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Story of pensions success

Croatia’s second pillar pension funds have proved to be a spectacular success since their foundation in 2002, despite being launched against an unstable political background as the country grappled with recovery from the 1991-95 Yugoslav war and political parties pursued confrontation rather than consensus. The reform also paved the way for the creation of third-pillar voluntary schemes.
In part the success is due to a recognition that the first pillar will not be able to deliver on its current level of expectations. “It’s very questionable whether there will be a pension from the state in 20 or 30 years,” says Goran Kralj, head of portfolio management of the Erste mandatory pension fund. “People in their 40s or 50s will get something from the state but younger people don’t believe in the first pillar, therefore they are delighted with the second and third pillars.”
Over their three years of operation the funds have collected HRK10bn (E1.36bn), growing at 10% a year, with the mandatory funds showing an average 8.71% return on the year to May 2005 and 7.24% for the May 2002-May 2005 period, according to official data.
Nevertheless, the new pension funds face a number of challenges. Underlying many of the problems is Croatia’s chronic budget deficit, which is aggravated by a Constitutional Court ruling that a previous government’s first-pillar indexation change led to underpaid pensions during 1993-97.
The budget deficit has had a direct impact on the new funds, delaying the introduction of the pension reform and restricting the contributions to the second-pillar funds. “The law says those who participate in the second pillar get an explicit 50% reduction of the first-pillar benefit,” notes Zoran Anusic, senior economist at the World Bank regional office in Zagreb. “So of a 20% of gross salary pension contribution, it was anticipated that half would go to the first pillar and half to the second.”
However, the fiscal problems mean that 15% of a salary is diverted to the first pillar and only 5% to a second pillar fund. Consequently, an average pension for someone who only participated in the first pillar would be something like HRK50 for each year of work while a person with a second-pillar account would receive HRK25.
“Ironically, if we managed to increase the contributions it would threaten second pillar funds,” says Dinko Novoselec, president of the AZ mandatory fund, one of the four second pillar pension schemes. “We would add to the deficit and use the extra money to buy Croatian government bonds which would most probably go down. So we would not create any additional value for our members and the only effect would be an additional burden to the budget deficit.”
And for Dubravko Stimac, president of the PBZ Croatia mandatory fund, the level of contributions is not a problem. “We receive our contributions regularly, we manage the money and we are profitable,” he says. “Of course, we would like to see more but right now I don’t expect that we will see an increase.”
Increasing contributions through employer participation is not option as they receive no tax incentives. For Radojka Hainski, director of the asset management division of the Raiffeisen voluntary funds management company, the tax issue is the main problem. “They do not encourage employers to pay contributions for their employees, as such payments are regarded as salary. We think that the change in this direction would benefit the market most.”
Pension insurer Royal, which specialises in providing benefits that make up the pension shortfall for employees who take early retirement, does not face this problem. “We sell a supplementary pension that is paid for exclusively by the employer, usually in the public sector,” says Royal marketing manager Jasmina Bandur. “But because our pensions are not seen as having the status of a salary, employers receive tax benefits on their contributions.”

For Damir Grbavac, president of the Raiffeisen mandatory fund and of the Croatian Pension Fund Association, the crucial issue facing Croatian pension funds lies elsewhere. “Our main challenge is the general underdevelopment of the Croatian financial market on the supply side,” he says. “The demand side is growing and is pretty professional and well organised. But there is a shortage of instruments and this reduces the possibility for diversification.”
“In fact we feel two types of restrictions,” says Novoselic. “There are those you can read in the regulations and those from the capital market. For example, the regulations say we can invest up to 30% in Croatian equities, but all four second pillar funds have only limited exposure because there are not enough that fulfil the legal requirements.”
“We have a very shallow equity market,” notes Stimac. “Pension funds in Croatia are allowed to invest just in the first quotation on the Zagreb and Varazdin stock exchanges, which in fact means we can invest in just two domestic shares, Priva and Podravka, and that is a very bad situation.”
“There is a debate on whether pension funds should be allowed to invest in second quotation publicly listed companies, of which there are more than 200,” says Anusic. “But even if they are allowed to invest in this less-transparent equity, public debt will remain very attractive. Because of the government’s fiscal position and its very high financing requirements the interest paid on the public debt has been fairly high. And given the discounts that they have been getting from the government on large issues, this was one of the pension funds’ best investments. On two occasions the discount was several basis points, which made the discount for the issue of above 10%, and this is money that the funds could not have earned elsewhere in the market.”
But there is a downside. “There is a legal limit of 15% on international investments but our international exposure is 10-12% and was never close to 15% because, for example, there is a legal limit on cash,” adds Novoselic. “Croatian government bonds have a duration of five years and completely illiquid so as long as we want to park more than 5% in cash and we need it to be liquid the only option we have is to buy short-term bunds. So we are not using our international limit for equities and we have to save some of this 15% limit for parking our cash. It is not stated in the law that you have to do it like this.
“It’s true that in absolute terms we have had a very good performance during the three years that we have been operating, but this was partly due to the tightening of Croatian spreads and to the fall in general interest rates, especially in Europe,” adds Novoselic. “But this raises the question of where we will get our future performance and here the question of derivatives is very important.”
“We have a problem in that we have limitations on swaps and options,” says Goran Filibic, portfolio manager of Croatia voluntary fund. “We have a huge currency risk because our liabilities are in kuna and our assets are mostly in euros and we don’t have the possibility to hedge this risk yet, a change in regulation has been announced but the enabling laws have not yet been passed.”
“In the short term it is not such a problem because the volatility of the euro-kuna exchange rate is very predictable, 7.50 plus or minus 2-3%,” says Kralj. “But there could be risks, especially when you look at the currencies of other EU convergence countries whose currencies have appreciated against the euro.”
“The pensions law prescribes less restrictive investment regulations on voluntary pension funds than on mandatory pension funds but in practice they are not able to benefit much from the difference and the portfolio structures of both kinds of funds are very similar,” notes Hainski. “And we consider the 20% ceiling on assets invested in foreign securities to be too restrictive. Voluntary pension companies can manage more than one fund so by investing more in different sorts of OECD-listed foreign securities they could achieve diversity in investment strategies to compensate for the lack of the domestic financial markets and could offer pension funds designed for different targeted members, including younger people willing to take more risk.”
The regulator Hagena’s 1.2% cap on the management fee that the pension funds can charge is the main risk for the companies, according to Kralj. “It’s a problem for us because we are the smallest of the four second-pillar funds, so it’s difficult to be profitable but we have more or less the same costs as the others. If Hagena cut the management fee too much companies will not be profitable.”
The result would be another round of the consolidation that over their three years of operation has seen an initial seven mandatory funds reduced to four.
And the government plans to merge three of the four financial institution regulators, including Hagena, may pose a further challenge to the pensions sector. “The aim is to make regulation more efficient and perhaps cheaper, although whether it will be cheaper remains to be seen,” says Grbavac.
The Pension Fund Association has not taken a position on the move but the industry is clearly unhappy. “The crucial point is that the other agencies that are merging with Hagena – the Securities and Exchange Commission and the insurance company regulator – are not as successful as it is and don’t have the procedures so there could be a scaling down of standards,” says one source.
Others were even more outspoken, noting that it appears to be a political decision as there had been no research, consultation or debate on the issue.
“I am upset by this,” says Stimac. “It runs the risk of interfering with something that is good and failing to fix other things that are bad – like other regulators. The pension fund industry is one of best organised and best controlled parts of the Croatian economy. As an industry we expect to see at least the same level of quality from the new regulator as we have had from Hagena.”

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