Since 2014, Brazil’s economy is in dire straits. The country is in a deep recession with the economy contracting by 3.8% in 2015 and 3.5% last year. Fiscal deficits exploded to around 9-10% of GDP, resulting in run-away public debt reaching 78.3% last year and expected to increase to 81.2% this year. Michel Temer, who became president after Dilma Rousseff was impeached in August 2016, aims to address Brazil’s precarious financial position by cutting government expenditures. Mr. Temer wants to do this by the introduction of a federal spending cap and by reforming the pension system.

The spending cap was approved in December of last year (of course, after raising salaries of some groups of civil servants first) and limits the growth of federal government spending (excluding interest payments and transfers to local government) to the rate of inflation for 20 years (with a presidential review after a decade). The spending cap would stabilize the fiscal accounts in about 10 years time when public debt peaks at over 90% (Brazil’s Treasury expects to reach its first primary budget surplus only by 2020, assuming trend growth of 2.5% per annum). Expenditure on pensions and other benefits, which are enshrined in the constitution, would still rise in real terms, crowding out spending on other budget items (e.g. education and health care) over time. Therefore, reform of the pension system is important for the spending cap to work.

Brazil’s (pay as you go) pension system pays high pensions relative to working age incomes and at a low retirement age, whereas pensions can be claimed along with employment. The average retirement age for men currently is 56 years at which a retiree would receive about 70% of pre-retirement income (increasing to 100% when retiring at 65). As a relic to Brazil’s hyperinflationary past, minimum pension benefits are indexed and cannot be lower than the minimum wage (which happens to be rather high at around 70% of median income). In order to receive this minimum pension benefit at the age of 65 years, Brazilians only need to contribute to the system for 15 years. Furthermore, if a married retiree dies then the survivor will continue to draw almost all of the pension (in addition to his or her own pension!). Brazil’s pensions are ridiculously generous, so much that single retirees are attractive marriage candidates.

Happy to retire…

According to IMF, spending on pensions and social benefits reached 11.3% in 2015 and will grow rapidly over the coming years because of an aging population (population aged 65 and above will increase from 7.6% today to 38% by 2050). To put the numbers in perspective: Brazil’s spending on pensions as percentage of GDP is about equal to that of Germany but Germany’s dependency ratio is about 3 times as high. IMF estimates that by 2021 spending may reach 14% of GDP. The deficit of Brazil’s private and public pension system in 2016 reached approximately 3.7% (of which 2.5% for private pensions and 1.2% for public pensions). You don’t need to be Einstein to understand that Brazil’s current pension system is financially unsustainable.

In December of last year, the government proposed a set of sensible amendments. The mandatory retirement age for both men and women was set at 65 years. In order to receive a pension one has to contribute for 25 years or more whereas the payment will be equal at 51% of average salary plus 1% for each year worked (i.e. the pension would be 91% for a 40-year working life). The reform covers both private and public pensions (except for the military) and for men below 50 years of age and women below 45 years of age (for older people transition rules apply). Even after these amendments Brazil’s pensioners will still be very well off compared to those in other countries. However, this being Brazil, even these modest amendments apparently are too bold for the country’s legislators. Thus, the reform proposal has been watered down. In the latest proposal the retirement age for women was set at 62 years, the base pension as percentage of average salary was increased from 51% to 70% whereas full pension would be received after 40 years of work instead of 49 years, the transition period was extended, more exemptions were introduced (apart from military also teachers, police and rural workers get preferential terms). The fiscal savings under the latest proposal are estimated to be one-third lower than under the original proposal (which, according to the ministry of finance, would result in estimated savings of BRL 678 billion in the first 10 years or about 12% of today’s GDP).

The pension reform will need approval from both houses in Congress with a 60% majority (in two floor votes). The proposed reforms, even after the agreed amendments, are not very popular with the general public and, therefore, additional modifications (by both the lower house and senate) cannot be ruled out. Of course, this means that fiscal sustainability, already at a fragile footing, is further endangered. Also, it could delay approval as modifications made by the senate would need to be considered by the lower house. Meanwhile, the window for reform approval is narrowing as presidential elections are to be held in October 2018. We think effectively 6 months are left to get the reform approved. The initial vote in the lower house is slated for next week.

I have a little secret to tell you…

A complicating factor is the Lava Jato corruption case which gathered speed following the Odebrecht plea bargain (Odebrecht is a Brazilian construction company, which is at the center of the case). The Supreme Court authorized investigations into 8 ministers in Temer’s cabinet, 24 senators and 39 deputies. Mr. Temer himself is also in a hot spot as allegedly he was present in a meeting with Odebrecht in 2010 to obtain an USD 40 million kickback for his party from a large contract with Petrobras (Temer vehemently denies the accusation). Although Mr. Temer is immune for any crime committed before he became president, the alleged case could sway the Electoral Court to annul the presidential elections of 2014 for illegal campaign funding. New elections would then be triggered, opening the way for an anti-reformist like former president Lula (if not jailed by then) to take the reins. In any case, uncertainty on whether approval for the reform can be obtained has increased with so many politicians under investigation and street protests against the measures increasing. A next government may have to pick up the pieces and most likely would need to make further cuts in entitlements to get Brazil back on a fiscally sustainable path. It is time for Brazil’s gerontocrats to pay their dues…