The present Social Security system has its origin in the mid 60’s. However, over the following five decades, the relatively generous benefit levels that were established at the beginning suffered several successive reductions due to significant shortfalls of the expected income from contributions, because of the relatively high level of unemployment (around 20% during most of the 90’s, coming down to around 8% in 2007 but growing again to levels near 25% in 2012) and the worsening of the demographic scene with an ageing population. Already in 1995 all the political parties agreed on some important adjustments that were implemented during the following years. The main change affected the period over which the pensionable salary had to be averaged in order to determine the base for calculating the retirement benefit. Initially, the Social Security benefit was a function of the average contribution base over the best two years of the last 7 years before retirement, then it was changed to the average of the last 8 years, with a partial updating for inflation, in the reform of 1995 this averaging period was extended to 15 years and finally, in 2011 it has been established in 25 years. The last comprehensive and deep reform was approved in 2011. The new normal retirement date has been set at age 67 instead of 65. The averaging period of the contribution bases to calculate the retirement benefit has been extended from 15 to 25 years. These changes will start to be implemented gradually from 2013, entering fully in force from 2027. The present regulation also includes some incentives trying to promote late retirement although, with the very high unemployment rate of 2012 that exceeds 25%, and is still expected to rise, these incentives might look very weak in practice. Compulsorily, all workers, including self-employed, have to join the Social Security system. To reach the full retirement benefit 35 years of contributions were required but this has been changed to 37. Regarding Company pension plans to supplement Social Security, the Insurance Law established in 1995 that all pension commitments of the employers had to be funded through insurance contracts or a pension fund. These funding instruments had to be in place before November 16, 2002 but the effective transfer of funds could be established, under certain rules, over an additional ten years period (in some cases 15 years). That means that in 2012 most of the funds that corresponded to past service have been transferred. Until this regulation was introduced most of the pension promises had been internally funded through book reserves. In 1987, the first Law on Pension Funds had tried to encourage funding outside the company using Pension Funds, but the strong control of these funds by the Unions and the relatively low levels of maximum annual individual contribution to these funds made that only very few employers found attractive to sponsor the creation of pension funds. Supplementary pension schemes are unevenly distributed. In some sectors, most or all employers would have in place such arrangements in favour of their workforce (financial sector, utilities, technology, …) but others would rely just on the benefits provided by the Social Security system. In any case, since the late 80’s most of the defined benefit plan existing at that time were closed to new entrants who, in the best case, were offered small defined contribution retirement plans.
In Spain, the State Social Security system covers retirement, death (widow’s, orphans and other dependents’ benefits) and disability. Social Security has two caps: one for the contribution base (this is the salary subject to contribution; the excess over which is not taken into account neither for contributions nor to determine benefits) and the other for the pension benefits (when the pension formula yields a result above this limit, no amount is paid above the benefit ceiling). For salaries below the contribution ceiling, the Social Security benefit is a relatively generous proportion of the last salary (in many cases the net income substitution rate is around 75%-80%). The contribution rate for retirement, death and disability (excluding workmen’s compensation) is 23,6% paid by the employer plus 4,7% by the employee. Beyond that there is a 8.90% contribution for unemployment and other coverage (7.20% employer and 1.70% employee). The maximum annual contribution base (salary subject to contributions) for 2012 has been fixed in 39.148 Euros. This ceiling is normally updated every year with inflation. The minimum contribution period to qualify for the retirement benefit is 15 years, after which the accrued pension is 50% of pensionable earnings. Every month of contribution in excess of the initial fifteen years attracts an additional percentage which varies over the transitional period. From 2027, that is when the reform will enter fully in force, with retirement at age 67, if at least 37 years of contributions have been reached, the pension benefit will be 100% of the “regulatory base” that is computed as the average of the contribution basis over the last 25 years before the retirement date. To calculate this average, the last 25 months are taken at their original amount and the previous ones are partially corrected with inflation. An employee who has not exceeded the ceiling of the contribution base can reasonably expect to receive a total benefit which might provide an income substitution of 75% to 80% of his last salary (with a reversionary widow’s pension of around 52% of the retirement benefit). As a general rule, early retirement will be allowed from age 63 if the worker has contributed to the Social Security at least over 33 years. In case of early retirement, the benefit calculated using the general formula is then reduced by 1,875% per each quarter, that the effective retirement age is below what would be the normal retirement age of that worker. If at the moment of taking early retirement the worker has contributed for more than 38 and a half years, the percentage of reduction applicable per quarter of anticipation is only 1,625%. In case of Long Term Disability the Social Security benefit is a pension of an amount that depends on the type of disability and that is determined from a “regulatory base” which is computed in a similar way than in the case of retirement. Finally, in case of death in Service a widow’s (or widower’s) and orphans’ pensions are recognized. In this case the “regulatory base” is determined as the best average on the contribution base during 24 consecutive months taken over the last fifteen years before the death occurred. The total pension (widow’s plus any orphan’s pension cannot exceed 100% of the “regulatory base”) For any of the contingencies mentioned above, beyond the fact that the basis of calculation of the corresponding benefit is the “contribution base” over a certain period and that a ceiling has already been applied to each of those bases, the resulting benefit is subject to the “maximum benefit” that for 2012 was fixed at 35.320 euros per year. The benefit ceiling was introduced in 1983 and its level was kept frozen for the first five years of its existence. After that initial period, every year during the following years, the benefit cap has been updated in line with inflation. But these last years it has been updated below inflation and for the near future it is expected to loose value in real terms. As consequence of the existence of a ceiling in the State Scheme, the employees with compensation exceeding that amount suffer a shortfall in their income substitution rate. In such cases the Social Security pension is a flat amount equal to the maximum benefit so that the higher the salary the more significant will become the gap in the substitution rate. This gap of coverage does not affect only in the case of retirement but also in case of death in service and disability. This is why in Spain some economic sectors have set up Supplementary Plans.
Book-reserved pension plans are very rare now (only financial institutions are allowed to keep book reserves and very few remain making use of that capacity). Except for entities of the financial sector, all the employers with pension commitments that supplement the Social Security have to externally fund those promises through an insurance contract or a pension fund. Originally, many of these supplementary arrangements were of a defined benefit nature with income replacement levels very high (80% – 100% of final earnings, including Social Security). Benefits were frequently based on final salary and they did not depend on years of service but, on the other side, once they started to be paid they were not updated with inflation (on those days inflation was regularly a two digit figure). . Since the mid 80’s many of the defined benefit plans were closed to new entrants. In many cases, the DB plans were substituted by DC plans In many sectors the new employees are not entitled to any benefit, or they are just eligible for a small defined contribution plan. It is important to note that most of the DC plans do not grant the payment of a pension but the benefit is rather a lump sum paid at retirement.
Plans established in accordance with the Law of 1987 have to be funded through external pension funds managed by specialised entities subject to the control of the Insurance and Occupational Pensions Supervisory Authority. Life Insurance Companies also qualify for the management of these Pension Funds. Contributions to these plans are tax deductible for the employer but must be individually assigned as income for the employee. Individuals are tax exempted but there is an annual cap to the total annual contribution of 8.000 Euros (increasing from age 52 to 12.500 Euros). Investment income is tax free. Benefits are fully taxed as income when received. If the vehicle used to fund the plan is an insurance contract instead of a pension fund, the premium is tax deductible for the employer only if it is assigned as income in kind of the employee, immediately taxable. Benefits when received are considered taxable income of the beneficiary, with a partial relief if the premiums were treated as income in kind when they were paid. Most of the insured plans are not assigned as income in kind of the employees, in which case the employer suffers a deferral on the tax deductibility of that expense until the employee effectively receives the benefits.
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