Conservative in approach
Private pensions are still a young industry in central and east European (CEE) countries, but differing legislation has produced a range of investment strategies, reports a survey* produced by FI-AD Financial Advisory of Budapest. The survey, sponsored by East-West Management Institute of Vienna, used its own and the standard Organisation for Economic Development and Co-operation (OECD) questionnaires, site visits and interviews to uncover the investment policies of private second and third pillar pension funds in the eight CEE countries set to join the EU in May 2004.
Most of the investment data is for the end of 2002, but the survey has also captured more recent developments such as the launch of Lithuania’s private pillar in late 2003.
Private pensions are close to 10 years old in some countries, but the sizes of individual countries’ pension industries depend on their population sizes rather than how early they introduced their programmes. The fact that Hungary and the Czech Republic had the second and third biggest amounts of assets under management (AUM) as of end-2002 has less to do with the fact that they were the first to introduce private pensions (third pillars were legislated in 1994) than that they are the second and third biggest in the region. Poland, which launched its second pillar scheme in 1999, and which has a bigger population than the rest of the CEE’s new EU members combined, also had the highest amount of AUM, E7.40bn in both second and third pillars.
The presence of a second pillar inevitably boosts AUM, as these are usually compulsory for some part of the workforce, and it also affects regulation. Countries with both pillars have stricter laws for the second pillar, except Slovenia where the same investment legislation applies to both (although Slovenia’s second pillar scheme is only for selected professions such as hazardous occupations), while those with no second pillar or only a restricted one, notably the Czech Republic and Slovakia, have stricter legislation for the third pillar than the CEE average.
In the second pillar foreign investment limits include restrictions on the domicile of eligible securities - usually the OECD, EU and European Economic Area – and also the percentage of assets available for foreign investment. A number of countries operate currency-matching systems, as in Estonia and Latvia, while in Poland, with the most restrictive system here, there is a 5% cap on foreign investments. At the other extreme, Slovenia has no limit on the amount invested, as long as it is in EU and OECD member states.
The amount of equity permitted ranges from 50% in the case of Hungary and Estonia to 30% in Latvia and Slovenia. In the case of Hungary, Slovenia and Estonia, this limit also includes mutual fund investment, while in the case of Poland, with a 40% equity cap, the combine equity and fund limit is 60%. Derivatives are forbidden in Poland and Slovenia, and allowed only for hedging purposes in Estonia, Latvia and Hungary. Polish and Latvian second pillar funds cannot invest directly in real estate while Estonia and Slovenia allow a certain portion, and Hungarian funds have been allowed to do so since 2003.
Different rules also apply to deposits, cash and money market instruments, ranging from no limits on deposits in Hungary and Latvia to 20% in Poland. There is least variation in the case of fixed income, although Estonia is the only country to place a limit, 35% in this case, on state issued and state guaranteed securities. As the survey notes, “countries with more restrictions on low risk instruments force pension funds to expose themselves more to the capital market”.
In the case of the third pillar, the rules tend to looser. In Poland the foreign investment limit was raised to 30% for EU member states, while Estonia extends the permitted domicile to the 102 members of the International Organisation of Securities Commission (IOSCO). The Czech Republic is the least liberal, restricting foreign investment to state and state guaranteed bonds, although without any quantitative limits. Equity investment limits range from 20% in Slovakia and 25% in the Czech Republic (in both cases including mutual funds) to none in Poland, Estonia and Latvia. Most will allow real estate investment except Poland and Lithuania.
The variation in limits set by different countries, especially on second pillar funds, stems from different political climates and the relative development of the capital markets. Poland’s tight foreign investment limits reflected policies geared to building up a strong domestic capital market, which is mirrored in the comparatively low equity and mutual fund limits. As the survey notes, this is the only country in the region where pension funds have a significant impact on the local equity market. Estonia has to be relaxed about foreign investment limits since its equity market is small and its state bond market virtually non-existent (the country by law can only run state budget deficits in exceptional circumstances). Not surprisingly, it has the highest overall exposure to foreign securities.
Limits are a frequent source of complaint by pension funds, but as the survey found, they still had room to expand in those currently set. In the case of the second pillar, Hungarian funds at the end of 2002 has used 28% of their equity limit and 13% of their foreign investment one, Poland 56% and 28% respectively. A similar picture emerges in the case of third pillar funds, despite their less restrictive regime, because of a variety of factors including cost in the case of foreign investment (see table).
Regardless of the extent of regulation, the survey found the region’s pension funds a conservative group. The survey identifies three categories of risk strategy:
o Domestic: Poland is the best example, with a higher than average investment in domestic equities, but a small exposure to foreign equities;
o Foreign risk: Estonia, and to a lesser extent Latvia, have a higher than average exposure to foreign securities. Estonia’s second and third pillars rank the most diversified, but the fact that the Estonian kroon is pegged to the euro means that it has eliminated currency risk on its investment in Euro-zone securities. The same will apply to in Lithuania, whose currency is also pegged to the euro, and whose pension funds started accumulating assets at the beginning of 2004.
o Risk averse: The avoidance of market risk, as seen in the Czech Republic, Hungary, Slovakia and Slovenia, is typified by a high exposure to fixed income. In Hungary’s case, 86% of second pillar and 80% of third pillar funds were invested in fixed income at the end of 2002, although as the collapse of the Hungarian bond market the following year showed, diversification should also play an important role in risk avoidance.
* Investments of Pension Funds in CEE countries Research Report is available for download from FI-AD Financial Advisory, www.fi-ad.hu and from the International Network of Pensions Regulators and Supervisors, www.inprs.org