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Transforming Post-Communist Political Economies
produce in the pay-as-you-go system. Similar proposals are also circulating in Poland and the Czech Republic. In 1995, the Latvian government became the first in Eastern Europe to enact a radical reform of the system, including a commitment to developing the second tier for the purposes of prefinancing. Latvia achieved this goal by adopting a whole new approach to the benefit formula. The remainder of this chapter discusses that reform and draws from it lessons for further reforms.
THE NEW LATVIAN PENSION SYSTEM
Since achieving independence from the Soviet Union in 1990, Latvia has moved steadily toward the establishment of a market economy and the development of democratic institutions. An initial reform of the Soviet system was undertaken in 1990. But the reformed system left in place most of the Soviet eligibility conditions (retirement at age 55 for women and age 60 for men, with earlier retirement permitted for certain occupations and categories of people). The benefit formula provided a flat guarantee of 30 percent of the national average wage, with an increase of 0.4 percent for each year of service. By July 1995, the average old-age pension was 33 lats, or 50 percent of the average net wage (pensions are not taxable). This formula implied full wage indexing for pensions, although in practice this indexing did not take place when revenues were inadequate.
In January 1995, the government submitted to Parliament a new pension reform concept, calling for the introduction of a three-tier system. The first tier would be a modified pay-as-you-go system, with stronger links to contributions and a minimum pension to protect the lifetime poor. The second tier would be a mandatory, funded system of privately managed savings accounts. Participation would be limited to new entrants and the younger members of the current labor force. The third tier would be voluntary, privately managed pensions, organized primarily (but not exclusively) through employers. The new concept was accepted by Parliament, and work began immediately on the first stage of the reform—new legislation for the first tier. This legislation was submitted to Parliament in July 1995 and approved in November 1995 as part of the package of welfare system reforms. The new system took effect in January 1996.
The new public pension system has two main elements:
Pensions are linked directly to an individual's total contributions and the retirement age on the basis of a new formula.
Provision is made for introduction of the second tier. Beginning in 1998, contributors will have the option of assigning a portion of their contributions to privately managed individual savings accounts. This will result in a partial funding of the system, reducing the debt for future generations.