CEE: Pensions and the economic crisis
The global recession has affected the countries of central and eastern Europe in markedly different ways. Krystyna Krzyzak analyses the significant impacts of the crisis on the region’s supplementary pensions systems
With their open economies and trade, the central and eastern Europe (CEE) countries were badly hurt when the economic crisis caused their export partners to retrench. Still classed as emerging markets, they also suffered the additional hit of seeing international investors pulling out of their markets in a flight to ‘quality’, dragging down their stock and bond markets as well as their currencies. Yet the overall effect on individual economies has been extremely varied.
At the one extreme Poland stands out as the only country in the EU that did not fall into recession. At the other, the Baltic states had double-digit year-on-year contractions in GDP (see panel opposite). Poland appears to weathered the crisis by allowing its currency to depreciate, thus keeping its exports competitive. Poland did experience its own toxic assets shock, however, as many companies had earlier taken out currency option and related bets on the Polish zloty it continued appreciation. The currency’s sudden plunge at the start of 2009 created exposures of around PLN4.5bn (€1.1bn). “Yet despite the FX options story, exporters managed to improve their profitability,” notes Marcin Zoltek, CIO of Aviva Pension Fund.
Grzegorz Chlopek, board vice-president and CIO at ING PTE, explains that companies were partly conditioned by the 2002-04 recession. “At that time they cut staff and then were not able to hire them and increase production when the economy recovered. This time round they focused on how to keep their staff, so unemployment has not grown as fast as would be expected.”
Countries with either a currency board system (such as Bulgaria and the Baltic states), and those in the euro-zone (Slovenia and Slovakia) could not adjust their currencies. Overall the fiscal measures used by countries such as the US and UK were simply not available, and some, like Hungary, Latvia and Romania turned to the IMF for help.
Hungary faced the crisis with a hangover of the highest budget deficit in the EU over 2005-07. “Hungary has already experienced a lot of cost cutting and budget restructuring, so its starting point may be better than for, say, Poland and the Czech Republic,” observes Andras Szalkai, investment director of East Capital Asset Management in Vienna. The European Commission sees Hungary’s deficit at around 4.1% of GDP in 2009, compared with 6.4% for Poland and 6.6% for the Czech Republic. In contrast, prudent Bulgaria managed to run a near-balanced budget in 2009.
The general budget deficits used by the EU for, among other things, determining a country’s eligibility to join the euro-zone, include imbalances built up by the state pension systems. In a number of cases governments reduced the share diverted from the state system into second pillar funds, as was the case in the Baltic states. The Polish pension system also faces this possibility.
The impact on assets
The main impact of the economic crisis on pension fund assets was felt in equities, with their portfolios declining both as a result of fund sales and falling values until the markets recovered in spring 2009. In those countries with extensive pension funds, foreign investment moved to safe havens such as German government bonds.
In Estonia, which has hardly any domestic government bond market and a very small local equity market, funds have typically invested more than three quarters of their assets abroad, including a significant portion in neighbour countries. However, in the last 12 months there has been a marked shift away from Russia and Latvia, and an increase in investments in France, Germany and Finland. “We are more conservative about central and eastern Europe, and investing more in developing markets in Asia and Latin America,” says Agnes Makk, CEO of Swedbank Investment Funds in Estonia.
However, local regulatory issues, including the reactions of individual governments, have had a more profound effect on asset allocation.
For Hungarian pension funds the collapse in stock market performance coincided with the 2008-09 switch from a single portfolio to multi-fund lifecycle funds, including the establishment of equity-oriented portfolios. As a result, the performance of funds differed wildly depending on where they were in changeover phase. “The pension funds introducing the lifecycle portfolio system in 2008 with their growth portfolios containing a large proportion of risky asset (equity) have been severely exposed to the financial turmoil,” says Mihaly Erdos, deputy director general of prudential supervision at the Hungarian Financial Supervisory Authority. “Those pension funds introducing the lifecycle portfolio only in 2009 have started with a lower risk compiled portfolio.”
According to Gabor Borza, CFO of ING Life & Pensions in Hungary, at the worst point in the crisis at the beginning of 2009, growth (equity-oriented) funds returned a weighted average of minus 23%. “However, we decided that it would not be professional to change our asset allocation and sell off equities at the bottom of the market,” says Borza. As a result its growth fund rode back on the stock market revival in spring 2009, with a return of 31% year to date as of mid November, compared with 17% for the classic bond-weighted portfolio and 23% for the intermediate balanced one. The earlier market falls also prompted some clients to switch out of high equity funds. Fortunately for the system, only a small number of clients panicked when the market fell, realised their losses, moved to less aggressive portfolios and then missed out on the subsequent gains. However, classic portfolios still account for a relatively small 1.5-1.6% of all portfolios.
The large but voluntary Czech system, with its unique requirements that the funds must generate a positive return, was the least affected country in the region. As a result, the system with probably the most conservative asset allocation in the region - bonds have typically made up a good three quarter of average portfolios - became even less risk averse, with fixed income accounting for more than 80% since the beginning of 2009. “In 2008 the pension funds faced problems getting a positive performance as demanded by law. Nevertheless, all the funds achieved this,” says Jiri Rusnok, pensions director, ING Czech Republic.
For 2009 he expects the funds to return 1.5-3%, depending on their allocation. “Some funds sold off all their equity and did not participate in the recovery of the markets.” Foreign investment accounted for around 8% of total portfolios in the third quarter of 2009, marginally higher than at the end of 2008. “The foreign exchange risk is important for Czech funds. We prefer Czech crown bonds: the interest rate is stable and close to that of the European Central Bank, but we will need to look for some alternatives in 12-15 months’ time.”
The impact of property price collapses on pension funds has been relatively limited across the region, because even in those countries where such investment was permitted, it remained small. In Hungary, for example, real estate investment, including via funds, has remained pretty much constant at around 1.5% of total assets. Bulgaria has been one of the exceptions: in addition to physical real estate, pension funds have traditionally invested a certain proportion in real estate investment trusts (REITs). The Bulgarian property market was hit by, among other things, a collapse in holiday home development. “Most investors now think of property as a dirty word,” observes Miroslav Marinov, deputy CEO and CFO at Pension Assurance Company Doverie, the country’s largest pension fund management company. In the case of physical property, many projects have been frozen. In the case of REITs, while some continue to trade well on the local stock exchange, others are finding it difficult to service their high debts.
In Hungary second pillar pension members over the age of 52 years have been given the option to opt back into the state system. According to Borza, when the system was initiated in 1998, those older members who joined on a voluntary basis - in the process giving up a quarter of their first pillar entitlement - did not necessarily understand the risks. For those who only had 15 years left to retirement, it was unlikely that their second pillar fund would grow sufficiently to compensate for what they gave up from the first pillar. “We are advising those over 57 years to leave the second pillar, and leaving it up to the 52-57-year-olds to make their own decision,” says Borza. The client outflow has not, however, been that dramatic. Borza says that while 27,000 of ING’s 600,000 pension members are eligible to opt out, only 5,000 have done so. Erdos adds that he expects around half of the total 125,000 eligible mandatory pension members to do so by the end of 2009.
The crisis led to the postponement of the 40% minimum equity share requirement in growth portfolios from 2009 to 2011. However, the authorities will be introducing a cap on foreign investments in 2010, ranging from 45% of assets for the riskiest portfolios to 5% for the least risky. The aim is to support domestic investment. Overall the recent share of foreign investments in Hungarian pension portfolios has ranged from 27% at the end of 2008 to 21% in the third quarter of 2009. Erdos acknowledges that the new limits, which take effect in September 2010, could prove problematic. “For the time being, the current capitalisation of the Budapest Stock Exchange provides sufficient amount of equities. In the long run, there is the threat that following the recovery period of the Hungarian economy the investment demand raised by the pension funds cannot be met promptly.”
The Slovakian second pillar system has suffered the most in recent months, but as much due to politics as market conditions. The country’s economic contraction, at 5.3% in the first nine months of 2009, is more intense than the EU average, but improving. Its unemployment rate, as calculated by Eurostat, has shot up, to 12.2% in October 2009 from 9% a year earlier, which will inevitably affect contribution flows. More significant is the constant stream of regulations from a government hostile to the system. “The government has used the second pillar as an example of political marketing activity against global capitalism,” observes Rusnok of ING.
In mid 2009, following the negative returns produced by the growth and balanced funds in the wake of the economic crisis, the government introduced a six-month performance benchmark. “So the pension funds did the logical thing and sold off equities, and when the markets recovered there was no significant improvement,” Rusnok says. As of the end of October 2009 the aggregated Slovak pension fund portfolio was virtually an equity-free zone, with shares accounting for a mere 0.2%. The other shifts were equally dramatic. The portion of bonds, traditionally the biggest, fell to 32%, while deposits took up 68%. With some 45% of these deposits lodged in two banks, the National Bank of Slovakia has warned of a growing concentration risk.
Such portfolios are unlikely to give savers much more than what they would get if they left their money in the bank, so the government has instructed the finance ministry to prepare new legislation that would force the funds to generate increases as high as that currently provided by the state pension, which is indexed 50% to salaries and 50% to inflation.
Focus on risk management
The economic crisis has refocused pension asset managers towards risk management.
“Bulgarian pension funds now have more understanding of risks associated with every type of investment,” reports Marinov of Doverie. For instance, the lack of liquidity on the local exchange prevented the funds from selling their domestic equities. “Some risk appetite has appeared in the market, maybe due to the 40-50% rise in some indices, as well as international government support to the economies, markets and banks. Most of the funds are now investing back into equities. What is new is that they are investing into international equities, through mutual funds, exchange-traded funds as well as single-name corporates,” he adds. In the case of government bonds, portfolios are shifting towards highly-rated international issues, especially German bonds.
Fund managers are also adjusting their methodologies. As of September 2009, Sweden’s SEB Bank has been using a new system for the pension funds of its subsidiaries in Latvia, Lithuania and Estonia. “We re-defined our previous generic benchmarks, and introduced tracking error to limit the fund manager’s ability to take bets and to take successive bad bets,” explains Gediminas Milieska, CIO at SEB Wealth Management in Lithuania.
The previous focus was on risk-adjusted performance, where the portfolio manager tried to achieve alpha and take account of standard deviation. “We now understand that the standard deviation is more or less a market measure, and tracking error shows you how much of that deviation is caused by the portfolio manager.”
The system is applied across SEB’s Baltic subsidiaries, albeit with different benchmarks. While the structure of the portfolio has not changed markedly, the main impact has been to reduce aggressive strategies. The system uses a tactical period of three to six months and a strategic one of one to two years. “Currently we are negative on both, and underweight, though the underweights are moderate,” adds Milieska.