Between 1997 and 2008, 11 countries in central and eastern Europe (CEE) implemented multi-pillar pension reforms, which involved the creation of mandatory funded schemes. These reforms were motivated by a foreseeable reduction in future pension contributions and extended benefit payments as a result of falling birth rates and people living longer.

The multi-pillar reforms were perceived as a way of mitigating pension risk. While pension benefits derived from pay-as-you-go (PAYG) systems depend on future resources, funded pensions depend on market performance. As the correlation between the two systems remains low, contributors were to be better off by diversifying their pension risk.
Secondary effects, such as increases in savings, economic growth and capital market development, were also potential benefits of the reforms.

However, in the past three years, many of these countries have partially or completely reversed their reforms for three main reasons: incomplete reforms; tension between implicit and explicit debt; and institutional design.

Firstly, the pension reforms were incomplete in the sense that they were not followed by economic policies that allowed these countries to take advantage of them. Despite commitments to help finance the transitional pension deficit created by the reforms with tax contributions, some countries mainly used explicit debt. Countries with elaborate schemes of tax financing, such as Hungary, increased the benefits of the PAYG systems right after the reform, leaving the funded scheme vulnerable to future attacks. In the presence of debt financing, the expected benefits of the reform, national savings, capital formation, economic growth and capital market development, did not happen.

Secondly, the tension between the short term and the long term is a consequence of the transitional burden the reforms created. From the fiscal perspective, pension reforms typically aim to solve long-term problems, but impose a fiscal burden during the transition period that needs to be financed. Faced with lower revenues and higher borrowing costs during the financial crisis, countries sought to boost social security revenues by shifting contributions from the mandatory funded schemes to the social security system. While this might help to explain some transitional changes, such as in Estonia, it does not help to explain the outcomes in the other countries.

The tension between the short term and the long term is aggravated by the treatment of implicit and explicit debt. Most of the CEE countries with PAYG systems have accumulated undisclosed amounts of implicit debt, which is equivalent to the amount of pension contingent liabilities at any given time. While explicit liabilities are constantly monitored and the cost of financing depends on the credibility of the government, implicit liabilities are issued and taken by the governments, always at par value, and are rarely monitored. Markets only pay attention to these liabilities when they are likely to have a short-term impact on the default probability of explicit debt, as in the case of Italy in 2011.

During the financial crisis, countries that were financing their transitional deficit with debt took the opportunity to reduce their cost of financing their deficit by switching contributions from the funded scheme to the PAYG scheme. This switch transfers the risk of default from the explicit to the implicit debt holders, and therefore increases the probability of default on the future pensions from the PAYG scheme. While the switch improves the risk perception towards pressing bondholders of explicit debt, it transfers the default risk to a more obscure place. Future governments and pensioners will have to deal with the consequences of the switch.

Unfortunately, as it ignores the amount of implicit pension debt, the stability and growth pact (SGP) plays against the possibility of stable mandatory funded schemes in euro-zone accession countries. Countries in Western Europe might be hiding higher amounts of implicit pension debt compared with CEE countries, and the effort of managing this progress has not been properly recognised. By reversing its pension reform, Hungary was able to reduce the explicit government debt, which allows the country to get closer to the SGP parameters. Unfortunately this reversal increases the probability of default on future pensions.

Thirdly, the emphasis on individual choice, and dysfunctional performance measurements, have resulted in high transaction costs and portfolios heavily invested in government securities and bank deposits. The emphasis on individual choice came at a great price, as shown by the lack of basic financial literacy among pension contributors. This implied not only high costs for hiring armies of sales people during the launch of these reforms, but also opened up the possibility of building entry barriers that resulted in oligopolies. In the presence of similar, but poorly diversified asset portfolios, competition was focused on stealing contributors between pension fund managers.

High costs are not intrinsic to mandatory pension schemes. Preserving the principles of individual accounts and market risk, the pension fund management industry needs to be re-organised to reduce costs and create portfolios optimising long-term returns.
Four policy conclusions can be made from the experience of CEE.

Firstly, funded pillars have an important role in pension provision across the CEE. In the face of demographic deterioration, and in order to ensure good pensions, governments should reconsider some of these reversals and commit to financing the transitional deficits using tax-payers’ money.

Secondly, funded pension schemes will be unsustainable as long as the transitional deficit does not have a clear and sustainable financing mechanism. Until the transition period is over – two to three decades from now – the temptation to unwind these reforms will be strong. Moreover, mandatory funded schemes will be in danger as long as the promises of PAYG systems remain unfunded. The development of a common methodology for calculating implicit pension debt across Europe might help to rebalance its treatment compared with explicit debt. Most importantly, and in order to avoid sudden reversals, governments will need to explain how they expect to finance the future pension deficits derived from the PAYG system.

Thirdly, governments and the industry should make pension fund management more efficient, with more focus on managing costs and long-term performance, and less focus on short-term performance, individual choice and quality of service. Following the successful experience of Sweden, the benefits of a funded system might be optimised by economies of scale, such as in account management, and by enhancing competition in asset management. As in Sweden, the introduction of blind accounts and price regulation may help to keep costs down and focus asset managers on managing portfolios, rather than stealing clients from the competition.

Lastly, in the absence of a well-defined pension fund management industry, competition for short-term performance will not guide pension funds on their optimal path. There is no guarantee that competition between portfolio managers will optimise returns for contributors. While improvements in financial literacy might solve this problem, it could take decades to educate contributors about their optimal asset allocation. In order to address this problem, pension regulation needs to define portfolio benchmarks that optimise pension returns in a more straightforward way.