Funding of earnings-related pensions
Old-age and disability pensions for private-sector employees are financed using a partially funded system. Some of the pension contributions collected annually are placed in funds and invested for future pensions.
Combination of a pay-as-you-go system and funding
Earnings-related pensions are financed using two main methods: the pay-as-you-go system and the fully funded system. The pay-as-you-go system means that the sum total of the pension contributions collected annually equals the sum needed to pay pensions in that year. 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. These contributions are placed in a fund pending payment of the pension.
In a partially funded system, these two alternative ways of financing earnings-related pensions are combined.
A partially funded system means that some of the pension contributions collected annually from employers and employees are placed into funds, i.e. saved and invested for pensions paid in the future. The remaining annual contributions are used directly to cover pensions paid in the same year.
From the perspective of pensions paid, a partially funded plan means that some of the pensions are financed by the pension contributions collected during the current year and some by assets deposited earlier in funds and their returns.
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.
Funding lowers the earnings-related pension contribution
Thanks to the partially funded system, earnings-related pension contributions remain lower, which in turn reduces labour costs and increases the employee’s take-home pay. From the individual’s point of view, funding has the benefit that assets are collected – or saved to secure old age – when income is usually at its highest, i.e. during a person’s career. Funds, in turn, are dismantled when income is lower than during work years.
In a partially funded system, the returns on funded pension assets can also be taken into account when the earnings-related pension contribution is determined. Thus, the level of the earnings-related pension contribution can be kept lower than would be the case if pensions were paid exclusively by means of annual pension contributions. In 2021, for example, without funding, about 2.8 percentage points more in earnings-related pension contributions should have been collected.
Without partial funding, earnings-related pension expenditure would be covered only through pension contributions collected from employers and employees. If earnings-related pension expenditure were to increase, earnings-related pension contributions would also rise immediately. On the other hand, if employment were to fall significantly, pension contributions would again have to be raised to cover the pensions paid. In both cases, labour costs would increase. Another option would be to cut the pensions paid.
In partial funding, in turn, the financing of earnings-related pensions does not depend solely on the labour market or the financial market; instead, the risks are distributed between these two.
In addition, partial funding mitigates the effect of differences in the sizes of generations on the level of pension contributions. As the population shrinks and an ever smaller proportion of the population pays the costs of pensions being paid out, a pure pay-as-you-go system would result in specific payment pressures on small age groups. Partial funding focuses the cost of pensions on the correct generation more accurately than the pay-as-you go system.
Returns on funds must exceed the increase in wages and salaries
For the funding to be profitable, the long-term return on funded earnings-related pension assets must exceed the growth rate of the sum of gross wages and salaries paid annually. In this way, pensions can be financed at lower pension contributions than without the partial funding.
If the return on assets remained at the same level as the increase in wages and salaries, funding would no longer be a useful way to reduce the pension contribution.
For example, between 1997 and 2021, the insured sum of wages and salaries for private sector employees increased by an average of 2.4 per cent per year in real terms. The real return on earnings-related pension assets in the corresponding private sectors during the same period was 4.6 per cent per year.
Funds are used every year
Each year, some earnings-related pension contributions are transferred into funds and, conversely, some assets in the funds are released to cover the earnings-related pensions payable in that year.
At present, about one-fifth of the earnings-related pension contributions paid by employers and employees in the private sector are transferred into funds. Correspondingly, funds cover about one quarter of the earnings-related pensions paid. Each earnings-related pension paid is divided into two: a part covered by contributions and a part covered by funds.
Some earnings-related pensions paid have always been covered by pension funds – even when the annual earnings-related pension expenditure was lower than the pension contributions collected. Since 2013, earnings-related pension expenses in the private sector have exceeded the income collected as pension contributions. The difference is covered by the funds and their returns.
The sources of financing for pension contributions and pension expenses are described in more detail on our page Circulation of pension money.
Each provider of earnings-related pensions in the private sector is responsible for funding among its own policyholders. However, all providers of earnings-related pensions are subject to the same rules and principles for implementing funding.
When the adequacy of funds is calculated, attention is paid to the returns gained on the assets funded and the adequacy of the pension for the lifetime. The calculations also take notice of the fact that in the future, policyholders will receive pensions for different periods of time, depending on their life expectancy, and that some policyholders will not receive any pension at all owing to death before the retirement age.
Funds are not earmarked
In the Finnish pension system, no one has their own ‘pot’ of pension savings, and the pension contributions of individual policyholders (employees or self-employed persons) do not specifically target their own pension. Or, conversely, pensions paid to individual retirees do not explicitly include pension contributions paid by the persons themselves.
Instead, each employee and self-employed person accrues a certain amount of earnings-related pensions from the earnings of each calendar year. The pension system promises to pay this accrued pension upon retirement on an old-age or disability pension. To prepare for this accrued pension, the insurer puts assets into funds for pensions to be paid in the future (this use of funds applies to employees only). In that sense, every insured person, and future retiree, is entitled to a funded part that is paid to him or her as a pension.
Thus, the insured do not have individual pension savings; instead, they have the promise of pension security defined by law.
Funds can never be dissolved completely
For every calendar year, each insured employee accrues a previously agreed portion of an earnings-related pension. To prepare for the future, some of this money is placed into funds during the same year. As a result, more money comes into pension funds every year, even though the funds are simultaneously used to pay pensions to current pensioners.
This logic of continuous funding also means that pension funds can never be dissolved completely. Every year, funded portions of pensions accrue from the pension rights earned in that particular year.
Nor are the funds composed exclusively of the assets of present-day retirees, but the assets of all age groups who have been employed in the past and present.
Although the so-called baby boomers have already largely retired, pension funds have been used for paying their pensions only for a few years.
About 30 per cent of pensions come from funds
The Finnish Centre for Pensions calculates the value of accrued pension rights, i.e. the so-called pension entitlements. Pension entitlements refer to the amount of assets that would be needed to cover the total amount of future pensions accrued up to a certain point in time, taking into account the future income from the assets, if earnings-related pension contributions no longer provided financing for the payment of previously accrued pensions.
The most recent calculations describe the situation at the end of 2017, when pension entitlements amounted to approximately EUR 714.5 billion.
Correspondingly, the value of pension funds amounted to EUR 199.9 billion at the end of the year 2017. Thus, the funds covered about 30 per cent of the pension entitlements. The ratio is called the funding rate.
When the funding rate is calculated, the return on invested pension assets is taken into account. The aforementioned funding rate of 30% has been calculated with a discount rate of 2.5% until 2028 and 3.5% thereafter. The calculation is based on the long-term sustainability calculation prepared by the Finnish Centre for Pensions and published in spring 2019: