Reform has come to define an entire decade of Central and Eastern European history. Common sense suggests that poorly conceived reform is worse than no reform at all, yet those enacted across the region since the fall of Communism have often been less than ideal.

Lithuania is no exception. Since regaining its independence in 1991, the country’s legislative process has often retracted from and for long periods entirely abstained from reform. The rapid economic growth of the last two years (in 2003, GDP grew by nearly 10%) offered the government political leverage for expensive structural reforms, but it failed to pursue such a course.

One piece of major reform, though still relatively modest and cautious, nevertheless progressed significantly in 2004. Until the end of 2003, Lithuania relied on a simple redistributive mechanism to provide for its elderly. This traditional pay-as-you-go (PAYG) system, employed in many European countries, is based on a money transfer from workers to retirees. The system accounts for 90% of total pension income in the European Union countries. Despite its widespread use, however, the system is flawed in a number of ways. It places the sole responsibility for future pensions in the hands of the politicians, it encourages early retirement while discouraging job mobility, and it puts a high burden on labour, though it excludes the self-employed.

Most importantly, a PAYG pension system entails an unsustainable strain on government social spending. Some EU countries are currently piling up liabilities on the scale of war debts. Based on current trends, nine EU countries will accumulate gross debts of 150-300% of GDP by 2050, causing the eventual collapse of a system to which pensioners have diligently contributed throughout their working lives.

Acknowledging the inevitable, the Lithuanian Government began modelling what was to become a three-pillar pension reform in 2000, known as The Lithuanian Law on the Pension System Reform. The existing system became the first pillar. A second pillar was eventually added to the first pillar tax-roll contributions in January 2004, and a third pillar—voluntary savings—is being implemented in 2005. While Lithuania was the last of the three Baltic States to undertake this reform, its implementation occurred relatively smoothly.

The second pillar allowed every socially insured employee to direct 2.5% of his earnings into a private pension fund of his choosing from January 1, 2004. This contribution rate is being increased annually (at the expense of the first pillar share) until it reaches 5.5% in 2007. A bill has been recently sent to the Lithuanian Parliament proposing a greater increase in tariff increments, reaching ten percent by the year 2010.

Under the current law, those taking part in the new system can accumulate funds that will remain the sole property of the individual, and can also choose the fund and manager who best suits them on a risk/return ratio.

These reforms in Lithuania also allow employees of all age groups to participate in the second pillar, a provision unique within Europe. In most countries, workers have been discriminated against on the basis of age. Participation benefits should depend on individual contributions, not imprecise age brackets.

Guaranteed returns and investment security can only be ensured through competition. The Lithuanian Law on the Pension System Reform is rather obliging in this respect—it allows participation of both financial intermediaries as well as life insurance companies, fostering conditions for competition. Indeed, competition could be strengthened further if, for example, an individual could save for their basic pension in any EU member state.

The model has some economic advantages. It boosts economic growth (extra savings lead to higher investment and thus faster growth); it provides an incentive to remain in the labour market longer; and it is a more efficient use of capital. It also motivates people to become actively involved in decisions about their pensions.

The reform has also had an effect on the amount of wage transactions in the informal sector. Official statistics suggest that 30% of Lithuanian wage earners receive additional wage payments under the table, and a recent survey of market participants suggests that as many as one in four minimum wage earners receive additional informal wages. The funded pillar model encourages people to declare their true earnings.

On the other hand, an essential shortcoming of the reform is the restrictions on the size of the installments that can be directed into the second pillar—the amounts are too small to allow big returns on investments. As such, they may be limiting participation levels since the incentive to save remains insufficient. Further reform of the pension system must allow the size of these contributions to increase in order for low- and middle-income workers to accumulate real wealth.

This pension reform is a significant, albeit small, step toward the free society. Certainly, fund management firms have adopted the system enthusiastically—twelve different companies are now offering their services. Public interest has been similarly impressive. As many as 48% of Lithuanians have chosen to participate in the new system, while in Latvia and Estonia, participation rates hovered around 6-7% during the first two years of the funded pillar model’s adoption. Fears about a dearth of competition among service providers and a lack of public participation have thus proved to be unfounded. Considering that participation is not obligatory, the number of participants is impressive.

The danger is that the government now will rest on its laurels. Additional reform will soon be needed to ensure the public’s willingness to support it, to facilitate the success of the third pillar, voluntary savings, and most importantly, to encourage reform in other sectors of the public services.