Private pensions' two-pronged approach
After lagging behind its neighbours in private pensions and investment funds provisions, Lithuania has passed a comprehensive set of financial laws allowing for second-pillar pensions and clearing the way for third-pillar pensions and investment funds to operate on a level footing with life insurance.
The significant legal changes took place on 4 July, when parliament passed the Law on Pension Accumulation (LPA) and the Law on Supplementary Voluntary Pension Accumulation (LSVPA). The LPA governs the provisions for second-pillar pension fund contributions. The LSVPA, which amends and re-titles the former Law on Pension Funds passed in 2000, has adapted the EU’s UCITS directives into Lithuanian law. “Pension funds under this law are created similarly to investment funds,” explains Vilija Nausedaite, chief specialist of the Lithuanian Securities Commission’s legal and enforcement department. The LSVPA covers investment regulations for both second- and third-pillar funds. Parliament also passed a law on collective investment removing many of the obstacles previously hindering the establishment of investment funds.
The second-pillar law comes into effect next year, with the first transfers from the Social Insurance Fund (SoDra), which is responsible for the state pensions and benefits system and is acting as the registrar, due in mid- year. Potential members have until the end of December to join in the first phase and start building up their fund from 2004, and between the beginning of January and the end of April for membership in subsequent years. Under the new scheme 2.5 percentage points of the 25% of gross wages that currently funds an individual’s state social insurance contribution will be diverted in 2004 to the private pensions fund. This portion rises by 1 percentage point a year to 5.5% by 2007. There are no additional tax benefits on second-pillar contributions; investment returns are exempt from capital gains, while end-benefits are tax-free.
Unlike other second-pillar schemes in the region, Lithuania’s is purely voluntary, although the decision to join is irrevocable. Prolonged debates about whether the country could afford a compulsory system, as well as the contribution levels themselves, were largely responsible for the delays in introducing the reforms in the first place. SoDra has since 1997 run a deficit every year bar one, which is financed by the state budget and bank loans. Although Lithuania still has some large assets to privatise, notably its electricity companies, there are other calls on these revenues. In particular it has committed itself to close down the Ignalina Nuclear plant, the world’s largest Chernobyl-style reactor, by 2009.
On the other hand Lithuania’s economy has been the region’s star performer. This in turn has enabled SoDra to reduce benefits payment and build up a surplus this year. For their part the legislators have had to acknowledge the country’s demographic pressures. Since 1997 the workforce has shrunk by 12% to 1.6m. Over the same period the number of over-65s has increased by 11% to 509,700. “It became clear to both politicians and the public that with the decreasing number of employed per pensioner, measures were needed to secure a bright future for people,” says Asta Ungulaitiene, general manager at Commercial Union’s Lithuanian subsidiary. Meanwhile the average monthly pension in the first quarter of 2003 averaged only LTL333.4 (e97) a month. “The second pillar will enable people to raise their retirement revenue by some 20%,” she adds.
Although from the state’s perspective private state pensions are now affordable, SoDra is forecasting that only around 6% of the currently insured population will join the second pillar for next year, which would cost SoDra some LTL21m, rising to 13% by 2006, when assets would total some $31m. The industry, on the other hand, is far more bullish. “We’re projecting 20% of the workforce joining in the first year, and some 70–80% to join by 2007, when the assets could total around LTL2bn,” predicts Aurimas Mazdzierius, managing director of Hansa Investment Management. Saulius Racevicius, managing director and chairman of the board of VB Investment Management, the investment arm of Vilniaus Bank adds that by mid 2004 most of the middle-classes - some 50-60% of the insured workforce - will have signed up.
The industry has to be optimistic since the market looks set to be highly competitive. As of early September, eight providers offering a total 20 plans had received licences, making some market consolidation inevitable. Ungulaitiene predicts that the market will be dominated by three to four players. “It will be a similar situation to the life insurance market where there are nine competing companies but four to five have most of the market,” she adds.
Pensions providers can be either life insurance companies licensed by the State Insurance Supervisory Authority (SISA) or fund management companies under the regulation of the Lithuanian Securities Commission. SISA has licensed UAB Lietuvos Draudimo Gyvybes Draudimas (the country’s largest life insurer and former state-owned monopoly), and the Lithuanian life insurance divisions of Commercial Union, Ergo and Sampo. According to Paulius Rutkauskas, chief specialist at SISA’s life insurance division, eligible companies must have legal technical provisions for the last financial year, have invested them according to the insurance law, and meet the LTL4m solvency margin requirement.
The Securities Commission has licensed the investment management arms of the brokerage Finasta, and of Vilniaus Bank, Hansabankas and Nord/LB, Lithuania’s three largest banks. There are no specified minimum capital rules for the life insurance companies as these are already covered by the statutory requirements for their industry, while fund management companies must have a minimum e300,000.
By law, providers have to offer at the minimum a ‘conservative’ fund that invests only in OECD-member state bonds issued or guaranteed by central or local authorities, or their central banks. All the licensed funds are also running one or two additional funds with varied proportions of equities that reflect the member’s age and risk appetite. As a typical example, Hansa Investment Management is offering, alongside its conservative fund, one with up to 20% stock investment and a more aggressive portfolio with 40% of equities. Investment and diversification regulations are defined by the UCITS-3 directive.
The government is planning a marketing campaign to raise awareness of the new state pension system. The providers, meanwhile, can market only under strict guidelines, with all advertising and promotional campaigns subject to prior approval from their respective regulators. The insurance companies will rely on their agency network, while the investment companies can use their bank branch networks. There is some competitive scope within the fee structure, which is currently capped at 1% for asset management and 10% for front-end contributions. Although cross-selling is permitted, providers cannot offer any incentives on multiple purchases. Furthermore, they can only use the officially sanctioned calculator from the Ministry of Labour and Social Security to allow individuals to determine whether it will be worth their while switching part of their contributions to the second pillar.
The legal changes also make third- pillar funds a realistic prospect. Although legislation for these was passed in 2000, none were set up. Contributions did not attract the same level of tax exemptions afforded to life insurance policies, while from the provider’s perspective they required the expense of setting up separately capitalised subsidiaries. “It is now easier for asset management to set these up,” explains Hansa’s Mazdzierius. Investment requirements have also been eased in line with UCITS-3. The tax treatment has been equalised with that of the life insurance industry, with contributions up to 25% of the gross wage exempt from personal income tax, while benefits are taxed at 15%.
Unlike the second pillar, where the employer plays no role other than to file their workers’ social tax to SoDra, companies are expected to sign up to occupational schemes as a means of providing additional benefits to the workforce. The new system should provide a somewhat improved return on the existing pension, which only covers 30% of the final salary, less in the case of higher-paid workers. VB Investment Management’s Racevicius estimates that the second pillar will raise the replacement rate to 45%, while third-pillar participation ups this to 55% for middle-income workers and up to 65% for the higher paid.