Poland: On a collision course
A proposal to cut second pillar contributions to pension funds would leave most OFE pension funds unprofitable and the rest to invest in low-yielding investment strategies, finds Krystyna Krzyzak
Poland's economy has outshone those of the rest of the EU, but its resilience has not made life any easier for the second pillar pension fund industry. By far the largest in the CEE with PLN1,67.9bn (€40bn) of pension assets as of the end of September 2009 and more than 14m members, the industry is a powerful market force. Its relationships with parts of the coalition government are, however, becoming increasingly terse.
The Polish economy itself has been the only one in the EU to escape recession, although GDP growth, at 1.3% year-on-year in the first nine months of 2009, was significantly down on the previous three years' performance. Nevertheless, economic growth did not protect share prices on the Warsaw Stock Exchange (WSE) in the wake of the economic crisis. The Polish second pillar funds (OFEs), which have traditionally been the heaviest local equity investors among the region's pension funds - a situation somewhat forced upon them by a 5% limit on foreign investment designed to support the local capital markets. Currently OFE investments account for 16% of the WSE's capitalisation and 35.2% of its free float. Inevitably, they paid a heavy price for their support, with returns turning negative until mid-2009.
Polish stock prices rose throughout 2007 on the expectations, subsequently not realised, of good corporate earnings. By the end of June 2007 equities as a share of the portfolio hit a high of 38.5% - close to the 40% equity investment limit. The funds started selling off equities and remained relatively passive, making small purchases from new contribution flows, until November 2008 when they resumed their buying activities, says Grzegorz Chlopek, board vice-president and CIO at ING PTE. In 2009, with share prices still relatively cheap, the OFEs have been big buyers, accounting for some PLN9bn (€1.8bn) as of the end of November. International investors added to the selling pressure as the economic crisis intensified, in the case of global financial groups partly to boost their own capital positions.
According to Chlopek, the weighted average performance for June 2007 to February 2009 fell to -23.7%, although this has since improved, to -8.8% as of the end of November 2009.
The stock market is still around 50% down on its 2007 highs. "The Warsaw Stock Exchange did not fall as much as other CEE exchanges, so the rebound has not been as great," explains Andras Szalkai, investment director of East Capital Asset Management in Vienna.
The pension funds have also been keeping their portfolios open for the many IPOs and share capital increases, including the 2009 recapitalisation of PKO Bank, the country's biggest lender, and PLN6bn flotation of the state-owned electricity giant PGE. In 2010 planned WSE listings include the privatisation of the insurer PZU, state company divestments of the mobile phone operator Polkomtel, and further shares from PGE.
The Polish second pillar system, which has remained essentially unchanged in terms of investment limits in its 10-year history, has occupied an uneasy space between its capital market-oriented supporters and government critics who claim it has been overcharging its members, and not providing adequate returns.
In November 2009, finance minister Jan Rostowski and minister of labour and social affairs Jolanta Fedak, floated a proposal that from 2010 OFE contributions should be cut from 7.3% of gross wages to 3%. The remaining 4% portion, which would go to the social insurance fund ZUS (in addition to the 12.2% of wages that already finances the first pillar), is equivalent to the 60% minimum share of OFE portfolios invested by the PTEs in Treasury bonds. The proposal creates a virtual account indexed to government bonds and run by ZUS.
Critics point out that this would create a deferred liability for the government. And there is no guarantee that the government would not break its promise to maintain indexation should ZUS face troubles. "The current government has raided the ZUS Demographic Reserve Fund [the fund used to make up shortfalls in the first pillar payment fund] before," says Chlopek. "The ratio of politician's horizons to that of pensioners is about four years to 40 years." Meanwhile, Rostowski and Fedak claim that as a result pension fund members would benefit from not paying PTE management fees on bond transactions and thereby ending up with a larger pension.
The economic reasoning is that the switch would alleviate Poland's growing debt. While Maastricht's criterion for entering the euro-zone on public debt stands at 60% of GDP, Poland has its own lower legal limit wof 55%. However, the European Commission (EC) has forecast that the country will breach its internal limit in 2010 and the 60% threshold in 2011. The EC has also forecast that Poland will run budget deficits of around 7.5% of GDP in 2010-11, well above the Maastricht level of 3%. More immediately, ZUS faces a gap in the first pillar pay-as-you-go (PAYG) system.
"Cutting transfers to the second pillar pension would solve the public debt and PAYG problems, but in the short term only," observes Marcin Zoltek, CIO of Aviva Pension Fund.
"The second pillar pension funds are included in public debt, so that would lower the ratio, while the PAYG system would have more money to pay out current pensions. But the official reasoning is that the only goal of the proposal is to increase the efficiency of the second pillar pension funds."
The Polish Chamber of Pension Funds, the industries' trade association, has described the proposal as the beginning of the process of nationalising the second pillar. Pension funds, meanwhile, have not been informed as to how they will be expected to manage what would effectively be the high-risk part of what remains of their funds portfolios. "We don't know if the government has any plans to change the investment limits," complains Zoltek.
Rostowski and Fedak's proposal, which so far has been limited to a press statement by the two ministers, has not been accepted by the government, let alone entered the legislative process - and Michal Boni, cabinet member and the prime minister's chief adviser, has spoken against the idea in public.
But it has sown confusion and fears about the future economic viability of the system. "Our rough calculations show that if the contribution was cut to 3% only five funds would be profitable, while the smallest ones would be practically bankrupt," says Zoltek.
The proposal comes on top of an already increasing division between the pension funds and government over fees. The cut in up-front fees, which were to have been scaled down from 7% of assets to 3.5% by 2012, have been set at 3.5% for the start of 2010. In autumn 2009 the government introduced a PLN45bn asset limit above which the fund management companies cannot charge management fees.
"That makes new business worthless," says Zoltek. Only two of the funds, Aviva and ING, are already close to this limit. Chlopek notes that the rule introduces risk into the system as the larger, more cost-efficient funds will turn away potential clients. Additionally it will force the larger funds to pursue more conservative, and ultimately less rewarding investment strategies.
The proposal to cut contributions has also overshadowed other discussions that the industry has been having with the government about reforming the second pillar scheme, such as replacing the single fund system with a lifecycle scheme similar to that in Slovakia and most recently Hungary. Neither the labour and social affairs ministry nor the trade unions are keen on the idea.
The pension fund industry wants three funds, ranging from a conservative, fixed income structure to a riskier one heavily invested in equities. "This is the most urgent priority. The current ‘one fund for all' is not suitable for either young people entering the workforce or people close to retirement. The experience of the last crisis showed that savings should have some protection on the downside for people close to retirement," observes Zoltek.
The ministry of social affairs is reportedly not keen on lifecycle funds. In any case, as the Polish Chamber pointed out, the ministry's recent proposal, with its virtual government bond account, would make lifecycle funds impossible.
The issue of the existing benchmark guarantee system is also up in the air. The benchmark is the lower of 50% or minus four percentage points of the aggregate funds' weighted three-year annualised return. Pension companies that fail to meet this must make up the full difference from their capital. This system attracts criticisms. First, it generates herd behaviour, with the funds concentrating more on risk management than returns, and arguably may have contributed to the recent poor returns of the funds. Zoltek adds that the penalties incurred in underperforming the benchmark completely outweigh the negligible fees paid for generating good returns. In Aviva's case a one percentage point underperformance would cost the fund PLN400m.
The raising of the contentious 5% limit on foreign investment, meanwhile, has moved to the EU's Court of Justice, which will decide whether this breaches the single market's requirement for free movement of capital. Supporters of the existing system have pointed out that it ensured that Polish funds did not end up with foreign toxic assets.
On the other hand, the Polish pension funds, unlike, say, their Bulgarian counterparts, have not have not been able to benefit from the good recent performance of German bunds and other highly rated country sovereign debt.
If the limit is raised the government would have to consider allowing pension funds to use derivatives - currently banned for any purpose, let alone hedging - in order to manage their currency risk.