Central & Eastern Europe: Tempered optimism
Latvian pension funds remain cautiously optimistic about their future as the country enters the euro area on 1 January, according to Rachel Fixsen
Signs of hope for the Latvian pensions sector emerged last year as the Baltic state looked forward to joining the euro-zone. With pension contribution levels slowly rising and the risk of currency devaluation no longer a concern, the industry has reasons to count on its future.
But recent political moves by Hungary and Poland to undermine their own funded pension systems, and the decision by one key player to exit the Latvian market, have kept optimism within limits.
Latvia was given final approval by the EU’s Economic and Financial Affairs Council in summer 2013 to adopt the euro on 1 January 2014. It is the second of the three Baltic states to join the euro-zone, following Estonia’s entry in 2011.
Pēteris Stepiņš, funds manager at Swedbank Investment Management in Riga, sees the challenges for Latvian pension funds as broadly similar to those faced in other countries. “The low-yield environment is leading to assets being overvalued and that oppresses potential returns,” he says.
The way the Hungarian and Polish governments have dealt with their second-pillar pension systems recently is “not a good sign for pensions everywhere,” he remarks. However, Stepiņš notes that the Latvian government is showing commitment to pensions, sticking to its plans to increase pension contributions from 2% to 4% last year.
Although 2014 will see a parliamentary election in Latvia, Swedbank Investment Management sees no threat of any changes to pensions policy, he says. In the second-pillar state-funded pension scheme, assets have grown by 14% in just 10 months last year, reaching €1.65bn, observes Dace Brencēna, chief executive of the SEB Pension Fund.
Meanwhile the private pension savings assets of the third pillar have grown more slowly – by 11% to €250m. Latvia still has one of the most attractive tax environments for long-term savings in pension funds and life insurance contracts, according to Brencēna.
But private pensions still have only a small market share, she says, with just 17% of tax payers involved in the private pensions market.
“The average accumulated pension capital per participant over 13 years has only reached €1,000 – only two monthly average salaries,” she says.
In 2013, one pensions provider opted to get out of the Latvian market altogether. GE Money Bank stopped operations in the country and the GE Money Pension Fund closed its operations by transferring pension plans to Citadele Pension Fund.
Armands Ločmelis, chief executive at DNB Asset Management, sees a mixed picture for Latvian pension funds right now. “On one side there are plenty of positive signals such as new members joining in the pension system, steadily increasing contribution rates, increasing awareness of the role of pensions in society and more flexible investment limits, but as well as this, we face stricter capital regulations,” he says.
As the Latvian government aims to increase second-pillar contributions further to 6%, after already raising them from 2% to 4% in 2013, Pēteris Stepiņš, fund manager of both second and third pillar schemes at Swedbank Investment Management in Riga believes the Latvian government will not follow in the footsteps of its Czech, Hungarian and Polish neighbours and attempt to nationalise the second pillar.
“Of course political risks can never be completely ruled out but at the moment we do not see a threat,” he says.
Pension funds’ primary goal – to achieve decent returns – is rather difficult given current low interest rates, Ločmelis notes. “Will standard asset classes such as government and corporate bonds provide the required returns over a long horizon? Or should pension managers shift allocations towards illiquid instruments such as private equity and real estate?”
Legal constraints also mean that the second-pillar pension funds cannot directly invest in real estate – only through alternative investments funds. “The biggest challenge for the second-pillar pension industry is trying to work together with the government in the creation of instruments for real assets, such as infrastructure and timberland funds. We would like to invest in those vehicles, as we believe a lot of potential has yet to be realised in the local real asset space but currently they are non-existent.”
Stepiņš adds that the industry is also currently trying to convince the government to relax overall restrictions. “We would, for example, like to have a 10% limit on private equity investments instead of the current 5% ceiling. We would also prefer fewer restrictions on currency – currently currency hedges are not accounted for from a legal perspective.”
As a result of the investment limits, optimal portfolio allocation can sometimes be a challenge. January’s euro adoption is not seen as having a big effect on pension funds in Latvia. In practical terms, second-pillar pension funds have been working with the European single currency for several years, Ločmelis says.
“Firstly, there were no investment limits in the euro, which has resulted in a sizeable portion of assets invested in euros, and finally, the euro has been well accepted by the economy and financial markets,” he says.
For most pension plans, between 50% and 70% of investments are already in euro accounts and on top of that, he says, there is another proportion of investments in other currencies which are pegged to the euro.
“Interest rates for Latvian lats, where the substantial part of portfolios are invested, have converged to euro and the interest rate differential has been basically eliminated,” Ločmelis notes.
DNB Asset Management was planning no changes to its investment strategy and allocation as of January 2014. Stepiņš says that although asset allocation depends on the pension plan, there are two components — global liquid assets and less liquid local and regional assets. The latter make up the largest proportion of second-pillar portfolios, he says.
Towards the end of last year, Swedbank Investment Management switched away from euro-zone government bonds and US Treasuries in favour of Latvian government local currency and euro bonds for some third pillar pension plans.
“Due to euro accession we think that the overall country risk of Latvia decreases and it could lead to rating upgrades of a couple of notches,” Stepiņš said.
Brencēna said that at the end of last year, SEB pension plans were generally overweight in equities and credit. “And taking into account the situation in financial markets we are going to keep this situation in the near future,” she said.
“If it was legally possible we would offer a plan with an equity ratio of over 50% in the second pillar, but to date this has not been possible,” says Stepiņš.
But as the maximum equity level was already changed from 30% to 50% in 2008, he remains hopeful that a further relaxation is not far off, as changes in legislation are being discussed in parliament.