By the mid-nineties, the Latvian government was facing major problems with its pension system. The country was in transition from a centrally-planned to a market economy, economic activity had fallen sharply and the informal sector was growing. A decline in the number of contributors to pensions and an increase in evasion were major problems. In addition, high numbers of individuals receiving pension benefits relative to those making contributions(as a consequence of the low retirement age and early retirement among several occupations) added further difficulties. The resulting mismatch between contributions and benefits required the government to step in and meet a significant shortfall in the short term, but significant overall change was needed.

In fact, this situation threatened the financial stability of the country’s pension system and deep reform was required to ensure benefit security for future retirees and long term fiscal stability of the country. In order to achieve these goals, the Latvian authorities, in early 1995, proposed a reform of pensions oriented towards producing three tiers: a non-funded state system, a mandatory funded defined contribution system and a voluntary private pension funds system.The new system took effect in January 1996 with the implementation of the first tier, with further changes to the old system being gradually introduced in subsequent years.

The mandatory state defined contribution scheme, the first pillar of the reformed system, now covers every worker in Latvia from age 15. The chosen approach is similar to a defined contribution scheme in that contributions are channelled into individual accounts, although it retains the principle of intergenerational solidarity whereby existing pensioners are paid by current contributions. The system is administrated by the State Social Security Agency and currently is funded at a contribution rate of 18% per annum which is intended to be reduced to 10% per annum by 2010, once the second pillar of the system can increase its contribution rate to 10%.

The second pillar of Latvia’s pension system came into force in July 2001 with the aim of increasing the amount of pensions without having to increase contribution rates. Currently the contribution rate to this second tier is 2% but, as stated above, will gradually increase to reach 10% by the year 2010. Hence, a worker that participates in both the first and the second tier would contribute a total of 20% split between the two pillars.

This pillar is mandatory for those workers who were under the age of 30 in July 2001 and voluntary for those who were between 30 and 49 at that time and it is expected to be fully mandatory by year 2035.The scheme is fully funded and originally was administrated by the Latvian Treasury only, which was allowed to invest tax contributions solely in Latvia’s government securities and term deposits with banks. However, since 2003 workers have been allowed to choose private providers, such as those asset managers that are authorised to offer a wider range of investment options and more diversified portfolios.

The Finance and Capital Market Commission is in charge of supervising the performance of the private providers, whereas the Latvian Treasury is supervised by the ministry of finance.

At retirement, participants’ have two options; either to contract a life annuity pension with an insurance company in the open market or combine the accumulated amounts of the two pillars and receive a pension based on the sum of the two funds.

Regulated by the “Private Pension Funds” law, this third pillar has been operating since July 1998 with the aim of providing additional income at retirement for voluntary contributors. The Finance and Capital Market Commission supervises this pillar and allows only commercial banks, insurance companies or investment companies to

administer these assets.

At the moment there are two types of private pension funds: closed and open. Any individual may become a member of an open pension fund, either personally or through his employer, however, closed pensions funds are only available to employees of companies which have their own pension fund. Regulations limit these pension funds’ investments to state securities, with no more than 25% of the total capital in real estate, no more than 15% in foreign countries and no more than 25% in companies listed on Riga Stock Exchange.

Benefits from private pension funds can be claimed from the age of 55 in the form of a lump sum or a life annuity from an insurance company. Also, capital accumulated in private funds can be transferred to first pillar notional capital in order to receive a pension based on the first pillar calculation formula.

Now, a decade after the creation of these new pension schemes, the Latvian pension system is considered a good example of pension fund reform. Indeed, following an example from the reform of Swedish pensions, Latvia was the first country to implement the change to notional defined contribution schemes. Notwithstanding, the issues related to the ageing population and the future financial stability of the new system are still under debate.

Early studies have stressed the financial stability of Latvian pension system in different demographic scenarios and over the long run. However, the main challenge to the reforms is the proposed increase in contribution rates to the defined contribution scheme and the consequent decrease in contributions to the notional capital scheme. As a result, questions are being asked as to whether capital reserves will be sufficient to maintain stability of the first pillar without having to further increase retirement age or contribution rates. This will be a key challenge that the Latvian authorities must tackle during the next decade.