Marcin Kawinski, Dariusz Stańko and Joanna Rutecka argue that the shift of risk to the individual within CEE pension systems requires greater protection mechanisms

The CEE countries face similiar demographic challenges that endanger the long-term financial stability of their pension systems. Increasing longevity places a greater burden on financing current and future pension benefits, whereas decreasing fertility has cut the number of workers able to pay social security contributions.

Governments reformed their pension systems in the 1990s by changing their pay-as-you-go systems and introducing funded pension pillars. In most cases, new pension funds emerged as mandatory institutions managed by private pension fund companies. This is an example of public-private partnership – whereas administration and asset management is outsourced to commercial companies, pension contributions have been carved out from mandatory pension systems.

The most profound, and the least visible, outcome of these reforms was a shift of various risks directly to the individual. The introduction of funded pillars brought about a change in the calculation of future pension benefits – before the reforms these were computed on the basis of defined benefit (DB) formula and now they are based on defined contribution (DC). In countries like Poland and Latvia, the DC system was also introduced to the pay-as-you-go pillars and others, such as Bulgaria and Romania, decided to use point systems reflecting individuals’ contribution to the system.

A switch to a DC system results in lower redistribution. What is more, members not only face higher investment risk (due to greater reliance on funded pillars) but also hazard taking wrong decisions (concerning choice of a fund, investment policy and the timing of these decisions).

This is why issues of guarantees and safety mechanisms are becoming more important for policymakers in the region. We analyse several of those mechanisms:
• Minimum pensions and social assistance for those whose pension savings will be inadequate;
• Indexation of pension entitlements and benefits in the first pillar to preserve their purchasing power value;
• Supervision and legal requirements to guarantee safety of investing in funded pillars;
• Guarantees of returns in funded pillars in case of serious underperformance;
• Reimbursement of pension contributions during periods of justified professional inactivity (for instance during maternity leave);
• Life-cycle portfolios;
• Safety measures during the payout stage;
• Reserve funds established in statutory pension systems to guarantee their financial solvency.

Pension funds, and the institutions that manage them, are usually separate legal entities.
There is a strict segregation of assets. Supervisory offices execute strict control over the daily activities of fund managers whereas pension laws foresee quantitative investment limits imposed on asset managers. These investment limits specify strategic asset allocation and, in turn, the long-term performance of pension funds. We believe that these limits not only reflect the risk-taking preferences expressed by regulators but also the potential (depth and liquidity) of local capital markets and economic policy preferences (limits on foreign investment).

Regulators offer some protection to the insured by imposing on pension management companies guarantees of return. The only exclusions are the Baltic countries. Most return guarantees have a relative character, ie, they represent the minimal required rate of return calculated on the basis of industry average. Such solutions function in Bulgaria, Croatia, Poland and Romania. The peer benchmark is an idea copied – with local modification – from the Chilean pension system. The Czech Republic, Romania, the Slovak Republic and Hungary offer absolute return guarantees either in the form of protection of nominal rate of return (first three countries) or real rate of return (Hungary). Even within the same type of investment result guarantee, there are substantial differences related to the frequency of its calculation and the length of the assessment horizon.

Half of the surveyed countries operate guarantee funds that enhance the solvency of the system. However, if a funded pension system offers minimum return guarantees, this protection is insufficient, because the potential cost of underperformance increases in line with rising pension assets. In the case of underperformance experienced by a huge pension fund it can have a devastating effect on the market.

We conclude that DC systems in CEE countries have protection mechanisms based on minimum pension benefits. As a result, they actually incorporate DB mechanisms. It is likely that many low-income employees in CEE countries even with long contribution periods (35-40 years) will end up with minimum pensions. However, minimum pensions are likely to decrease due to the fact that benefits are indexed on the basis of prices, not wages.

That is why CEE countries will require  stronger protection mechanisms for women and low-paid workers. This can be achieved by the introduction, or extension, of a coverage mechanism – ie, paying (by the state or social partners) funded contributions to pension funds on behalf of those whose economic activity was disrupted. However, to find resources to finance such a device one needs to cut direct protection facilities. We assume that this can be done partly by further lowering expenditures on minimum pension guarantees (in the ‘output phase’) or rationalising social expenditures in other areas.

One potential solution might be the introduction of several levels of minimum pension in relation to the length of the contribution period. The introduction of a partial minimum pension for shorter periods would not discourage workers in the informal economy from participating in formal pension systems.

The problem with return guarantees is that they are costly for providers and this cost is returned to pension fund members, either in a form of high fees or a conservative investment policy. Particularly costly are guarantees that have an absolute character. The typical problem for relative, peer-based benchmarks is so-called herding (similar investment patterns). Also, relative return guarantees offer only a partial protection for members. That is why we believe the performance evaluation framework for pension funds should be changed in the favour of external benchmarks, such as capital market indices.

We observe that in some countries (Bulgaria, Poland, Romania), the issue of life-cycle portfolios has not been addressed. However, even in those that have already done it, governments and industry need to alleviate the problem of decision taking, by providing pension fund members with financial education and a homogeneous, straightforward set of information.

People tend to be passive with their decisions and that is why the state should use a paternalistic pension policy with prepared default solutions for those who do not want to (or cannot) take active decisions. We also consider a hybrid DB/DC pension plan where part of contribution was used to buy the guarantee of minimum (floor) level of future benefits and another one would be invested on the pure DC scheme basis. In the case of underperformance, a retiree would be granted a payment supplementing their benefit to the minimum level. The difference would be financed by other savers from their DB premiums. In the case of overperformance, the DB-related contribution would be placed into the guarantee fund.

We find that the existing level of protection of purchasing power of pensions is not satisfactory. Decumulation within funded pension schemes will require that annuities offer at least some inflation indexation for pensioners. As a protection against inflation is costly, the state should provide some inflation-protected treasury bonds to lower the cost of annuities. This would imply shifting this cost onto taxpayers. Similar instruments with regard to longevity risk could be considered as well.

Marcin Kawinski, Dariusz Stańko and Joanna Rutecka are at the Socio-Economic College of the Warsaw School of Economics

*This article is based on the paper Are CEE Old-Age Pension Systems Safe?, which was published in the October 2012 edition of the Journal of Pension Economics and Finance