Slotting in on pensions
The eight CEE states that joined the EU on May 1 lag their colleagues on most economic parameters, but as a bloc they are unique in having adopted funded state-supported pension schemes alongside the defined-benefits state pension.
The typical communist era pension system was a defined benefits, pay-as-you-go scheme, funded by a generally hefty social security tax, with negligible links between contributions and final benefits, which were usually tied to the final few wage-earning years. As unemployment was generally illegal, funding was not considered an issue. Certain sections of society, including those in hazardous occupations such as mining, as well as artists, received larger, privileged pensions.
The sustainability of the region’s pensions system became a critical issue in the early 1990s. Privatisation of the large state owned companies inevitably raised unemployment, and is still high in a number of new EU members, notably Poland (around 20%) and Slovakia (18%). In addition, they all faced the demographic pressures of low birth rates and, from the mid-1990s, increasing life ex-pectancy, leaving fewer workers to support more pensioners. All the reforms have incorporated an overhaul of the state system, including a closer link between contributions and benefits, the introduction of individualised accounts, and the gradual raising – and often equalising – of the retirement age, which was typically five years earlier than in western Europe.
The reforms also acknowledged the need for privately funded systems to offset the shortfalls from the unfunded state schemes. Starting with Hungary in 1998 and finishing with Slovakia, whose second-pillar programme was passed by parliament in 2003 and takes effect in 2005, six of the eight now have a three-pillar system. The two exceptions are Slovenia – where trade union hostility prevented the introduction of a compulsory state-run system, and where a compulsory funded second pillar only exists for hazardous occupations- and the Czech Republic, which historically rejected any element of compulsion, opting instead to provide tax incentives for a third pillar.
Even the Czechs are having second thoughts however. Along with Poland, the republic was identified in a recent Standard & Poor’s survey as one of the 25 OECD countries facing severe problems on funding old-age expenditure – severe enough to raise its debt ratios and threaten it sovereign credit ratings. Pension reform returned to the Czech agenda last year when the government drafted a reform proposal centred on Notionally Defined Contributions and a Swedish-style ‘virtual’ accounts in the first pillar, although it disappointed the pensions industry in not following neighbouring Slovakia’s example in setting up a mandatory state system.
The Czechs have a long-standing distrust of the financial industry as a result of the privatisation and banking scandals that followed the collapse of communism. However, financial regulation has improved dramatically, and experience has shown that second-pillar schemes have proved extremely popular with the public. In Estonia, where membership of the second-pillar is only compulsory for those born after January 1983, the number of members as of the end of March already totalled 359,550 or some 60% of the employed population. The high take-up occurred despite Estonians having to contribute an extra 2% of their salary into the privately funded schemes alongside the portion diverted from the first pillar.
In Lithuania, where the system was made entirely voluntary to avoid unnecessary strains on the state system once a portion of contributions got diverted, it has been a similar story, with 438,000 members or 30% of the workforce joining in the first year of subscription, compared with the government’s original estimate of 10%. There has also been the odd case of reversal, as in 2002 when Hungary relaxed the opt-out extension for voluntary participants in the state system (the scheme was originally only compulsory for new workers), as well as removing the element of compulsion, leading to a significant decline in membership. The decline was stemmed the following year by the new government, which promptly reintroduced compulsion.
Meanwhile, in terms of assets under management, pension funds now rank as the largest single investment class in the more mature markets.
In Hungary second and third pillar funds totalled HUF935.75bn (E3.7bn) as of the end of 2003, compared with HUF906.8bn (E3.6bn) for investment funds and HUF870.35 (E3.4bn) for insurance companies. In Poland by this February the assets of second-pillar pension funds totalled PLN44.2bn (E9.4bn), ahead of investment funds at PLN29.8bn (E6.3bn).
With the exception of Slovakia, where the number of third-pillar pensions providers has remained at a stable four, the establishment of private pensions legislation resulted in large numbers of providers, a rapid market concentration and subsequent attrition. In Poland the top two of the 16 second-pillar funds account for 53% of assets under management. Of the 10 providers in the Lithuanian second pillar system, two had acquired a market share of 30% apiece within the first year. Some consolidation has been inevitable. In Hungary the number of second-pillar funds has shrunk from 25 at its start in 1998 to 18, but there are still some 80-odd third-pillar schemes in a country of 10m. In Poland, with a population of 39m, the number of second-pillar funds declined from 21 in 1999 to 16 by 2004, with the two smallest funds recently announcing their intention to merge.
Consolidation will prove more problematic where each pension company offers more than one fund. In Estonia and Lithuania, for instance, pension providers must offer at least one conservative, fixed-income fund, and in addition funds with an equity components for more risk-tolerant, usually younger workers. This option is currently not available in Poland, and is seen as an oversight. However, it is questionable whether a pensions industry in a country the size of Estonia, with 1.4m, can sustain its current number of 15 second-pillar funds.
The role of occupational schemes has been mixed. In Latvia, which was the first of the Baltic states to introduce pensions reform, the largest of the five third-pillar schemes is a closed pension fund for employees of the former state telephone monopoly and the electricity supplier. Occupational schemes have generally succeeded where the legislation has been well drafted, and where the employer (who traditionally paid most of the state scheme contribution) received tax benefits.
In high-unemployment countries such as Poland, where employers had little incentive to provide additional worker benefits at their own expense, the company-sponsored Employee Pensions Programmes have not proved particularly successful.
In the long and tortuous negotiations towards EU accession, pensions played little role. However, EU legislation is now becoming an issue in the case of investment. With the notable exceptions of Estonia and Slovenia, most the CEE countries have imposed limits on the amount that their private pensions schemes can invest overseas. In the case of Poland this remains a low 5% for second-pillar schemes, while the limit for third-pillar schemes was raised to 30% (for EU member states) for third-pillar programmes. In Estonia investment limits would have been impractical as the country’s government bond market is negligible, and its domestic equity market small. Poland, in contrast, has the region’s largest stock market, as well a sizeable government bond market funding a considerable budget deficit. The establishment of private pensions was part of a well-established strategy of developing the local capital markets industry alongside domestic institutional investors, and it is the only CEE country where the pensions industry plays a significant role in the domestic stock market.
The Polish government continues to argue that the second-pillar scheme is still a state system and therefore not subject to the same EU provisions of free capital movement as the private sector. Arguments about the role of international investment in maximising and diversifying pension returns - from both the local pensions fund industry and outside commentator - have so far proved academic. Estonia excepted, most of the CEE private pensions funds confine their investments to domestic markets, primarily government bonds, regardless of their overseas limits, largely because of cost factors. In Estonia, meanwhile, a recent survey of pension fund members showed that the majority would prefer to see their funds contribute more to building up the local economy.