Economic difficulties and political turmoil have hindered but not derailed the country's creation of a three-tier pension system. Thomas Escritt reports

Romania was one of the last countries in the CEE region to introduce a reformed, three-pillar pension system. The timing was fortuitous: the first funds were set up in 2007. This meant that the impact of the market turmoil of 2008 and early 2009 was limited. "The funds were launched quite late, and they were small enough in size that equity holdings could be quickly liquidated. It was a happy coincidence," says Mihai Bobocea, secretary general of APAPR, the Romanian pension funds association, adding that investment managers had handled the crisis well.

Not only were the funds still small, with barely a year's contributions accumulated, but equity holdings were well below the maximum 50% allowed by regulation. Listed equity holdings in pension funds peaked in May 2008, when they made up 9.5% of holdings on average, and fell continuously until February last year, when they bottomed out at 1.2%. Since then, equity holdings rose steadily, reaching 7.6% in October.

This cautious approach to equities has been complemented by substantial fixed income holdings, which have grown over time. In May 2008, government bonds made up 42.1% of portfolios on average. In October, their share was 62.7%.

The small size of the country's funds, together with the freshness of the system, has given the sector a certain nimbleness that has allowed it to weather the turmoil of the past year better than many expected. While Romania appeared to be doing better than many of its regional neighbours in 2008, output collapsed in the final quarter, and the country eventually turned to the IMF and the EU in 2009 for a €20bn emergency loan.

The economic difficulties have gone hand in hand with political turmoil. A grand coalition set up following general elections at the beginning of 2009 lasted just 10 months, collapsing in October and leaving a political vacuum ahead of presidential elections which were held in December. The lack of a government prompted international lenders to delay payment of a €1.5bn tranche of financial support, forcing the finance ministry to tap local commercial banks and expensive capital on the international markets.

The presidential elections delivered little relief: the contest between centre-right incumbent, Traian Basescu, and Mircea Geoana, his Social Democrat challenger, finished with Basescu winning by a hair's breadth. The result, highlighting Romania's serious political divisions, means Basescu has little clout when it comes to forming a government - this could lead to a new coalition, and the IMF money Romania needs, could be months in coming.

It is not an easy position for a fund manager to be in. "The investment community wants a stable government with strong support from parliament for public sector reform," says Horia Braun, the investment director of ING Romania's pension funds business, pointing to the one thing that seems a distant prospect, although he sees the system's newness as a saving grace. "Romania just began with private pensions in 2007, so this was a blessing. We didn't head into the financial crisis with huge exposure to equities or credit."

The sector's small size brought other benefits. Whereas Hungary's cash-strapped government moved to tap the country's larger and better-developed pension funds for emergency funding, leading to a string of regulatory changes and resulting uncertainty, Romania's fledgling portfolios were not a sufficiently tempting target.

But the teething troubles of establishing a new funded pension system have created their own uncertainties - and the finance houses behind the funds make tempting targets for a government in urgent need of cash. The establishment of the country's pension system in 2007 was preceded by a huge marketing campaign, funded by the financial institutions seeking a footing in the market. The set-up costs, which also included establishing back offices, recruiting customers, creating IT systems and hiring staff, were substantial - on the order of €500m for the industry as a whole.

At first, accounting rules appeared to allow the companies providing the pension funds to write off the initial investment over many years, but a recent clarification has confirmed that the start-up costs must be dealt with as a lump sum in one year.

"The rules were first interpreted as allowing for deferred acquisition costs," says Bobocea. "But this year the ministry of finance changed its mind, meaning companies will lose their tax deductions. The total cost of this change runs to around 10-15% of the original investment."

Another blow came when the government decided to delay a planned increase in minimum pension contributions. Originally, individuals' contributions were set to rise by 0.5% a year, freezing at 16% of their annual income in 2016. But, with real wages standing still or declining, the government introduced a temporary freeze on contributions, limiting them to 2% of gross income, depriving funds of contributions.

While the tax changes will not have a direct impact on the funds, the tax hit - combined with lower management fees resulting from the contribution freeze - will come as a blow to the financial institutions behind them. They do not now expect to break even on their investment before 2020. "They had been planning on getting a return on their investment in the next seven or eight years," says Bobocea.