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Spain is considering freezing pensions and speeding up a planned rise in the retirement age as it races to cut spending and meet conditions of an expected international sovereign aid package, sources with knowledge of the matter said.

The measures would save at least 4 billion euros a year as well as fulfil recommendations in a European Union document released in May which senior euro zone sources said was being used as a blueprint for the terms of a sovereign aid programme.

The acceleration of the raising of retirement age to 67 from 65, currently scheduled to take place over 15 years, is a done deal, the sources said. The elimination of an inflation-linked annual pension hike is still being considered.

Spain, the new epicentre of the euro zone debt crisis after Greece, Ireland and Portugal, is hesitating to apply for external aid to handle a high public deficit and soaring debt. Its borrowing costs fell on Thursday at an auction of a 10-year benchmark bond but relief may be short-lived.

The new pensions steps, which could be announced as soon as next week along with the 2013 budget, would send a strong signal to investors that Spain is serious about implementing structural reforms it has delayed because of the political cost.

Spanish Prime Minister Mariano Rajoy, who was forced earlier this year to break campaign pledges such as not raising taxes, repeatedly said he would not touch pensions, but he has few options left to trim the budget after drastic cost cuts.

He toned down his language last week and said it would be "the last thing" he would do. On Tuesday, Deputy Prime Minister Soraya Saenz de Santamaria said the government was not implementing any cut on the pensions "for the time being".

Sources with knowledge of the government's thinking said Rajoy's comments were a sign that his stance was shifting. "He just said that he would not cut the pensions. But did you hear anything else? We both know that there are several ways of cutting. One is to simply leave them steady against inflation," said one of the sources.

A second source said the acceleration in the change in the retirement age was backed by the government while a third source, who discussed the issue with senior Spanish officials, said a freeze was expected. "Not increasing them is also an adjustment," the third source said.

Freeze

Many economists also believe a freeze is inevitable. The 2012 budget earmarks a 1 percent inflation review – or about 1 billion euros - but inflation is running close to 3
percent, meaning an extra 4 billion euros that would be paid to pensioners in January but booked to the 2012 budget.

So cancelling this year's inflation-linked raise would save the government about 5 billion euros. For following years, based on annual inflation of 2 percent, which is the reference used by the European Central Bank to set its main rates, the adjustment would cost 4 billion euros.

"There is no way around it. You have to cut the link with inflation and freeze the pensions next year," said Jose Carlos Diez, chief economist at Intermoney brokerage in Madrid.

"And to me, that would be just a start... The pensions, the unemployment benefits and the borrowing costs are eating up all the efforts on the spending side so you need to act in those areas," he added.

Both removing the inflation adjustment and accelerating the retirement age increase are long-standing European Union demands and any bond-buying programme to help Spain finance its debt would insist on this conditionality, senior euro zone sources said.

Countries which were previously rescued, such as Greece, Ireland and Portugal all had to pass steep cuts on pensions. In Greece, the cuts ranged from 20 percent to 40 percent,
while new pensioners had a 10 percent pay cut in Ireland and Portugal scrapped the Christmas and summer extra payments.

Sustainability

While an announcement could be made next week when the government adopts the first draft of the 2013 budget, political analysts say Rajoy may be tempted to wait until after a regional election in his native north-western Galicia.

Rajoy performed especially well among pensioners when he was elected in a landslide last year and his first move after taking office was to restore the inflation adjustment his predecessor Jose Luis Rodriguez Zapatero had removed in May 2010 when Spain entered in the eye of the storm of the euro zone debt crisis.

Zapatero also passed last year a law to add two years to the retirement age by 2027. Rajoy's People's party, then in the opposition, voted against the change.

With unemployment soon to top 25 percent and set to remain at high levels until at least 2015, the number of people contributing to the state pension system has fallen to its
lowest level in 10 years and the sustainability ratio has dropped to 2.39 workers per pensioner.

Taking into account the expected further increase in unemployment and a rapidly ageing population, this ratio is set to fall to 2 in the next months, a level which Spain should have reached only in 2050 according to a 2011 report from the Organisation for Economic Co-operation and Development (OECD).

The government tapped 4.4 billion euros from an insurance fund to make July and August payments to the 8.1 million Spanish pensioners, about a fifth of the country's population.

It also said it could not rule out using the pension guarantee fund -- meant only for emergencies - by the end of the year to pay the pensioners their monthly cheque.