Freefall into the precipice
Hungary's economic crash came at a bad time for its private pensions sector, says Thomas Escritt
After many years during which observers repeatedly warned that Hungary was teetering on the edge of a precipice, disaster finally struck on 16 October when, over the course of a single day, its currency fell more than 5%, bond markets froze and interbank lending dried up, while the stock exchange sagged 10% on the day.
Hungary, with its long history of budgets deficits and spiralling state debt, had long been identified as one of the countries most exposed in the event of a global loss of confidence. But, even so, the sudden meltdown came as a shock.
Interbank lending remained frozen for days, while the National Bank of Hungary was repeatedly forced to abandon sovereign paper auctions when no bids came on successive days. During those days, the sense of crisis was tangible. With most of the country's mortgage lending in euros and Swiss francs, the currency's collapse hit hard, doubling mortgage payments overnight for many.
When it took the combined injection of a €5bn loan from the European Central Bank to get inter-bank lending moving again followed a week later by a record-breaking €20bn loan from the IMF, the EU and the European Bank for Reconstruction and Development to get the country's debt financing through a rocky patch of sovereign and private sector bonds all maturing within a few months of each other, the population was more receptive than at any time to severe budget cut-backs. In short order, the ‘13th month pension' - a bribe from the public purse to the country's retired made ahead of the 2004 elections - was scrapped. "At least they've got cover to slay this sacred cow," says Krisztian Szabados at Budapest-based public affairs consultancy Political Capital.
Hungary's problems had been years in the making. A common refrain among economic commentators is that it tries to "offer Scandinavian levels of social protection coupled with east European levels of productivity". And over decades, the country had built up levels of social protection that would make many a northern European envious. State-funded maternity leave allows mothers to take decade-long career breaks in their 20s, while during the 1990s successive governments bought social peace by allowing workers made redundant as a result of the painful downsizing of socialist industries to take disability pensions instead of entering the labour market.
As a result, despite a formal retirement age of 62, the average retirement age is nearer 55. None of this was cheap, and by 2006, Hungary had eye-watering levels of debt, fuelled by a budget shortfall of 9.7% of GDP. But there was nothing new to this: since the 1960s, Hungarian governments had been borrowing money to finance rising standards of living, originally as part of an implicit bargain imposed by withdrawing Soviet troops. Moscow gave Hungarian governments a free hand in managing their domestic economy in exchange for a promise that the events of Hungary's 1956 anti-communist uprising would never be repeated.
And the spending habits continued, more or less, until 1995 when the then finance minister Lajos Bokros was forced to implement a drastic package of cuts which led to a 17% drop in real wages. A pattern was established: Bokros's personal approval levels in polls plummeted and the socialist government in which he served was swept from office in 1998. But he laid the foundations for six years of strong economic growth, the proceeds of which later governments spent by doubling public sector wages and by introducing the totemic 13th-month pension.
The drama came at a bad time for Hungary's private pensions sector. Despite the generous public provision, especially for those in various kinds of early retirement, Hungary made the move to private pension saving early on. Pension funds, offered with one or two exceptions as retirement products by high street banks and insurers, have been on the market since 1998, when Hungary opted for a three-pillar system.
Although the country's funds have enjoyed considerable freedom in their investment policies compared with pension funds in many neighbouring countries - funds have been relatively free to invest abroad and have long been allowed exposure to real estate and other alternative asset classes - funds have been characterised by a high degree of conservatism when it comes to equity exposure, with 25% being the norm. According to István Hamecz, chairman of OTP Asset Management, which manages the OTP Mandatory Pension Fund, this reflects Hungarians' typically high degree of risk aversion. "Funds followed the preferences of their members to some extent, and the members didn't want to take on that additional risk," he says, alluding to a conservatism that mirrors Hungarian voters' reluctance to endorse governments that seek to make cuts to the country's welfare infrastructure or chop back at a redistribution ratio which, at 50% of GDP, is the highest in the region.
This conservatism, coupled with an uncompetitive pensions market that has led to high administration costs, led, as the actuary Agnes Matits points out, to poor returns, making pension funds an unattractive proposition. Seeing this, regulators sought ways to foster a greater hunger for risk among pension savers. The approach chosen was to force pension funds to provide three different portfolios - one oriented towards growth with high equity exposure, an intermediate balanced fund and a conservative portfolio that is invested largely in government debt providing for automatic mirroring of the pension funds' benchmarks.
The transition process began last January, and 1 January 2009 was the cut-off date by which time laggards needed to have an alternative portfolio system in place. Members who fail to choose a particular portfolio are automatically allocated on the basis of the number of years they have to go before retirement. To avoid an unruly process of transition management, funds have been given until 2011 to raise their equity ratings in the growth portfolios to the required minimum of 40%.
However, timing has been bad; 2008 was not the year to move heavily into equities. Hamecz is philosophical. "All our funds have lost value this year, of course, and our growth portfolios have lost 40%," he says.
To compound this misfortune, OTP was ahead of the game, introducing growth portfolios well before it was required to. The laggards have profited from their tardiness.
Peter Heim, (pictured right) head of asset management at the insurer Aegon's Hungarian subsidiary, refrains from crowing, but insists that a market view informed Aegon's decision to delay its transition to an alternative portfolio system. "We thought of moving to the new system this quarter, but felt that the market wasn't right," he says.
Of course, poor performance for an aggressive growth portfolio in a year that has seen a global equity slump should be neither a surprise nor a concern. "The optimisation in our growth portfolio is designed for 30 years," says Hamecz. "What's happened shows how important it was to change: the people who are protected are closest to retirement. Those 30 years from retirement are in equities and will lose out now and win later."
These nuances may be lost on members, the same voters who have resisted attempts at pruning back the country's social safety net since the 1990s, and among whom levels of financial literacy are very low. Results are published throughout the year on the financial regulator's website, but the fireworks are expected when savers receive their annual statement in the post. "It's going to cause political problems, and there will be public opinion problems," says Hamecz. "We're just going to have to tell our clients pension funds work like this."
But neither manager believes a pension fund has much alternative to sticking to its guns in the current climate. "It was a terrible year - for us, for the pension fund system, for the whole region, and for the pension fund system globally," says Heim.
Hamecz agrees, saying that a long-term investor would be best advised to stick to its existing strategic allocation, confining changes to tactical shifts.
The tactical allocation involved a strong negative bias to equities, Heim adds. "We expect something of a bear market rally. When equities hit the bottom of their range we'll buy. When they hit the top, we'll sell." And he would be long on Hungarian bonds for the foreseeable future. "They have an average yield of 10% at the moment. This year could be the year of Hungarian sovereigns."