Slovakia is set to overhaul its entire pensions system, introducing a second-pillar privately funded plan alongside changes to its existing first and third pillar systems. The new proposal is a more radical version of the previous government’s attempts at pensions reforms, which in any case fell by the wayside after the September 2002 elections, and include a more important role for the new second pillar at the expense of the pay-as-you-go state system.
The rationale behind the overhaul is nevertheless the same: Slovakia’s increasingly ageing population, an unemployment rate of nearly 18%, one of the highest in the EU candidate state, and the prospect of increased labour mobility after Slovakia joins the EU in 2004 are placing severe strains on the existing social security system. In addition the low linkage between contributions and eventual benefits encourages the practices of undeclared wages and tax evasion. “The new government’s one primary objective is that the new system is financially sustainable,” says Marek Lendacky, expert at the Ministry of Labour, Family and Social Affairs’s insurance department.
The concept was approved by the government in early April, with the aim of having the second pillar law in place by the beginning of 2004, and the new contributions regime starting a year later once the necessary IT systems are ready. The second pillar law, closely modelled on Chile’s three-pillar system, is being drafted with the aid of Chilean pensions experts Augusto Iglesias and Guillermo Martinez. The proposed second pillar would be compulsory for all new entrants to the labour market, the system used in Estonia, and voluntary for those with at five years of first-pillar contributions left to pay. Once the law comes into effect those workers will have a limited period to make their decisions - the proposal suggests three years - but a decision to join the second pillar will be irreversible.
The scheme would be funded by diverting a 10% portion of the employer’s first pillar contribution of 21.6% of gross wages. Employees, who currently contribute 6.4% of gross wages to the first pillar, will not pay any further contributions. The proposals assume that as the new system matures, the proportion paid to the first pillar will decline. The newly established second pillar asset management companies will be not be allowed to conduct any other business, but will be legally separated from the funds under management. They will be allowed to outsource certain operations such as contributions collection and IT but not the asset management itself. At retirement clients will be able to purchase either an indexed lifetime annuity or one combined with a scheduled withdrawal.
In the case of a company’s bankruptcy, the pension fund will remain secure be passed to another company for management. Although the government is not guaranteeing minimum returns in the second pillar sector, it is to set benchmarks of the type operating in Poland where companies whose funds’ rate of returns under-performs the industry average significantly will have to compensate clients from their own share capital.
The regulator will be the Financial Market Office, the country’s securities overseer. Meanwhile the Social Insurance Agency (SIA), which administers the first pillar, has signed an IT contract to develop a system for handling individual accounts and contributions. Under the concept the SIA will not itself be collecting and then diverting the second-pillar contributions as happens in, for example, Poland.
The regulations defining the requirements for the pension fund management companies have not been defined yet but will undoubtedly be more onerous in terms of capital and track record than those governing the third pillar firms. “There is a high probability that only strong international companies will join this market, but the criteria will be the same for every institution willing to join,” adds Lendacky. Each company will be allowed to set up a maximum of three funds, reflecting different risk horizons.
No decisions have been made on the tax treatment, which will most probably follow the standard pattern of exemptions on contributions and investment returns, while the benefits will be taxed. However, under separate proposals the finance ministry wants to reform the tax system and switch from a progressive to a flat rate system (the suggested level is 20%), while eliminating tax exemptions. Likewise there have been no decisions on the investment criteria that second-pillar companies must follow, although these are likely to be similar to those now applied to the third-pillar companies. These include a 15% limit on overseas investment, 20% on equity and 10% on real estate and securities of a single issuer. In addition, the funds cannot invest in the shares of their depositary bank or securities brokers performing transactions on their behalf.
The third pillar law will also undergo changes. Slovakia’s current system, which dates back to 1996, has four pensions insurance companies. Their funds collectively had around 457,430 members and SKR9bn (E00bn) of assets under management at the end of 2002, with the bulk of their clientele coming from company-run schemes for whom relatively generous tax exemptions for both employers and employees have made supplementary pensions provisions an attractive fringe benefit. “Under new proposals these will be transformed into classic asset management companies and there will be a clear division between the asset management company and pension fund,” explains Lendacky.
The first pillar will remain a pay-as-you-go system but the overhauls here include the incorporation of unemployment benefit into social insurance, and the separation of pensions insurance into old age and disability provision. The revised law would also raise the retirement age, currently 60 years for men and between 53 years for women with four or more children to 57 years for those with none. As of the beginning of 2004 this is being equalised to 62 years, by 2006 for men and 2020 for women. In addition the state will no longer pay insurance contributions for students. Early retirement will be possible provided the end pension is not less than 1.2 times the minimum subsistence level, but the pension benefit decreases by 0.5% a month for each year of early retirement. The indexation of state pension benefits changes to the so-called Swiss formula based on price and wage increases from annual parliamentary decisions invariably preceded by fractious discussions between the government and trade unions.
There will also be changes in the definitions for qualifying for disability benefits, and the current pensions insurance fund will be split into old-age insurance and disability insurance funds. For individuals in a joint first and second pillar system, benefits provisions would transfer to the annuity company with which the asset management company has signed a contract. The new system would allow those disabled who can work to do so without losing their disability benefit.
The transition cost – the initial shortfall in the first pillar – caused by the loss of the 10% second pillar contribution will by financed by some SKr70bn of privatisation revenues currently on deposit. The extent to which these would cover the shortfall obviously depend on the take-up by the voluntary category. According to Marek Lendacky, if the system proves as popular as it did in Hungary where around 50-60% of the workforce signed up for the second pillar, the sum would last three to four years. “But the higher retirement age from next year will generate higher surpluses in the first pillar which can also be used to cover the transition costs,” adds Lendacky. The ministry of labour is forecasting that between 30-50% will sign up, while the marketing campaign will stress that joining the second pillar will be of more benefit to younger workers than older ones.
The new proposals have by no means been welcomed by all sectors. The trades unions in particular wanted a lower contribution -more like 3% – to the second pillar, have objected to the high level of transition costs and argued that the ultimate requirement for an annuity will prove expensive. The new pensions concept was recently bundled together by the Confederation of Labour Unions with a series of grievances, including demands for a 10% rise in the existing pension this July – against the government’s offer proposed 5% which brings the average monthly pension up to SKr6,400 – a 45% increase in the minimum wage and higher family allowances. The union’s main concern with the pensions concept is that under the linear formula that will apply in the new calculations for state pensions, a low earning worker could end up with a pension below the subsistence minimum.
The existing system provides a replacement rate ranging from 90% for low earners to 20% for well-paid individuals. If the new law was applied to today’s conditions, a worker with 40 year’s service earning half the average wage would end up with a monthly state pension of SKr3,600 ($100), some 90% of the current subsistence minimum. However, this will be offset by the higher wages that will accompany the above-European average growth rate expected in transition economies such as Slovakia, especially when it joins the EU in 2004.