Central & Eastern Europe: Worth the long-term risk?
The Polish government is set on its plan to dismantle the second pillar. Krystyna Krzyzak sees grave implications for Poland’s capital markets in the plan, which could also backfire on the government’s plan to reduce the debt burden
The Polish second-pillar system, the biggest in the CEE region with an investment pool of PLN304.1bn (€72.6bn), is set to shrink dramatically following a radical overhaul by the government.
The single biggest loss of assets, equivalent to some PLN147bn, will come when the government transfers 51.1% of the portfolios of second-pillar funds (OFEs) to the Polish Social Insurance Institution (ZUS), which operates the first pillar. This averaging mechanism will hurt some funds more than others, and those without sufficient government bonds will have to transfer non-stock paper such as road, municipal and corporate bonds, and bank deposits.
The one asset the government will not take is equity as it would effectively become a large shareholder in many Polish companies and be forced to make tender offers, completely undermining the earlier promises of Donald Tusk, the prime minister, that this is not a nationalisation.
A good number of consultees in the run-up to the final draft questioned the matter of the constitutionality of the reforms. Among them was the Attorney General’s office, which initially called the reform a “classic expropriation”. It, along with the Treasury and Justice Ministries, has since been whipped into line. Even the new finance minister Mateusz Szczurek – who in mid-November 2013 replaced the deeply unpopular Jacek Rostowski, one of the key architects of the changes, and who had earlier supported the second pillar – has had to renounce his earlier views.
For the government, supported by the National Bank of Poland, this exercise has been first and foremost a means of straightening its finances. According to the Finance Ministry, the OFE system in aggregate generated a debt of PLN279.4bn from inception in 1999 to the end of 2012 due to the government’s need to issue bonds to support investments. This is equivalent to 17.5% of GDP and more than 30% of Poland’s total public debt.
The transfer of government bonds, which the government will then redeem, would reduce public debt by some eight percentage points from 2014-15. The European Commission forecasts that this one-off event would move Poland’s budget to a surplus of 4.6% of GDP in 2014 from an estimated 4.8% deficit in 2013.
The new legislation also finally addresses payouts, albeit at the last minute given that 2014 sees the first major tranche of retirees. These will be handled by ZUS under a mechanism by which 10% of a member’s portfolio will be transferred each year to the first pillar institution 10 years before retirement (see panel). Few alternatives were available, especially given that older members have not had the opportunity to save enough to make annuities worthwhile, while the pensions industry’s proposal for a programmed withdrawal lasting only 10-15 years received a poor reception.
The switch from a mandatory to a voluntary system is also proving highly controversial. For its part, the government seems intent on getting as many as possible of the approximately 16m participants to leave by making it as difficult as possible to remain in an OFE. Participants can make their choice by post, in person at a ZUS office or online, but the online option is only open to those who have confirmed their ‘trusted profile’ at a ZUS office.
During the April-July 2014 selection period, pension companies will not be able to make any advertisement that is construed to be persuading members to remain in the system or switch to their fund. The only concession the government has made here is to drop its earlier proposal including two years’ imprisonment as a penalty.
The impact on Poland’s capital market may be profound, and could well backfire on the government’s ultimate intention of lower debt costs. Until now, OFEs have been the second biggest investors in Polish government bonds after foreign investors. According to Paweł Cymcyk, investment communication manager at ING IM Poland, Polish debt will be much more readily sold off by foreign investors. “Polish debt will become more volatile and less liquid, which means higher risk premiums for investors, and the Polish government will have to pay higher interest rates to be attractive to foreign capital.”
The risks for equity markets are even greater. According to Warsaw Stock Exchange (WSE) data, in the first half of 2013 OFEs accounted for 24% of the main market’s turnover. Compared with pension funds elsewhere in the CEE, they have been the heaviest equity investors, with 43.2% of the aggregate portfolio in stocks as of the end of October 2013, against a maximum cap that year of 47.5%.
Partly to placate the WSE, the government acknowledged the implications for the stock market by tying the funds to investing a minimum 75% in equities in 2014, after which the level drops in increments of 20 percentage points annually and disappears in 2018.
Following the bond transfer in 2014, funds will initially hold at least 85% of their portfolios in equities. “They will probably not be interested in buying further equities straight away and will wait till prices drop, or will start to invest in corporate debt for some diversification,” predicts Cymcyk.
Foreign assets, currently restricted to 5% of total assets, are a further source of diversification. Following the European Court of Justice’s ruling in December 2011, OFEs will finally be allowed incrementally higher limits – in EU, EEA and OECD assets – of 10% in 2014, 20% in 2015 and 30% thereafter. This has serious implications for the Polish market as the funds would most likely sell off the most liquid domestic holdings, potentially leading to large falls in benchmark indices like the WIG20, argues Cymcyk.
The biggest headache for the OFE managers from 2014 onwards will be to compensate for the inevitable outflows. From August 2014, the funds will only receive new contributions from those members who choose to continue with the second pillar. Additionally, as a result of the payout legislation, they will start losing assets that are transferred incrementally to members 10 years before retirement.
Further asset losses will be generated when members switch from one OFE to another, as in this case a fund loses the member’s full portfolio. Given the continuing ban on active acquisitions by pension fund companies, members will have to scrutinise the funds’ annualised returns for themselves, and the weaker performers will inevitably lose out.
“We estimate that 20-30% will remain in the OFEs, although even that is optimistic,” notes Cymcyk. “It means that the funds will have to sell, in the first year of reforms, PLN2-3bn of equities to cover their outflows, so Polish equity demand will fall by some 30%.” Foreign investors are the most likely to anticipate this and turn to markets with better returns. Further down the line, a downturn will deter retail stock market investors, who tend to look at historical performance, and the mutual fund industry that depends on retail investor demand.
Poland’s Treasury Ministry warned in November 2013 that the changes could lead to falling equity prices, and of the consequences. The ministry is responsible for privatisations, and relies on high demand and respectable prices for successful IPOs. However, it argued against forcing the funds into a 75% minimum limit because in the event of a sharply falling market the funds would have to sell off other liquid assets to maintain that level, at the expense of portfolio values.
None of this bodes well for the members whosee poor pension fund returns. The vast majority will choose ZUS, leading to the extinction of the second pillar.