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Hitting the ceiling

At either end of the Zaliasis Tiltas, the Green Bridge that spans the river Neris as it flows through central Vilnius, statues of idealised workers, peasants and soldiers pause in the construction of ‘real' socialism to stare with a fixed certainty towards a Soviet future that was never to be. Nearby, real workers are busy constructing independent Lithuania's financial centre, erecting buildings that are intended to help the country catch up with the European mainstream.

"Hansa operations are housed in nine buildings scattered around Vilnius at the moment," says Aurimas Mazdzierius, CEO of Hansa investiciju valdymas. "But they will be brought together in a new office block on the right bank of the river."

Hansa investiciju valdymas is the largest of the 10 pension asset management companies established under 2003 legislation to run second pillar pension funds.

Employers pay 31% of an employee's gross salary to the State Social Insurance Office (SoDra) and the employee pays an additional 3%. Of this, 18 percentage points goes to the old age pensions system. Under the 2003 legislation individuals were allowed to divert 2.5% of the 18% to a private pension fund of their choice, with the contribution rate increasing by 1% of a salary a year to reach 5.5% by 2007, leaving 12.5% to the SoDra budget.

"The participant can choose both the manager and the strategy," says Vaiva Tyliene, head of sales and business development and deputy managing director of SEB VB investiciju valdymas, who was directly involved in the introduction of the group's pension operation. "The law requires that the companies must offer a conservative fund, with assets allocated solely to the government bonds of EU and OECD countries, but then they can decide how many additional funds to offer. We have three: a conservative, a balanced and an equity-oriented fund."

So far so orthodox, in that the pattern is fairly typical of that followed by many post-communist states. However, the Lithuanian model also has some distinctive characteristics. First, the system is totally voluntary, so there is no requirement as seen elsewhere in the region that new entrants to the labour market or those up to a set age threshold be obliged to join a second pillar pension. And there is no upper age limit on joining a pension fund. "The law's only requirement is that a person sign up to a fund before retirement, while they are still working," says Audrone Morkuniene, undersecretary at the ministry of social security & labour, which oversees SoDra.

Another feature has been that although the process began quite early, its implementation came very late and after a series of delays. "It was a very long process," concedes Morkuniene.

This reflects another element of the Lithuanian reality. Although Lithuanian governments have presided over a remarkably smooth transition from membership of the Soviet Union to membership of the EU, for the governments themselves the political ride has been quite bumpy.

In the first half of this year Lithuania's 13th government in 17 years collapsed and in July it was replaced by the 14th, a coalition that lacks a majority in parliament, the Seimas. The crisis was triggered by corruption allegations centring on the Labour Party, a grouping formed only a year before the 2004 general election from which it emerged as the largest party. The party withdrew from the government and an arrest warrant has since been issued for its leader, a former economy minister who is reported to be spending more time with his family in Russia.

And six months before the general election the outgoing Seimas had impeached the president, former premier Rolandas Paksas, for violating the constitution following accusations of leaking classified material and giving citizenship to a Russian businessman in return for financial support.

"The last few elections have seen the creation of populist special purpose election vehicles that have no ideology but tell people what they want to hear," said one pension fund professional. "Perhaps they are an expression of social disappointment. Society is suffering from reform fatigue and politicians are only now learning to look at a longer perspective than just four years until the next election."

"This is due to our Soviet heritage," says Morkuniene. "Not everybody in Lithuania is better off under these reforms, the regaining of independence and accession to the EU. Those used to a paternalistic state lost some of their guarantees for doing nothing and still getting something, and it is not easy to readjust. People had no experience of a democratic way of life, of elections, of demanding responsibility from our politicians, selecting them and recognising their realistic and unrealistic promises."

Organisations like the Labour Party and politicians like Paksas were successful because they pitched their message to the less educated and poorer part of the population who have been bemused by the changes and are looking for simple answers to complex questions, political observers say.

"This may be one of the reasons for the delay in pension reform, because no party took ownership of the issue and promised their constituency that they would undertake the reform," says the pension fund professional. "We in the asset management industry wanted the reform to allow the creation of private pension funds but there was no political will among the parties. They kept on postponing the move because of fears of what the impact of introducing the new funds would be on the social security budget; in the early stages of independence it was impossible to see that the economy would grow in the way it has. We had problems with the switch from roubles, when some who had pre-independence savings in roubles lost out, then we had a local banking crisis in 1994-95, and when we had high inflation people lost again. It seemed that every reform had a cost for the public. So politicians were unwilling to introduce a system where money would go out of state management to that of private operators and take the risk that there might be abuses. They were reluctant to start something complicated that could trigger another financial market crisis."

During the early post-Soviet period the economy had gone into freefall, with production collapsing and inflation and unemployment surging. But governments moved ahead with economic reforms, adopting disciplined budgetary and financial policies that slashed inflation, shifting trade away from the former Soviet Union towards western markets, and restoring economic growth. The 2005 GDP year-on-year growth rate was 7.6% and it reached 8.2% in the first half of 2006.

But pension reform had started promisingly enough, with the first moves coming even before the collapse of the Soviet Union when in 1991 the social insurance fund and the state budget were separated. Then, in line with a general economic restructuring drive, the system underwent a muscular parametric reform in 1994-95, when all political or professional pension privileges which remained from Soviet days were swept away to be replaced with a self-sufficient pay-as-you-go pension system based on contributions that laid the basis for the present system.

"Legislation to establish a system of voluntary private pensions followed in 1999," says Lina Sajyte, head of the investment management department of the Securities Commission, Lithuania's pension asset management regulator.

"In the mid-1990s we only discussed introducing a third pillar," recalls Morkuniene who has participated in all working groups since 1996. "One of our major employer organisations was keen to establish its own employer-based pension funds as in western Europe. But our experts resisted this purely employer-based model, especially when we saw the draft the employer group produced as it proposed something like a book reserve system. So we prepared alternative draft pension fund legislation, which envisaged third pillar funds that were open to everybody, run by investment companies and based on an investment culture. And it came into force on 1 January 1999."

"However, for the first several years no applications for licenses to establish such entities were received and the system did not develop," adds Sajyte. "The basic reason was lack of tax incentives for participants."

Morkuniene identifies other fundamental flaws: "The legislation was over-regulated, with every restriction you can think of because at that time politicians were so scared of any theft, or any failure of these pension funds because they should be secure for a person's retirement, for social purposes, and they were anxious that nobody should be blamed for any mistake that might be made."

But after this failure politicians started to think along the multi-pillar lines suggested by the World Bank, with a mandatory second pillar and a voluntary third pillar, she adds.

New legislation was drawn up by a centre-right administration led by the conservative Homeland Union (TS-LK), one of the country's two main political parties and a successor of the Sajudis movement that spearheaded Lithuanian independence.

"The introduction of the accumulative funds took a bit too long," says Irena Degutiene, a TS-LK deputy and twice an acting prime minister. "To implement something you must first have an idea, and when, in 1996-2000, the conservatives were in the majority and I was minister of social security and labour we started to prepare the legislation. But we did not implement it because those years were quite bad for Lithuania. For example, we had to arrange the withdrawal of Russian troops in the early 1990s then the Russia financial crisis in the late 1990s left the country in an economic hole because at that time most Lithuanians enterprises had close economic links with Russia. The social insurance deficit in 1999-2000 amounted to LTL500,000, there was high unemployment so contributions were low and we had a very conspicuous black economy, with an estimated 200,000 people working in this sector. So although we had approved a draft law with a contribution rate of 5%, it had not come to the Seimas when we left office in 2000."

The new government was a coalition of two Liberal factions led by Paksas. "They took our draft but we had some disagreements about how the social insurance deficit should be covered, so it was not passed," adds Degutiene.

"It proposed a second pillar that would be mandatory for people up to 30 and with those up to 50 being able to choose whether or not to participate, and this was the main sticking point," says Morkuniene. "It was resisted by the Social Democrats, because we had no investment culture and it was considered dangerous to push people into such an environment, although if somebody wanted it they could have the opportunity to choose the provision they preferred."

The Paksas administration was succeeded by a coalition of the Social Democrats, the country's other major party that is based round the Soviet-era communists who had embraced economic reform, and Paksas' coalition partner, the Social Liberals. "Discussion on whether it should be compulsory, the amount of the contribution and how the social security deficit should be covered, lasted for seven months and after that the government presented a new variant," recalls Algirdas Sysas, a Social Democrat deputy and chairman of the Seimas committee of social affairs and labour. "They decided on a contribution level of 2.5% and I think the figure was right. It prevented a possible social explosion and the decision to increase it by 1% a year was good because gradually the economy began to grow, unemployment decreased and the social insurance deficit was covered. But nevertheless it took us half a year to persuade [the then prime minister and Social Democrats leader Algirdas] Brazauskas."

Why did the government finally decide to go ahead with the reform? For Mazdzierius of Hansa it was due to external reasons. "Suddenly the politicians realised we were about to enter the EU and had still not introduced this basic reform," he says. "Then it appeared on the agenda of the Seimas and was passed."

Morkuniene disagrees that this was the cause: "Our reform started in January 2004, right before EU accession in May, but really we did not feel any pressure from Brussels to do something, it was mainly the local environment and the local political debate that determined that the draft would be finally passed."

However, once the decision was made progress was rapid. "We debated the reform for almost 10 years, but we implemented it in only two months," says Morkuniene. "This is incredible given the administration required. And it works very successfully."

But not necessarily in the way expected. "We anticipated that only the wealthiest people in Lithuania would join, around 5% of the workforce, and we got it wrong," says Morkuniene. "In the first year more than 40% of the working population enrolled."

Now the system includes some 55% of the working population.

"And our forecasts indicated deficits in the social security budget," adds Morkuniene. "We felt really threatened by this and it was one of the reasons why it was decided that some private provision had to be added to the pension system to ease the burden on the state. But now we have a surplus not a deficit because of economic growth and because currently the demographic situation is favourable - we still have baby boomers in the workforce and because pensioners are those born during World War II the cohort is smaller. And the black economy is retreating. Fewer employers are paying so-called ‘wages in envelopes' - we had a high-profile court case earlier this year where an employee sued an employer for not paying full taxes and this sent a signal to
business.

In addition, the tax inspectorate has become more efficient. This allows us to raise the state pension, which is indexed to wage increases. So last year we had wage growth of 14% and pensions were raised by 13%. We see the problems starting in 2015 and later we will slip into deficit and the curve will go down."

The debate is beginning to focus on whether to raise the contribution rate beyond the 5.5% of a salary foreseen in the legislation.

"I would be happy to see further increases to at least 10% in the near future and I think that the growth rate will be even higher taking into account the economic and financial situation," says Degutiene. "It is also possible that we will make participation compulsory for people aged between 25 and 35 but we will have to evaluate the social and the economic conditions at the time and calculate the impact on the social insurance deficit. We want it to be compulsory because we want the social insurance system to gradually disappear and we want all the younger generation to go to pension funds and earn pensions for their old age."

But Sysas disagrees. "I am against a further privatisation of the social insurance system," he says. "Therefore, 5.5% in 2007 has to be the maximum figure, and if we decide to increase the contribution rate it will have to be a voluntary increase by people from their salaries, not from SoDra, with the government's role being limited to applying tax incentives to their contributions."

"It's difficult to predict the future evolution of the system," says Morkuniene. "This government does not foresee an increase in the contribution rate to the private pillar, but who knows. The industry is calling for a further increase, and the surplus in the SoDra budget suggests we have the means to do it. But the law stated that the rate should reach 5.5%, and nothing more, and that level is foreseen in all the pension agreements signed by the pension providers and the participants so raising it could be considered breach of contract.

Those participating in the second pillar will get proportionately less state pension because they will have paid less into the system. Every year we calculate the relative contribution rates diverted to the private pension companies and left to the social insurance system, and this calculation is applied to the pension entitlement. It's a very fair system. But we don't know whether participants would like to get less state guaranteed pension and more private pension."

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