CENTRAL EUROPE - Central and Eastern Europe's second-pillar pension funds recorded exceptional year-on-year growth in 2005, well ahead of the rise in numbers of clients, despite their relatively conservative investment strategies. There have also been relatively few changes in the rankings compared with 2004. There were no changes in the top 10 in either the Polish and Hungarian mandatory second-pillar pension fund system.

Asset growth was particularly strong in Poland, by far the largest of the pensions markets. By value assets were up 44% to €22.3bn while the number of clients fell by 1.6% to 11.7m. This seeming anomaly in a mandatory system is because some 800,000 so-called dead accounts of people who never existed or should never have been enrolled were finally removed. The effect of the high emigration rate since EU accession - estimates run as high as 2m - has not been discernible so far, although this may be because of Poland's high unemployment rate, at 17% the EU's worst.

The Polish pension fund industry had good returns in 2005. Commercial Union Pension Fund, the largest in the region, reported a return net of management fees of 15.5% in 2005. Chief investment officer and member of the management board Michal Szymanski attributes this to positive returns on the Polish equity market and local interest rates that, aligned with Poland's loosening monetary policy, are falling. "Looking forward, that's a challenge," he notes.

Polish interest rates are now at a historic low, and Szymanski is unsure whether they can fall further, especially given the continuing convergence of Poland with the euro zone. "We will now have to look for other sources of return," he predicts.

According to Szymanski, the main asset allocation trends in 2005 were that the fund increased investments in non-treasury fixed income paper, including corporate, mortgage and revenue bonds, although these are still relatively underdeveloped markets in the region. The key features of the Polish market compared with its CEE neighbours include the strict limits on foreign investment, at 5% the region's lowest, and the relatively high investment in equity, an average 32% at the end of 2005. The equity bias has made Polish pension funds influential players on the Warsaw Stock Exchange.

A recent EBRD report, Regulatory induced herding? Evidence from Polish pension funds, shows that Polish pension funds have followed the same portfolio strategy rather than the best one. According to Szymanski, the two reasons for this phenomenon are the minimum benchmark that funds must achieve (currently over a three-year average) and detailed and timely publishing requirements of each fund's asset structure.

One solution, he adds, is that the currently strict limits on asset classes are widened to including new instruments such private equity and real estate. "The issue of diversification will become more important in 2007," he adds.