A rule allowing early withdrawals is changing the dynamics of the Estonian pension business

This month a shake-up of Estonia’s second pillar takes effect, transforming it into a voluntary system and allowing members to withdraw the accumulated savings from their pension fund before retirement age.

The changes, part of a coalition deal agreed in April 2019 after election, are intended to give participants more control over their savings while creating a more competitive market to improve returns and cut fees.

But they had been fiercely opposed in Parliament, and by the country’s president Kersti Kaljulaid, who, in a last-ditch attempt to stop them, had refused to give her assent on the grounds that they were unconstitutional.

In October, however, the Supreme Court ruled against the president, who signed the bill into law soon after the decision was announced.

The law gives all second-pillar participants the right – but not the obligation – to:

  • Stop future contributions and redeem their units;
  • Continue within the system using a personal investment account and choosing their own investments.

However, those withdrawing from the system cannot rejoin for the next 10 years, and withdrawals before retirement are subject to 20% income tax.

It is unclear how many people will take up their new rights. While recent surveys suggest that 25% of people will withdraw cash, those intentions might not be borne out in reality.

From October, people were allowed to stop their 2% monthly pension contributions for nine months to help mitigate the economic damage wrought by COVID-19. So far, only 1.4% have decided to do so, which is “a surprisingly low figure”, according to Joel Kukemelk, member of the management board of LHV Asset Management (LHVAM). 

But Kukemelk does expect a negative effect on cash flows into pension funds now the new law is in force.

However, in terms of LHVAM’s investment policy, he says: “Over the long term, we can probably continue investing pretty much the same way we’ve done so far, after the initial exit wave has washed out. But over the short term, a significantly higher liquidity position is being held.”

Arnolds Čulkstēns, head of life and pensions in the Baltic region at SEB, says: “We have adopted a wait-and-see approach with our illiquid alternative investment classes, in terms of how clients react to the ability to withdraw their money from existing funds or the system altogether, and then decide if and how we will continue with new investments in this space.”

Marketing – and communication with participants in particular – is a crucial part of educating existing and future members of pension plans about the importance of saving as much as possible to build up a decent retirement income.

Čulkstēns says that SEB’s communications activity has focused on increasing public awareness of building up funds for their pension. 

He adds: “We are also developing a separate marketing plan in the light of the pension reform, which would help us to explain the need to save and secure one’s future, as well as the impacts of different options on an individual’s personal pension plan.”

And this goes beyond the confines of each client’s plan.

Key points

  • Second-pillar members can withdraw all their savings before retirement
  • It is unclear how many people will take advantage of this right
  • Managers are maintaining higher short-term liquidity in portfolios
  • They remain calm about the long-term prospects for illiquid investing

“We understand that those individuals who are planning to withdraw the amounts which they have collected primarily do so for alleviating their current financial stress,” says Čulkstēns. “We will be working with the client to find a suitable solution for alleviating their current situation, as well as securing their future.”

Kukemelk agrees that “increasing public awareness about their future pension income has become very important. The ministry of finance has calculated that with the second pillar, future pension income can be 30% higher than with the first pillar alone. We will be aiming to join forces with all market participants to increase public awareness as much as possible.”

Latvia changes regulatory framework to increase pension risk

Latvia’s parliament (the Saeima) is reviewing proposed changes in the law governing the state-funded second pillar. These have cleared the first reading, but as IPE went to press, it was not known when they would be enacted, or take effect.

The changes will allow pension funds to invest more aggressively, raising the maximum for equity investments from 75% to 100% of portfolios.

The limit for alternative investments – including real estate, private equity and private debt – would be raised, from 15% to 25%, under certain conditions. 

Investments will have to be made through alternative investment funds, with companies meeting at least two criteria from a list including good corporate governance, a collective employment agreement with employees (where there are more than 50), and not being incorporated in a high-risk jurisdiction. 

Baltic funds hub
Over the past few years Estonia has been developing as a domicile for new collective funds, especially those investing in local businesses and with local pension funds as anchor investors.

Martin Kõdar, managing partner of BaltCap, the Baltic region’s largest investor in private equity, says: “We believe our existing funds will not be affected by the reform and pension funds will be able to keep their existing illiquid positions intact.”

However, he says that in the short term, the reforms will complicate the fundraising for any local fund manager, since Estonian pension funds have been active investors in private equity. 

Arnolds Culkstens

He adds: “I am sure alternative sources of capital will be found.

For example, we are witnessing increasing interest towards the Baltic region from foreign institutions. We are also looking to widen our investor base by targeting more family office and high-net-worth individual clients, while supporting our client pension funds in dealing with this situation.

“Over the long term, I still see pension funds continuing to invest in private equity, as the asset class enables them to achieve higher returns.” 

Indeed, he notes that the reform was initially prompted by the “deemed low returns” of pension funds. The coalition had claimed that the changes would create a more competitive market, forcing providers to lower fees to retain clients’ money and improving returns for participants. 

But this has not impressed the industry. Kukemelk says: “There will be no significant change to market share; damage will be done across the board.” 

Čulkstēns says: “We do not expect any special changes in the pricing of the pension funds. Given the small size of the whole second-pillar system, we think there are adequately priced passive and active products available, and as the system is opened to withdrawals, few new developments are expected in the short term before the system stabilises.”

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