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Progress means growing pains

In Hungary the average state pension stands at around HUF57,000 (E229) per month, and only around 10% of the population have state pension of more than HUF100,000. Not surprisingly, during the 1990s, as inflation took hold and raced ahead of state pensions Hungarians started to realise that they would have to make additional provision to keep the wolf from the door in their retirement.
Hungary has had much guidance from international institutions and corporations but as at the beginning of any vast project such as the setting up of a private sector pensions system the challenges are considerable.
Legislation was passed in 1993 that introduced third pillar schemes.This was followed in 1997 by a law that brought in the second pillar. Second pillar schemes started in 1998.
When the second pillar system was brought into being the third pillar already had half a million members. Membership had started to level off by 2001. Since then the main area of growth has been in the level of assets under management.
By the end of 2004 total membership of third pillar schemes stood at 1.25m, with assets of HUF512bn, compared with 1.1m members and HUF230bn in assets at the end of the first quarter 2001.
Being compulsory, second pillar funds grew much more quickly during that period: assets more than quadrupled from HUF195bn to HUF804bn; membership increased from 2.2m to 2.4m.
The second pillar system has been financed through the diversion of a portion of the employee contribution previously paid into the first pillar system. This portion now stands at 8% of salary. The employer and/or employee may add a further 2% so that the maximum contribution is 10%. No further increases are envisaged.
The Hungarian pensions system faces a number of structural problems. The first is that funds are owned by their members.
The Hungarian system was the first in central Europe to undergo major reforms. However, it works less efficiently in comparison with the reformed systems of other countries,” says Csaba Nagy, managing director of the OTP fund and chair of Stabilitas, the Hungarian Association of Pension Funds. “For example, if a fund needs its members to vote on an issue, it takes a very long time to organise.”
The problem of members being owners is highlighted by Gábor Borza, managing director of the ING pension fund. “We always advertise the AGM to each member but they never come,” he says. “So this system can never work.”
In practice, elected representatives act on behalf of members but the participation rate at the representative electorate meeting is low.
Part of the problem is the relationships that already exist between the population and the financial services industry, as Mihály Erdös, deputy managing director of the Hungarian Financial Supervisory Authority (PSZAF) explains: “Members of the bank and insurance company funds see themselves as the client not the owner.”
In principle the management of the fund is exercised by the board of directors, which must make sure that members are also represented. But a study carried out by the Hungarian Central Bank (MNB) has found that members employed by the sponsoring group typically have a majority in the board of directors and that sponsor company top management are also represented. “Based on this, sponsor groups are likely to wield significant influence over the managing bodies of the pension funds.”
The MNB study notes that over the past three years, on average, delegates attending general meetings have represented hardly two thirds of second pillar fund members. Some 99% of general meeting resolutions have been passed unanimously over the past five years.
The funds backed by banks and insurance companies dominate the market. According to the MNB study, banks and insurance companies held 92% of total pension fund membership and 91% of AUM by the end of 2004, and the total number of second pillar funds had fallen from 38 to 18.
Because of the domination of the market by pension funds backed by banks and insurance companies, the MNB study focuses on these players.
The study notes that the membership of funds with employer sponsors consists mainly of employees of the sponsoring company, so these funds have registered no increase in business, even though they are, in principle, open funds.
Tamás Szabó, investment director of the railway workers’ fund highlights the competitive disadvantage faced by employer funds: “The challenge is that we don’t have the resources which the banks and insurance companies have for marketing and advertising,” he says. “We try to compensate for this by stressing our small size and the more personal service that we are able to provide as a result.”
The railway workers fund dates back to 1995 when the third pillar scheme was set up, followed by the second pillar in 1998. It is one of the smaller funds: by the end of 2004 its third pillar fund had 38,650 members and assets of HUF16.1bn, while the second pillar fund had 8,587 members and assets of HUF4.4bn.
The fact that boards of pension funds are dominated by their respective sponsoring companies has led to an uncompetitive situation. The MNB study notes that in order for the capital investment to break even, sponsor companies had a stake in the conclusion of a long-term contract between the fund and the asset manager controlled by the sponsoring group.
So the OTP pension fund uses the asset management arm of OTP to manage its pension assets; the other funds backed by banks and insurance companies have similar arrangements.
The MNB study points to a lack of transparency in the asset management costs. In some pension funds group performance fees and transaction fees are consolidated with the asset management fee.
Indeed the pension funds that are backed by insurance companies and banks have been accused of overcharging their members.
“Most bank and insurance company-backed pension funds use their own asset manager for their investments which provides them with more room for manoeuvre,” says Tamás Szabó.
But it has not always been this way. Patricia Molnár, economics editor of Hungarian news weekly HVG, notes that the banks and insurance companies built a competitive advantage for themselves at the beginning. “At the start they offered lower fees than other players by subsidising their pension offering from other areas of their business,” she says.
In the case of pension funds from the employers, the asset management fees are much lower because fees charged by managers selected through the tender process only contained asset management fees. The benefit of the tender process is clear. “The second pillar funds who go out to look for managers stimulate competition and therefore lower fees,” says Emilia Papp of HVG’s business staff.
The MNB study notes that in the first one to two years following the establishment of the pension funds significant deductions were made so that the necessary infrastructure could be established. Fair enough.
Nagy explains that the membership of the association is trying to cut its costs so that fees can be lowered. “Now the computers have been developed costs are stable,” he says.
But MNB points out that even though these charges were reduced once the infrastructure had been set up, the fees did not decline materially. It notes that within the fees the fund management fees have been increasing steadily and are expected to become dominant within fees and charges over the long term.
Marianna Lukács, managing director of the pharmacists’ fund which launched at the beginning of this year asks: “Why did people choose the banks? Either they did not look at the costs or they are too lazy to change.” She notes that part of the problem lies in member awareness. “According to PSZAF, fees range between 1.5% and 2%; our fees will be 0.3%. Newspapers only show the results, not the costs.”
But are things really that bad? Erdös explains that the world bank did a study of second pillar costs of other countries in their seventh year of operation and found Hungary to be within the range. “If assets increase then unit costs should fall,” he says; “if this does not happen then legislation will be needed.”

Perhaps it is time for another structure altogether. “Legislation should be introduced to move pensions into investment funds where the member knows how much he will pay. If we could make the system more transparent in this way costs would be driven downwards,” says Erdös.
The returns of funds have been very varied, although generally the feeling is that pension funds are under-achieving. Part of the problem lies in the focus on short-term performance, which derives from the obligation which pension funds have to publish their performance on a yearly basis. This discourages them from taking risk which then limits the likely returns, even though pension fund investment strategies are, in principle, set for the long term.
“Some have done very well while others just returned inflation – and some have returned below inflation,” says István Horváth, senior consultant at Mercer’s Budapest operation.
He adds: “The reason for the reluctance to take risk is that performance figures for each fund are published yearly so there is very intense competition among funds – based on short-term performance. Now funds are obliged to publish investment return on a five-year average. This will help people to select a pension fund based on long-term performance.”
Borza highlights the problem at fund level: “The fact that we have to show the results each year means that if they are not as good as the next fund many members could be tempted by other funds’ agents to leave and take their pension somewhere else. This discourages equity holding (and outperforming bonds only in the long term). So the decision to bring in the five-year average performance data is a very good one.”
Note that the system in Hungary differs from that found in many western European countries, because second pillar simply means ‘compulsory’ rather than corporate. As a result individuals are not tied to companies and can go to whichever second pillar scheme they find most attractive.
But funds are moving in the right direction. The postal workers’ fund is a case in point. In 2002 the portfolio was almost 99% invested in state bonds. For the coming year the target is 80% state bonds, 15% equities and 5% in real estate funds; the return is expected to be 12.5%. “Our aim is to create a more diversified portfolio,” say Zsuzsanna Szabó, managing director of the postal workers fund. “We expect this to yield better results than those we have experienced so far.”
The postal workers’ fund is another relatively small fund, with a membership of 22,100 and assets of HUF12.5bn.
One of the reasons for the high allocation to state bonds is their high yield. But this advantage will gradually disappear as we approach 2010 - Hungary’s date for joining the euro. “We have to get ready for the introduction of the euro,” Tamas Szabo adds. But he notes: “Nobody is ready because the Hungarian bonds have done so well.”
The euro is the reason for the likes of the postal workers’ fund moving towards equities and real estate.
She explains that the decision to invest in real estate through funds is due to the lack of in-house expertise which would be necessary for direct investments.
Nagy’s experience is similar. He adds: “There is a big future for real estate as a replacement for fixed income and also for the capital gain.”
The possibility to invest in direct real estate was introduced in 2005. Until then only real estate funds could be used.
Funds can invest up to 5% in direct real estate and 10% in funds. “But they have not exploited this opportunity even though 2004 was a very good year for real estate,” Papp notes. “This would have provided them with double-digit growth, but instead they chose state bonds.”
As a whole in Hungary, pension assets are growing faster than the country’s stock of investible assets. Zsuzsanna Szabó explains: “As the fund grows by HUF3bn a year we can’t place all our investments in Hungary, so we have moved into foreign equities. But we have to remain careful because this is people’s pension money.”
Nagy agrees that the stock of Hungarian bonds and equities are too small to diversify risk adequately. The OTP portfolio includes 7% in central European equities (ex-Hungary) and 10% in other foreign equities as well as 65% in state bonds with a term longer than one year; 15% in short bonds, and 3% in Hungarian equities.
But this also shows us that in spite of being one of the largest pension funds, OTP fund also has a conservative profile. Lukács is puzzled by the degree of missed opportunity: “We are an emerging market and the Budapest Stock Exchange gained 40% in this past year. But funds have only 7.8% of their portfolios invested in Hungarian stocks. The funds do not have enough courage to exploit the opportunity; it should also be pointed out that their experience is short-term so many simply don’t see what is at stake.”
She adds: “For the market to be able to produce such bad results you need a membership that isn’t interested where their money is – Hungarians are that stupid. The investment culture of the average person is very low.”
Part of the problem with investments in the second pillar is that each fund can only have one portfolio for its entire membership. “This makes it more difficult to take risk,” says Nagy. “If the law allowed for a choice of funds this would make funds chose more equities.”
The MNB study notes: “Given such a high proportion of government securities… anticipated long-term real returns are unlikely to be able to provide the cost-adjusted profit that could ensure the level of pensions that the reforms set as their objective.”
At the beginning of this year the government launched a special type of voluntary scheme, dubbed the ‘fourth pillar’, which is intended to stimulate investments in equities.

As pension funds grow in experience and expertise so they are becoming more engaged with their asset managers. “We look at the performance of the asset manager and discuss with them any variations from the target especially performance shortfalls,” says Zsuzsanna Szabó. “We are growing up: we are starting to give frameworks within which to invest. As we progress so the frameworks we are giving are becoming broader.”
One of the issues facing pension funds is the fact that many third pillar schemes are coming up for their tenth year of operation. At this point, according to the 1993 legislation which introduced the third pillar schemes, members can start to withdraw interest accumulated on the capital tax free. “Many funds have lost several billion HUF as a result of these withdrawals,” says Tamás Szabó. “We reached 10 years last year; however we expect the greatest volume of withdrawals this year.”
The capital itself can also be withdrawn from this point but subject to tax which diminishes steadily to zero after 21 years. “Most people take the interest, not the capital,” he says.
The lack of investment culture among the mainstream population is part of the problem. “Because people lost assets under communism there is a culture of ‘what I have I want now’,” says Nagy.
In response to this issue PSZAF recommends that annuity payments be encouraged for third pillar schemes through tax incentives. “With the second pillar the fund can pay its members itself through the fund or via an annuity through an insurer.”

Second pillar pensions are not due to be paid until 2013, but there is already some confusion about responsibility for pension payment - whether the pension fund can pay the pension or whether it must it be an outside institution such as an insurance company.
Lukács stresses the need for cooperation among funds. “That way it is more secure and less costly. Pension funds have to start thinking about these things. However, my impression is that the pension funds don’t take this issue seriously enough. With the second pillar it is not clear whether there will be a lump sum or pension.”
But some funds are taking the matter seriously. “We would like to have the pension payment function in-house – insurance companies would charge a lot for this service, says Zsuzsanna Szabó. “We want to remain a small, stable and low-cost operation; if we hand this function to an insurer we would lose some of that.”
Erdös believes the solvency rules for pension funds are “too weak”; as it stands they can decide to pay the pension themselves even if they are not solvent. “So we have to change that,” he says. “We recommend that the solvency rules for pension funds should be the same as those laid down for insurance companies; these are far more stringent. Some experts say that only insurance companies should be allowed to pay out the pension. In any case we don’t have a final decision on this matter yet.”
A further difficulty lies in the fact that unisex tables are used to calculate annuity rates. “How do we calculate with a unisex table when there are funds that are heavily weighted to one gender or the other, such as railway workers and postal workers?” Nagy asks.
The origin of this problem is that the state pension system uses the unisex table so private sector funds have had to follow suit. “We are working on this,” says Erdös.
Another regulatory challenge is that there is a lack of consistency across the various sectors of the finance industry. The concern is that a positive development in one sector may not necessarily be applied across all sectors. “Integrated regulation and supervision could be better,” notes Erdös.
In 2000, when PSZAF was formed out of the merger of the bank, securities and insurance regulators, a new form of financing was introduced whereby market fees replaced taxation in a bid to make it more independent from government.
The larger the player the higher the fee, and this has given rise to concern that the system of member fees benefits some more than others. “The regulator does not pay as much attention to the bigger players because they pay the highest fees,” says Lukács.
However, Zsuzsanna Szabó believes that is more a case of the influence of the larger players generally rather than the fee itself.
But Erdös is keen to put the record straight. “All rules have to be adhered to whatever the size of the fund – big pension funds get punished just like the small ones,” he points out. “Indeed, the size of the fine is in proportion to the size of the fund. Furthermore, those with experts at their disposal – typically the larger funds – receive even higher fines, as do repeat offenders. Who pays how much is laid down by the law.”
He adds: “ING paid the second-largest fine for providing misleading information to their members. They also had to re-send the information which cost a further HUF20m. We also recommended a complete change in the management of Erste Bank which was duly implemented. It was Erste Bank that paid the largest fine.”

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