Rachel Fixsen finds a buoyant pensions industry in its infancy but improvements could be made

While professionals in the Estonian pensions industry would like to see some changes in funds’ investment patterns, they view the structure and functioning of the country’s young pension system with pride.  

The system consists of three pillars – a state funded pension, a mandatory funded pension and a supplementary funded pension.

The mandatory funded system was set up in 2002, but the history of voluntary savings options goes back to the late 1990s.

“In general, I believe we did a good job in the preparatory phase, which has helped us to continue along the same road,” says Silja Saar, managing director of Danske Capital AS in Estonia and chair of the Estonian Fund Managers Association.

The second pillar now covers around 90% of the country’s workforce, with individuals contributing 2% of gross salary and the state contributing another 4%.

It now has €1.42bn in assets, invested via six fund managers which offer 23 funds, with different risk levels.

Savings are registered in individual pension accounts, and are thus personal heritable assets.  

While the system works well, some improvements could be made.

Mihkel Õim, head of fund services at FinanceEstonia – a public-private organisation promoting Estonia as a financial services location – suggests the industry should improve communication to potential savers about investment strategies and value creation processes.

Costs, too – particularly for pension distribution – should be cut and kept to a long-term sustainable level, he says.

Paavo Põld, head of business development at Limestone Investment Management, says the structure of pension funds can make them costly. “Current pension funds are managed quite like fund-of-funds, which is of course the most cost effective way for the providers, but perhaps not the optimal solution for savers in terms of total costs,” he says.

Saar suggests the system could improve by increasing the level of savings in the third pillar, and making the payout phase more flexible.

At the moment third pillar savings are only a tenth the size of those in pillar two.

“This question goes down to general awareness,” she says. “People can’t be engaged more if they don’t realise the need to save for retirement on a voluntary basis too.”

Products offered for second pillar pensions in Estonia are those of a typical ‘new wave’ individual decision-based DC system, says Õim.

This is based on simple UCITS type fund structures with daily NAV, which has the advantage of being easily understood by a wide audience, he finds.

“It is great system to teach the participants about the principles of long-term investment,” he says. “But, that is not as good for long-term investments considering the cost structure and investment requirements needed to support daily liquidity.”

As far as investments in pillar two pensions go, the typical investment model is still based on backward-looking index-linked equity or fixed income allocation to manage the expected risk return profile, says Õim.

Pension fund returns in Estonia have attracted public criticism as a result of the recent financial crisis, says Ege Metsandi, management board member of ERGO Funds.

On top of the effects of the financial crisis, funds’ options for achieving higher returns have been hit by mandatory restrictions, which have pushed their strategies towards ‘safer’ products such as investment-grade debt instruments or OECD sovereign debt, says Ege, who is also on the management board of the Estonian Association of Fund Managers.

“However, this has put more stress on pension funds,” she says. “By stopping them from taking risks for higher returns, the safe products have demonstrated as high a risk as any other.” Ege believes future regulatory initiatives ought to take this change in paradigm into account.

“The long term aim of the pension funds is to exceed the CPI growth,” she explains. “As Estonia has higher CPI than other euro area countries, it is quite hard to find investments with a higher yield than Estonian CPI without substantially increasing the risk level.”

Swedbank Investment Funds has even centralised certain asset allocation decisions at its Stockholm headquarters.

While this may be cost effective, he points out that the general public in Estonia expects to see more funds invested in local assets as well.

As things stand, only around 6% of pension assets have been invested in Estonia, although smaller funds such as ERGO and LHV have invested about 20% of assets in the home country.

Õim believes that being major investors in the market, pension funds should be aiming to search for and support value creation in the domestic market.

“However good you are globally, you still remain a tourist on those markets,” he says. “It is quite complicated to evaluate and provide value creation in other markets.”