partial funding lowers the earnings-related pension contribution when compared to a pure pay-as-you-go system.
Buffer funds can also be combined with a pay-as-you-go pension system, as in the case of pension schemes for public sector employees. The buffer funds help reduce the pressure to raise earnings-related pension contributions in the future.
Regardless of the system, earnings-related pensions are mainly financed by pension contributions, which are described in more detail on our page on pension contributions.
Financing the pensions of private-sector employees
The pension system of private-sector employees is a partially funded system. Some of the pension contributions collected each year are put into a fund for future pensions, while the remainder is used to finance the pensions paid in that particular year. Correspondingly, some of the earnings-related pensions paid each year are covered by previously funded assets and their returns.
Among the different types of pension, partial funding only applies to old-age and disability pensions. Partial old-age pensions, part-time pensions, years-of-service pensions and survivors’ pensions are paid through a pay-as-you-go system, i.e. through annual earnings-related pension contributions. In addition, annual index increases to all outstanding earnings-related pensions are paid solely on annual earnings-related pension contributions.
At present, about one fifth of the annual pension contributions collected from employers and employees is transferred into funds, and the rest is used to pay current pensions. Thanks to investment returns, the sum transferred into funds accounts for a greater share of pension expenditure than contributions do. At present, roughly one in five pension euros is obtained from funded assets. According to forecasts, funds will account for one quarter of pensions paid by the year 2030 and for about one third in the longer term.
Because some pension contributions are placed into funds, pension providers are better prepared for changes in the population’s age structure. Since the funds can be used to cover some of the financing needed for pensions, the contributions obtained from employees and employers need not be raised to an unreasonably high level.
For people who were approaching the pensionable age when the earnings-related pension system was being established, the partially funded structure also enabled better pension benefits than would have been possible in a fully funded system.
The funding of pension contributions is discussed in more detail on our page Funding of earnings-related pensions.
Financing the pensions of self-employed persons
The pensions of self-employed persons are financed using the pay-as-you-go system. In other words, they do not involve funding. However, as a rule, the pension contributions collected from self-employed persons are not sufficient to cover the annual pension expenditure. In that case, the State covers the shortfall existing between the self-employed persons’ pensions due for payment and the contributions collected.
Financing the pensions of farmers
Farmers’ pensions are also financed using the pay-as-you-go system, without funding. Since the number of people receiving farmer’s pensions is double the number of people insured, the pension contributions collected annually are not sufficient to cover the annual pension expenses. In that case, the State covers the shortfall existing between the farmers’ pensions due for payment and the contributions collected. The average annual insurance premium charged to farmers is markedly lower (around 10 percentage points) than for other self-employed persons.
Financing the pensions of seafarers
The system of financing seafarers’ pensions is largely the same as that applied to the pensions of private-sector employees; that is, part of the annual earnings-related pension contributions is put into funds for future pensions. However, there is the difference that the State participates in seafarers’ pension costs by paying less than one third of the pension expenditure.
Financing pensions in the municipal sector
Until 1988, pensions in the municipal sector were financed using solely the pay-as-you-go system. A legislative amendment that entered into force at the beginning of 1988 made it possible for Keva to prepare for future pension expenses by depositing some of the pension contributions into funds. Part of the municipal sector’s annual earnings-related pension contributions were thus transferred into a fund until 2016, after which the fund’s returns have been used to pay pensions.
The funds have given Keva a buffer which makes it possible to keep the pension contributions collected from employees and employers at a lower level than what the pension expenditure would require. The assets withdrawn from the fund later are decided separately each year.
According to forecasts, a considerable portion of the funds will be used between the years 2020 and 2050. Those will be the peak pension years of the post-war baby boom generation, and pension expenditure will also reach its highest point in relative terms at that time.
Financing the pensions of State employees
In principle, State pensions are financed using the pay-as-you-go system. Funds have been adopted as a buffer to even out the costs of future pensions, both by means of investment returns and by taking assets from the fund.
The State Pension Fund was established in 1990 outside the State Budget. It places pension assets into funds and makes investments. The fund receives its assets from pension contributions and certain related payments, and from the returns on its investments.
The State Pension Fund does not pay pensions directly. Instead, all pensions in the State pension system are paid from appropriations reserved in the State Budget annually. An amount corresponding to 40 per cent of the annual pension expenditure is transferred to the State Budget yearly. The Ministry of Finance, in turn, ensures that the necessary assets are transferred to Keva, which in practice pays the pensions to State employees. Since 2013, the Fund has transferred a larger amount to the State Budget than it receives as an annual pension contribution.
The State Pension Fund Act has set a target for the State Pension Fund whereby 25 per cent of the full pension liability arisen within the State pension system must be deposited into a fund. The use of the Fund’s resources after the funding target has been reached is prescribed separately. The Ministry of Finance is in the process of drafting a law that would change the nature of the Fund’s activities, making them permanent.
Financing pensions in other public sectors
The pensions of Evangelical Lutheran Church employees are financed in the same way as the pensions of municipal employees. Although the pay-as-you-go system is in use, a buffer fund is also accumulated to even out pension expenses. The Church Pension Fund is responsible for the tasks associated with financing.
The employment-related pensions of the Social Insurance Institution’s employees are financed from the pension liability fund referred to in the Act on the Social Insurance Institution.
Pensions in the other public pension systems, such as those defined in the Act on the Orthodox Church and the Act on the Employees of the Government of Åland as well as the pensions defined in the pension guidelines of the Bank of Finland, are financed according to principles similar to those in other Acts on public pensions, i.e. the pay-as-you-go system supplemented with buffer-type funds.