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Pensions in Central & Eastern Europe

Pensions in Central & Eastern Europe






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    Pensions in Central & Eastern Europe Pensions in Central & Eastern Europe Document Transcript

    • Central and Eastern EuropeanPensions 2007Systems and Markets
    • ContentPreface 3Introduction 5 Demographic and Macroeconomic Developments in CEE Countries 6 The economy and the pension system 6 Catching up 7 Labour markets 9 The road to EMU 10 Demographic development 12 Pensions in Central and Eastern Europe: Reforms, Regulation and Markets 14 Reforming Central and Eastern European pensions 14 Regulating pension funds 17 Financial assets and their allocation in CEE countries 19 Regulatory trends in CEE 20 The future development of pension assets 21 Life Cycle Asset Allocation – A Suitable Approach for Defined Contribution Pension Plans 25 Challenges for defined contribution plans 25 How to invest retirement savings 25 An advanced life cycle approach 26 Conclusion 29Country reports 31 Bulgaria 32 Croatia 38 Czech Republic 44 Estonia 50 Hungary 55 Latvia 62 Lithuania 68 Poland 73 Romania 80 Slovakia 86 Slovenia 92Appendix 972
    • PrefaceThe provision of retirementincome is currently a hot topicall over the world, particularlyin countries where the popula-tion is quickly getting older.Ageing populations are a major challengefor countries that rely mainly on state-run,pay-as-you-go pension systems. This isbecause contributions either rise to unac-ceptable levels, or benefits decrease to thepoint that retirees are no longer guaranteeda decent standard of living.The present study is Allianz Global Inve- This study aims to analyse CEE pensionstors’ second on pension market develop- systems and their market potential. In thement in Central and Eastern Europe. After first part of the study, we analyse macroeco-the fall of the Iron Curtain, governments nomic and demographic developments inacross the region faced economic upheaval CEE. This is followed by an overview of theand unfavourable demographic develop- main pension, regulatory and market trendsment, both of which had a crippling effect in the region. We discuss all CEE states thaton state-run pension systems. Some CEE are members of the European Union, inclu-countries have felt the impact of demogra- ding new members Bulgaria and Romania,phic trends even more than their Western as well as accession candidate Croatia. ToEuropean counterparts, and populations in conclude the first part of the study, we con-the region will continue to age rapidly in the tribute to the discussion on asset manage-coming decades. As a result, pension system ment solutions for defined contributionreform has made its way to the top of the plans by analysing lifecycle models.political agenda, with structural reformsbeing introduced in most countries. In The second part of the study contains indiv-many cases, reforms in CEE have been more idual country profiles that provide detailedradical and courageous than in Western information on each country’s pension mar-Europe, with Eastern European countries ket. We investigate the design of pensionintroducing mandatory funded pension pil-lars of the defined contribution type. Inaddition, some countries have drasticallyreduced public pension provision. systems in CEE by analysing each pillar, dis- cussing pension fund regulations, exploring the pension markets and projecting future potential for each country. PrefaceIn light of longer life expectancy, diver- We hope that that this study will contributesifying sources of retirement income has to a better understanding of the new pensi-become vital to reduce the risk of old-age on systems’ mechanisms and of marketpoverty. With its reliance on funded pillars, development in CEE, and we look forward toCEE countries have set an inspiring example a fruitful debate.for their Western neighbours. Indeed, CEEhas become a promising market for theasset management and insurance industry, Brigitte Miksa,as asset management solutions are vital for Head of International Pensionsaccumulating pension assets. Allianz Global Investors AG 3
    • Introduction
    • IntroductionDemographic and MacroeconomicDevelopments in CEE CountriesThe fundamental things apply – as time markets are the subject of this study. Aftergoes by. One of these fundamental things is some introductory remarks, we will look atthe ageing of populations. In many parts of CEE countries’ economies in detail. Morethe world, people are living longer lifes as particularly, we will address the closefertility rates drop. Central and Eastern interaction between demographic andEurope (CEE) is no exception. The economic development and the new EUpopulation structures of the 10 new EU members’ prospects with regard tomember states from CEE in particular will membership in the European Monetaryface a major transformation in the coming Union (EMU), which will be of greatyears. In some cases, changes will be even importance for investors.more pronounced than in the EU-15 and therest of the world. Fertility rates havedeclined sharply since the collapse of The economy and the pensioncommunism, while longevity has reachedlevels almost comparable to Western systemEurope. Pension systems are always closely relatedTogether, these two trends will result in a to the economy. With pay-as-you-go (PAYG)substantial increase in the old-age systems, the link is clear. In the mostdependency ratio, the ratio of the population common case, employees pay contributionsaged 65 and over to that aged 15 to 64. This directly out of their salaries. Returns dependfigure tells us how many pensioners (over on the number of employees, the wage level65) there are for every 100 people of working and the contribution rate. Whenever theage (15-64). At the moment, the ratio in CEE number of contributors decreases, be it foris around 20, which means that there are 20 demographic reasons or because of anretirees for every 100 people of working age. economic downturn and risingThat number is expected to grow to 33 in 20 unemployment, the pension system suffersyears time and to 50 in 2050. This means the consequences. Short-term remediesthat two rather than five people of working include contribution rate hikes or taxage will have to support one retired person. subsidies to the pension system. In the long term, however, pension benefits usually endDemographic change is only one of many up being trimmed. Tax-financed pensionreasons why CEE countries have redesigned schemes operate along the same lines.their pension systems over the past 15 years. Ultimately, the development of the nationalAbove all, the necessity to adapt the social tax base, which is closely related tosecurity system to the new economic economic performance, determines theenvironment was far more pressing than generosity of the pension system.demographic considerations. To ensure thatthe market economy could thrive, the Funded systems operate differently. Insocialist-style social system had to be principle, the pension is determined by thereformed. For example, many CEE countries funds invested and the return earned ononce had pension systems that allowed these investments, as is the case withretirement at age 55 and offered generous defined contribution systems in thebenefits. Today the CEE countries, their countries under consideration. Whereas aeconomies and pension systems look very PAYG system operates domestically, fundeddifferent compared to 15 years ago. The pensions can be invested abroad, thusprospects for this region and its pension decoupling returns from domestic6
    • Introductioneconomic performance. Nevertheless, relatively small economic weight of the newcontribu tions or inflows still have to be members. The countries added around 5 %earned at home. In this respect, the different to the Union’s GDP, measured at currentpension systems are similar. Domestic prices. However, the population of the EUeconomic performance and income increased by about 20 %. The accession ofdevelopment determine the amount that Romania and Bulgaria has had similarcan be set aside for old age, either for the effects, but on a much smaller scale.individual’s future in a funded system or thecurrent pensioners in a PAYG system. In order to compare income levels across countries in a meaningful manner, varyingIt should be noted that pension funds are price levels have to be considered, which canfrequently subject to constraints when it be done by measuring GDP in purchasingcomes to investment decisions. If they are power parities. This approach adjusts thelimited to domestic investments, the exchange rate of currencies to equalize thedifference between funded and pay-as-you- price of a given basket of goods in differentgo systems gets smaller, and ceases to exist countries. The comparison of standards ofentirely if pension funds are required to living is usually closer to the truth than ainvest their money into national comparison using market exchange rates.government debt. Under such However, purchasing power parities are notcircumstances, implicit government debt is flawless and in order to assess a country’schanged into explicit government debt that economic weight, market exchange ratesstill has to be serviced by taxes. Domestic are more suitable. A glance at GDP per capitainvestment, for instance financing figures shows that the new CEE membersinfrastructure to improve long-term growth are still very poor compared to the EU-15.prospects, makes sense when decent Only the per capita GDPs of Slovenia and thereturns can be earned at home. This is Czech Republic show purchasing powerparticularly true for the new EU member standards above that of Portugal, thestates attempting to catch up with the rest poorest of the EU-15 countries.of the Union. In any case, the proper risk/return structure, given the liabilities of a Poor regions qualify for various EU funds,pension fund, should be left to fund and as the EU’s financial outlook for themanagement. In CEE countries, return budget period spanning from 2007 to 2013potential is high thanks to sound economic shows, net transfers into the countries rangeprospects. New EU members and between 1.5 % and 3.5 % of their respectiveneighbours such as Croatia have gained GDP, depending on the economic situationgood economic growth opportunities. EU of the country in question. For Croatia themembership – or in the case of Croatia EU situation is different, since it has still toneighbourship – fosters economic growth become a EU member. For the others,through trade and members benefit fromgenerous subsidies. GDP per capita 2005 purchasing power parities [% of EU-15 average], EU-15 = 100 100Catching up 80On January 1, 2007, Romania and Bulgariajoined the European Union, boosting the 60number of member states from CEE to 10.Poland, the Czech Republic, Slovakia, 40Slovenia, Hungary and the three Balticstates have already been members of the EU 20for three years, joining on May 1, 2004. Forthe EU as a whole, the impact of the 2004 0 Slovakia Bulgaria Estonia Romania Croatia Lithuania Slovenia EU-15 Hungary Latvia Poland Republicenlargement (Malta and Cyprus were also in Czechthis round) on key macroeconomicaggregates was relatively modest due to the Source: Eurostat 7
    • Introductionsubstantial subsidies are granted in the decades to reach 75 % of the EU-15 average,form of structural and other funds from provided that its real GDP grows constantlyBrussels, coupled with free access to the EU at 4.5 %, compared to 2.25 % for the EU-15.market. These funds will help accelerate thecatching-up process that is well on its way in These simple projections show that the EUCEE. However, the discrepancies within the member states from CEE will remainEU are enormous, and it will certainly take relatively poor compared to the EU-15 fortime for the CEE member states to close the quite some time. However, this goes handHypothetical development of per capita GDP in Portugal and Bulgaria18,00016,00014,00012,00010,000 8,000 Portugal growth 2.5 % p. a. 6,000 4,000 2,000 Bulgaria growth 5 % p. a. 0 2006 2012 2018 2024 2030 2036 2042 2048 2054 2060 2066 2009 2015 2021 2027 2033 2039 2045 2051 2057 2063 2069Source: Allianz Dresdner Economic Researchgap to the EU-15. The graph above shows the in hand with a lower cost of living anddevelopment of per capita GDP in Bulgaria lower wages, which have attracted(the poorest of the accession countries) and investment: many manufacturingPortugal (the poorest of the EU-15 countries) companies have moved production to CEEbased on the hypothetical, but realistic to take advantage of a cheap, highlyassumption that Bulgaria’s real per capita educated workforce. This, in turn, hasgrowth rate will be 5 % and twice as high as helped to boost growth. The following tablePortugal’s. In this scenario, it would take 60 shows average gross monthly earnings inyears for Bulgaria to reach the same level as CEE countries compared to the EU-15Portugal. average. While the differences are striking, wages in these countries are rising fast,Since the EU average is higher still, it will particularly for skilled labour. This meanstake decades for the accession countries to that the cost advantages that CEE countriesreach the average level. Even Poland, the offer will dwindle over time, as the gapbiggest economy of the CEE countries between old and new member statesconsidered here, will need more than four narrows.Average monthly gross income 2005 [EUR]2,500 2,2562,0001,500 1,192 882 8101,000 635 602 515 452 492 500 370 344 192 0 Bulgaria Croatia Czech Republic Estonia Latvia Lithuania Poland Romania Slovenia Slovakia EU-15 HungarySource: Eurostat, Allianz Dresdner Economic Research8
    • IntroductionGDP growth rates [%] Country 1997–2005 2006 2007* 2008* 2009–2013* Bulgaria 4.6 5.7 6 5.7 5.7 Croatia 3.3 4.6 4.3 4.1 4 Czech Republic 2.3 5.9 5 4.5 3.5 Estonia 6.8 11.4 8.7 7.3 4 Latvia 7.1 11.9 8.6 6.8 4 Lithuania 6.1 7.5 6.8 5.8 4 Hungary 4.3 4.9 2.2 2.3 4 Poland 3.9 5.7 5 4.7 4 Romania 2.8 7.2 6.3 6.1 7.2 Slovakia 4.1 8.3 7.9 6.2 8.2 Slovenia 3.9 5 4.3 4.1 3.5 EU-15 2.3 2.8 2.3 2.3 2* ForecastSources: European Commission, Allianz Dresdner Economic ResearchMember states with lower initial per capita were employed compared to the totalincome have grown faster, especially the number of people in this age group. OnlyBaltic countries and Hungary. At the same Slovenia showed a higher employment ratetime real wages increased by around 3.5 % in in 2005 than the EU-15 average, whereasthe new member states compared to 1 % per unemployment was lower than the EU-15year in the EU-15. Potential growth rates average in several CEE countries.have averaged 3.5 % since the late 1990s,demonstrating the CEE countries’ highly Clearly, CEE countries have low labour forcefavourable supply-side performance. This is participation overall, but there arealso reflected in the growth forecasts significant differences between them.depicted in the table above. Employment and unemployment rates [%] 90Labour markets 80 70Structural unemployment is one of the 60major problems that CEE countries face. 50From 2001 to 2005, the labour market 40participation rate was around 65 %, 30compared with an average of 73 % in the EU- 2015. Poor employment performance has a 10disproportionate effect on specific age 0 Croatia Czech Republic Lithuaniacohorts and groups. The employment rates Hungary Bulgaria Romania Slovenia Poland Slovakia Estonia Latvia EU-15of young, older and female workers inparticular are relatively low. The followinggraph shows the unemployment rate in2006 and the employment rate for 2005. The unemployment rate 2006 employment rate 2005latter shows how many people aged 15 to 64 Source: Eurostat; 2006, 2005 9
    • IntroductionWhile the Baltic states, the Czech Republic already very limited, interest rate policy isand Slovenia have employment rates still the task of national central banks.similar to the EU-15 average, labour market During the rapid catch-up process, theparticipation rates in the other countries European monetary policy – which caters toare considerably lower, most notably in EMU as a whole – may be too loose to keepPoland, Hungary and Romania. Higher local inflation under control. The extraparticipation rates could offset a small part degree of economic policy freedom that isof the demographically induced labour retained by not being part of EMU could beforce decline. very helpful for some time. Once the economic structures and cycles of the CEE countries are more closely aligned to those of current EMU members, the case forThe road to EMU joining will be stronger.EU membership eventually means Apart from the above-mentioned reasons formembership in the EMU. However, only not joining, there are other obstacles thatSlovenia has been admitted so far. As should be considered. With the signing ofrecently as 2005, it seemed as though most the Maastricht treaty in 1992, theof the countries that had joined the EU in foundations of European monetary policy2004 would become EMU members by 2008 were laid, and strict membership criteriaor 2010 at the latest. But things have established. These are:changed dramatically since then. In the CEEcountries considered in this publication, · Exchange rate stability, meaning 2 yearsEMU membership is no longer as high on the within the exchange rate mechanismagenda as it used to be. The reasons are without realignment;manifold, among them national politics andthe perceived consequences of EMU · Inflation of no more than 1.5 percentagemembership. points above the average of the 3 EU countries with the lowest inflation;EMU membership is an issue for pension · Long-term interest rates no higher than 2systems, too. While it has no direct effect on percentage points above the average of thethe pay-as-you-go part of the pension system, 3 countries with the lowest inflation;it does have implications for the funded part, · Sound public finances, meaning thatwhich is becoming increasingly important in government debt should not exceed 60 % ofthe CEE countries. Under EMU membership, GDP, and the budget deficit should be lowerexchange rate risk, which is manageable but than 3 % of GDP.costly to hedge, would disappear forinvestments in other EMU countries. Pensionfunds could find a broader set of assets to Exchange rate stability would not be a majorinvest in without having to consider currency obstacle to the countries under review. Amovements. Furthermore, EMU could make notable exception, however, is Hungary. TheCEE capital markets even more attractive for Euro – Forint exchange rate was ratherforeign investors, increasing liquidity and – volatile in 2006, with a fair bit of speculationhopefully – supporting asset prices, a in the market. Currencies participating inwelcome effect for local pension investment the European Exchange Rate Mechanism IImanagers. (ERM II) stayed within their corridors. The next table shows the exchange rate systemsFor current EMU members, the common of the CEE countries.monetary policy is largely considered Inflation is another area that could causebeneficial. However, the economic problems if the countries joined immediately.discrepancies between current members At the moment, most CEE EU countries wouldand CEE countries are considerable. At this fail the Maastricht test. If the three EUstage, it is not entirely clear whether countries with the lowest inflation in 2006relinquishing control over monetary policy (namely Finland, Poland and Sweden) arewould be beneficial. Even though exchange considered together, the average inflationrate movements against the Euro are rate amounted to 1.4 %. This means that the10
    • IntroductionExchange rate systems in CEE countries government debt is not an issue in CEE countries. Apart from Hungary, all of them Country Exchange rate system have very low levels of debt. Budget deficits, Bulgaria Currency board (Euro) however, could become a problem for some countries. Here, too, Hungary stands out, Czech Float with a budget deficit of 10.1 % in 2006 Republic according to EU estimates, though tough Hungary Exchange rate band +/- 15 % fiscal measures will likely help reduce this year’s deficit down to 7 % of GDP. The country Estonia Currency board (Euro), ERM II aims to get its budget in line with the Latria Currency board (Euro), ERM II Maastricht criteria by 2010, but this will Lithuania Currency board (Euro), ERM II require resolute reform implementation. Poland Float Hungary is not the only country with a Romania Float budget deficit exceeding 3 %. Poland, the Slovakia Float, ERM II biggest CEE economy, also has its share ofSource: Allianz Dresdner Economic Research problems. While last year’s budget deficit turned out to be substantially lower thaninflation criterion for new member states expected, there is still cause for concern.stands at 2.9 %, and only Poland and the The European Commission argues thatCzech Republic would pass the test. Inflation corrections to budget deficits arecould be a problem for some time to come, as insufficient; in fact, last year’s positivestrong economic growth tends to keep outcome could largely be attributed to highinflationary pressure high. revenues that resulted from striding economic growth. According to EU rules,In most countries, interest rates are Poland has to fully incorporate the costs ofrelatively close to the EMU benchmark. The pension reform into its budget, which it hasaverage spreads on 10-year government not yet done. For this reason, this year’sbonds in 2006 were below 100 basis points deficit will probably stand at 3.5 % of GDP.for most countries. Only Poland, Romania That is roughly the same figure we expectand Hungary are outside this corridor. for the Czech Republic in 2007.Obviously, capital markets are notconvinced that these countries will join Except for Slovenia, none of the CEE countriesEMU in the near future. The latter two qualified for EMU membership in 2006.countries would even fail to meet the However, as discussed above, early EMUinterest rate criterion. In 2006, the 10-year membership should not be an aim in itself. Agovernment bond benchmark yield for the country must be ready for membership, bothEU was 3.8 % – with 7.3 % and 7.9 %, Hungary economically and politically. The larger CEEand Romania were substantially above it. countries such as the Czech Republic, Hungary, and Poland are certainly not thereThe public finance criterion has not been a yet, nor are new members Romania andmajor hurdle yet. In practice, generalInflation and bond yields 2006 [%]10 8 bond yield target 6 4 inflation target 2 0 Estonia Republic Slovakia Bulgaria Czech Lithuania Romania Latvia Hungary Poland EMU 10 y gov bond yield InflationSource: Eurostat 11
    • IntroductionBulgaria. It is in all of these countries’ best Public financesinterest to postpone EMU membership. BulgariaAllianz Dresdner Economic Research government debt criterion 60 % Czech Republicforecasts that Slovakia will be the nextcountry to join the EMU in 2009. The Estoniafollowing table provides the forecasts for HungaryEMU accession as of spring 2007. LatviaExpected EMU membership budget deficit criterion 3 % Lithuania Year Country Poland 2009 Slovakia Romania 2010 Estonia, Lithuania Slovakia 2011 Latvia, Bulgaria –5 5 15 25 35 45 55 65 budget deficit % of GDP government debt % of GDP Czech Republic, Poland, 2013 Source: EU Commission Forecast Romania 2014 HungarySource: Allianz Dresdner Economic Research Much like in the rest of the world, the decline in fertility coincided with increasingDemographic development longevity. Men in the Czech Republic and Slovenia benefited more than theirThe demographic situation in the CEE counterparts in other CEE countries as theircountries is marked by a steep decline in life expectancy at birth increased by 5.3 andfertility, which began in the 1970s and 4.6 years between 1990 and 2005 in eachaccelerated in the early 1990s after the country, respectively. In the major EU-15collapse of the Soviet Union. This is not countries – Germany, France, Italy andsurprising, given that times of increased Spain –, the increase was between 4 and 4.2economic insecurity frequently lead to years in that period.sudden changes in birth rates. Between 1990and 1995, fertility in the 11 CEE countries The situation for women is similar. Here, too,considered in this publication declined much Slovenia and the Czech Republic showed themore sharply than in the rest of Europe. highest increases for CEE countries betweenCurrently, the fertility rate in these countries 1990 and 2005 with 3.9 and 3.7 years,lies between 1.24 and 1.42 children per respectively. Figures for the EU-15 countrieswoman; to keep the population constant, a range between 2.9 and 3.6 years. Longevityfertility rate of roughly 2.1 children per development in the other CEE countries,woman would be necessary. The drop was however, was not nearly as positive, and wasparticularly dramatic in Latvia, Estonia and generally well below four years. To see thethe Czech Republic. Croatia, Slovenia and big picture, it is helpful to look not only atHungary were less affected, as these changes in longevity but also at overall lifecountries were less economically dependent expectancy, and here it is clear that CEEon the former Soviet Union. countries are well below the EU average.Fertility [children per woman] 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003 Bulgaria Czech Republic Estonia Latvia Lithuania SlovakiaSource: Eurostat12
    • IntroductionIn the absence of any sizeable immigration, will be much higher still. In Bulgaria, therefertility decline is leading to shrinking will be 60 pensioners for every 100 people ofpopulations, while increasing life expectancy working age. The figure will be lowest inis boosting the average age. The age group Croatia and the Baltics, with about 42 to 45comprising people over 65 is the only one pensioners, while the EU-15 average will beexpected to grow in the future. Overall, the around 53. The following chart illustratespopulation of these 11 countries is forecast to these developments. It must be taken intoshrink by about 15 %, or roughly 16 million account that the EU-15 average is pushedpeople, by 2050. In absolute terms, Poland higher by Italy and Spain, which have the twoand Romania are among the worst hit, as fastest-ageing populations. The morethey will each lose about 4.5 million populous CEE countries are also ageing fast,inhabitants by 2050, representing 10 % and making their demographic situation even20 % of their respective populations. The worse than the EU-15 average.situation is even worse in Bulgaria. Accordingto Eurostat, the country will lose roughly a Given the rapid increase in old-agethird of its current population within the dependency ratios, CEE countries will find itnext 40 to 45 years. almost impossible to run sustainable pay- as-you-go pension systems. All of theThe old-age dependency ratio provides a good countries have reacted to the demographicindication of a country’s demographic threat in various ways and many introducedsituation and the resulting pressures on the funded pension elements to their systems.pension system. Currently the old-age In this report, we have put the spotlight ondependency ratios in the CEE countries under 11 different pension systems that rely onconsideration range between 16 and 26. With funded pensions to varying degrees.a ratio of about 16, Slovakia has the lowestold-age dependency, while Croatia has the Dr. Jürgen Stanowsky,highest with a ratio of 26. In 2050, these ratios Allianz Dresdner Economic ResearchLife expectancy [years]90858075706560 Croatia Czech Republic Estonia Latvia Lithuania Hungary Poland Romania Slovakia Slovenia France Germany Italy Spain Bulgaria men womenSource: EurostatOld-age dependency ratios*70605040302010 0 Croatia Republic Estonia Latvia Lithuania Poland Romania Slovakia Slovenia EU 15 Spain Hungary Italy Bulgaria Czech 2005 2030 2050* Ratio of over 65-year-olds to 15–64-year-olds; source: Eurostat 13
    • IntroductionPensions in Central and Eastern Europe:Reforms, Regulation and MarketsReforming Central and Eastern by dividing the sum accumulated in the notional account by cohort life expectancy.European pensions In this way, NDC systems establish a strict equivalence between contribution andAfter the fall of the Iron Curtain, Eastern benefits.European states faced the daunting task ofreforming their outdated pension systems. At In eight of the eleven CEE countries includedthe time, the systems in place were not in this study, reforms went further than thatcompatible with demographic developments and introduced mandatory second pillaror the new economic environment. Under the schemes with fully funded individualold regime, pensions were the exclusive accounts of the defined contribution (DC)responsibility of the state. Retirement type. Hungary was the first country tobenefits depended on years of service, not on introduce a second pillar along these lines,contributions paid, so that a link between followed by Poland. Most recently, Slovakiacontributions and benefits was more or less introduced a second pillar and Romania isnon-existent. Retirement age was low, and in the process of doing so. This is a radicalcertain occupational groups enjoyed reform step and has been inspired by theprivileges. Early retirement was widespread World Bank model of pension reform, inand was extensively used as a means of hopes that a fully funded second pillar willreducing the workforce during the transition help diversify retirement income and allowperiod. more people to participate in capital markets. This, in turn, will likely pushFaced with this situation, all CEE countries domestic capital market development.initiated similar reform strategies in the1990s that applied to the first pillar of their The only countries that have not introducedpension systems. Parametric reform of the funded second pillar systems are the Czechpay-as-you-go (PAYG) system was essential Republic, Slovenia and Lithuania. However,to cope with enormous financial pressure Lithuania has implemented a fundedand secure the solvency of public pensions. second pillar, which works in the same waySooner or later, every country increased theretirement age, reduced incentives for earlyretirement, changed the benefit formula to Overview of the pension systems after the reforms.establish a stronger link betweencontributions and benefits, scaled back NDC system Reformed PAYG systemprivileges for certain occupational groups Mandatoryand increased the required contribution Poland Bulgaria second pillarperiods. First-pillar reforms in Poland andLatvia were the most far-reaching. These Latvia Croatiatwo countries introduced a notional defined Estoniacontribution (NDC) system in the first pillar. HungaryNDC systems impose the logic of fundedsystems on public pension schemes by Slovakiagiving participants a hypothetical account Romaniacontaining all contributions made Voluntary second or Lithuaniathroughout their working lives, credited at a voluntary third pillar Czech Republiccertain rate of return. At the time of only Sloveniaretirement, pension benefits are calculated14
    • Introductionas the second pillar in the other countries, before, but a certain share was redirected toexcept that participation is voluntary. The the funded second pillar. An exception to thisCzech Republic relies on first pillar public rule is Estonia, where contributions werepensions and voluntary savings in the third increased to achieve higher contributions topillar, while Slovenia runs voluntary second pillar schemes. Some countries, suchoccupational schemes in the second pillar, as Latvia and Lithuania, have allowed thesimilarly to Western European countries. proportion of the second pillar share toExcept for the latter two countries, the third gradually increase; also Romania will do so inpillar of voluntary pension savings remains the future.fairly underdeveloped in Eastern Europe. In most cases, participation in the secondAfter the reforms, most CEE countries now pillar was made mandatory for new labourhave a three-pillar system with a reformed market entrants, while existing employeesfirst pillar, a mandatory second pillar made up to a certain age could choose whether toup of funded individual accounts and a join or not. Employees near retirementthird pillar comprising voluntary pension usually could not join, since the capital theysavings. The pillar terminology applied in could still accumulate was not sufficient toCEE is different from the common OECD cover appropriate retirement benefits.classification, which defines the first pillar Redirecting contributions to the secondas the state pension system, the second as pillar implies financing problems for theoccupational pensions based on first pillar, which previously received theemployment contracts and the third as full share of contributions. The losses inpersonal pension plans. While this revenue for the first pillar mainly depend onclassification is suitable for Western the number of contributors to the secondEuropean and other industrialised pillar and the share of contributioncountries, it is hard to apply it to CEE redirected. World Bank estimates for 2004pension systems. suggest that revenue losses in the public pillar ranged between 0.3 % and 1.3 % of GDPAs already mentioned, the CEE countries in CEE. In order to offset these losses,based their pension reform strategies on the countries such as Bulgaria, Poland andWorld Bank model, which is why we have Slovakia established a demographic reservechosen to follow the World Bank fund to be filled with privatisation revenues.classification in this study. The maindifference lies in the second pillar, which Overall, social security contributions arecomprises individual DC accounts in CEE, sizeable in Central and Eastern Europe, andbut (mainly) voluntary occupationalpensions in Western Europe. In CEE,voluntary employer contributions toemployee pension arrangements are part of Pension pillar classification in CEE and Western Europethe third pillar, but contributions are madeto individual accounts, not pension fundsestablished by a firm or industry. Some CEEcountries recently established a fourthpillar that aims to generate more employer Occupational Mandatory pensions/involvement in pension provision, or simply State Private additionalallow people to set more money aside for CEE funded pension pensions privateretirement. The topic will be discussed in pensions pensiongreater detail later on in this study. The savingsadjoining graph illustrates the differencesbetween CEE pension systems and those Occupa- State Privateprevalent in Western Europe. EU-15 tional pension pensions pensionsThe funded second pillar systems in EasternEurope were introduced by way of the carve- First Second Third Fourthout method, meaning that social security pillar pillar pillar pillarcontributions stayed at the same level as 15
    • Introductionemployers often pay the bulk of these. Reform Pressure Gauge*Contribution rates to the second pillar vary As of April 2007significantly, ranging from 4 % in Latvia to Greece9 % in Slovakia. Total net replacement rates Spainin CEE are relatively high. Net replacement Italy Belgiumrates are the ratio of pension entitlements – Portugalnet of taxes – to earnings, net of taxes and Sloveniacontributions. Net replacement rates are Austrianearly always higher than gross France Czech Republicreplacement rates, mainly because retirees Polandhave lower personal income taxes than Hungarybefore and typically pay low social security Slovakiacontributions, if any at all. In the present Germanycontext, net replacement rates refer to an Lithuania Finlandemployee with average earnings. The net Bulgariareplacement rates were calculated by the SwedenEuropean Commission and refer to the Romaniaretirement income in the first year of Denmark Norwayretirement, divided by income during the Netherlandslast year of employment. Since the pay-out Croatiaphase of the funded second pillar has not yet Estoniastarted, the rates refer to the first pillar. Over Switzerland Latviatime, the replacement rate of the first pillar UKwill decline and the funded pillar will Irelandaccount for a sizeable amount of retirementincome.1 0 2 4 6 8 * Scale from 1–10: 1 low reform pressure, 10 high reform pressurePension contribution rates, second pillar share, and replacement rates 2006 Employer Employee Second pillar Net replacement contribution [%] contribution [%] contribution [%] rate 2005 [%] Bulgaria 14.95 8.05 5 n. a. Croatia 0 20 5 n. a. Czech Rep. 21.5 6.5 79 Estonia 20 2 6 41 Hungary 18 8.5 8 102 Latvia 14.5 5.5 4* 78 Lithuania** 21.2 2.5 5.5 55 Poland 9.75 9.75 7.3 78 Romania 20.5 9.5 2*** n. a. Slovakia 14 4 9 63 Slovenia 8.85 15.5 82* gradually increasing ** voluntary second pillar *** once established, gradually increasing1 Replacement rates can be measured in different ways. The World Bank uses retirement income from the mandatory pillars – including the funded second pillar – as a share of individual average lifetime earnings. It calculates future pension entitlement based on current systems’ rules, thus considering the future contribution of the funded pillar. By applying this methodology, it shows that average earners in Bulgaria (will) have a net replacement rate of 75 % while Croatian earners get 62 %. The average net replacement ratio of the mandatory pillars in CEE (excluding Slovenia and Romania) will amount to 73.3 %, which is higher than the 67.9 % average for OECD countries. This is partly a result of a more favourable tax treatment of pensions in CEE. Further- more, since mandatory systems and thus the second pillar in CEE countries are included, this methodology tends to underestimate the replacement rates in Western countries, where pensions other than first pillar pensions are normally voluntary and thus not included.16
    • Introduction Allianz Pension Reform Pressure Gauge The ability of state pension systems across Europe to cope with demographic change varies considerably. The Allianz Reform Pressure Gauge attempts to illustrate the differences and takes developments determining the future stability of pension systems into account. These developments include demographic change and expected changes in the old-age dependency ratio. The generosity of the current PAYG pension system and reforms of first pillar pensions that have already been passed are also included, as are supplementary systems. Finally, the state budget is taken into account to assess the feasibility of financing deficits in the pension system. The result of this exercise is shown in the chart. As most CEE countries have introduced a mandatory funded part to their pension systems, they are on the right track. But much still needs to be done to remove the legacy of former pension systems. For instance, the retirement age is still low, even if it is rising in many countries, early retirement is still widespread, and some countries’ supplementary pension elements continue to be voluntary, possibly leaving a substantial part of the low income workforce uncovered. If nothing is done to change this situation, people with low incomes will be forced to rely on modest state pensions in the future. Of the Eastern European countries, Latvia and Estonia are well-placed to cope with demographic change, on a par with Ireland and Great Britain.Certainly, the reforms initiated in CEE particularly with regard to diversifyinglessened financial pressure on the assets. In contrast, in continental Europe,countries’ pension systems and made them quantitative restrictions are still prevalent.more sustainable. The Allianz Reform These specify the financial instruments thatPressure Gauge, which calculates the pension funds can invest in as well as thesustainability of pension systems and the maximum limits of certain asset classes inresulting reform pressure, shows that most the portfolio.CEE countries are ranked in the mid-rangein terms of necessity for pension reform. Central and Eastern Europe has opted for quantitative restrictions as a means of regulating pension funds. In many CEE countries, there are limits for equityRegulating pension funds holdings and other financial instruments, as well as for the share of foreign assets inPension funds, especially those in the the portfolio. From the viewpoint of capitalmandatory pillar, are heavily regulated in market theory, these limits are not withoutCEE. Fees, disclosure, number of funds problems. It is argued that restrictiveoffered and investment are the main maximum limits for certain financialregulated areas. Investment regulation is the instruments, especially equity, renderarea with the biggest impact on pension pension funds inflexible by constrainingfunds and asset managers, as it has a direct asset allocation and thus the upsideimpact on asset allocation and, consequently, potential of pension funds. If equity limitson the performance of pension fund assets. are overly restrictive, they may result in suboptimal asset performance, becauseGenerally, there are two main principles of pension funds cannot sufficiently takeinvestment regulation, the prudent person advantage of the higher-yielding equityprinciple and quantitative restrictions. The markets. Over the last 100 years, equitiesprudent person principle is applied in performed four percentage points betterAnglo-Saxon countries and increasingly in than bonds on average.Western Europe; it is the most liberal form ofinvestment regulation. It is based on the Caps on international investment canpremise that pension funds or asset hinder effective asset allocation bymanagers are obliged to invest in the same impeding an appropriate diversificationway as a prudent investor would for himself, across countries. In the case of restrictive 17
    • Introductionregulations, asset performance is very lead to distortions in asset pricing. Hence,dependent on domestic markets and the trade-off between the desire to developeconomic cycles, making investment risk local capital markets and efficient pensionhigher than it needs to be. fund investing is a delicate matter and policy-makers need to strike a balance.However, policy-makers have been facedwith a trade-off between the objective of Minimum return guarantees are anotherlocal capital market development and regulatory instrument that is often appliedoptimal asset allocation of pension funds. It in Eastern Europe and elsewhere. Minimumwas hoped that the funded pension system return guarantees can take the form ofwould lead to quantitative and qualitative absolute guarantees. This has been the casecapital market development. Qualitative in the Czech Republic, where pension fundsimprovements refer to the generation of have to generate positive returns every year.„institutional capital“, which includes better Or, like in Poland, they can take the shape oflegal and regulatory frameworks and more relative performance goals, where aprofessional investment management, more benchmark must be met that is based on thetransparency and better governance performance of all pension funds. Forstructures. To achieve these goals, pension pension fund members, minimum returnassets should, at least to a certain degree, guarantees have the advantage thatflow into national financial markets. retirement savings are predictable in theHowever, substantial inflows of pension case of absolute return guarantees. And inassets may result in imbalances between the case of relative return guarantees, thesupply and demand, particularly when local risk of choosing a poorly performing fund iscapital markets lack liquidity, which could minimised.Main investment limits and return guarantees in the second pillar Max. foreign invest- Max. equity share Absolute return Relative return ments [% of assets] [% of assets] guarantee guarantee Bulgaria 15 20 yes Croatia 15 30 yes None for OECD Czech Rep.* None yes countries None for EFTA and OECD Up to 50, depending on Estonia – – countries type of fund chosen Hungary 30 None – – None for EU/EFTA coun- Up to 30, depending on Latvia – – tries type of fund chosen Up to 100, depending Lithuania** None on type of fund – – chosen Poland 5 40 yes Romania*** n.a. 50 yes Up to 80, depending on Slovakia 70 yes type of fund chosen None for OECD Slovenia 30 yes countries* third pillar ** voluntary second pillar *** expected to start in 200818
    • IntroductionIn some regards, therefore, retirement their disposal, while Slovenians, the richestplanning is becoming easier. Nevertheless, country in per capita terms, have EUR 13,140.there is a trade-off. Capital market theory The modest wealth and income levelsargues that the necessity to secure short- explain why voluntary private pensionterm profitability may lead to homogeneous savings in the third pillar areinvestment strategies in the pension fund underdeveloped in CEE. Indeed, possibilitiesmarket. This „herding“ effect may result in for additional pension savings in general aresimilar performances of pension funds, limited. However, this may change if thethereby reducing the number of real choices catch-up process proceeds and incomesfor potential and existing pension fund continue to increase.members. A second related problem is thateffective longer-term investment strategies In CEE, investments in financial assetscannot be pursued if the guarantee applies compete strongly with housing investmentsto annual minimum returns. In this case, and consumption. The economicpension funds must sacrifice long-term turbulences of the transition period in thereturns for short-term profitability. In brief, 1990s resulted in plummeting incomequantitative restrictions and annual levels, which in turn led to pent-up demand.minimum guarantees are somewhat Rising income and a more favourableproblematic, as both limit the holdings of economic environment have now made itvolatile assets, including equities, which possible to realize this demand. As a result,have higher long-term returns, but can have saving rates in CEE tend to be lower than innegative returns in individual years. Western Europe. While saving rates amount to 11.7 % of disposable income in France,In recent years, some countries have relaxed 10.5 % in Germany and 8.9 % in Italy, Slovakiatheir investment regulations, especially has a saving rate of 2.4 %, the Czech Republicwith regard to equity investments. This has 0.2 % and Lithuania –2.7 %. The negativebeen the case in Hungary, for instance, saving rates can be attributed to the factwhich had a 50 % limit on equities until that people prefer to spend their savings on2004, and in the Czech Republic’s third buying houses rather than investing inpillar, where a 25 % equity limit was in place financial products.until the same year. While it is too early tospeak of a trend, these two examples In CEE, the bulk of household financialindicate that the increasing maturity of assets is often held in bank deposits. Inpension systems and capital markets might Slovakia, for example, bank depositslead to a loosening of regulatory account for two-thirds of all financialrestrictions. assets, the highest value of all CEE countries. Countries such as Slovenia, the Czech Republic, Poland, Lithuania and Latvia have a share of bank deposits of around 50 %. InFinancial assets and their Hungary, they account for roughly 40 % ofallocation in CEE countries assets. In many countries, however, there are sizeable holdings of shares and mutualNot only is there a considerable gap between funds – 22 % of total household assets in theper capita GDP among old and new EU Czech Republic, 29 % in Poland, 36 % inmember states, there are also major Hungary and 55 % in Estonia. In general, thisdiscrepancies in terms of financial assets. 2 is often a consequence of the privatisationWhile the financial assets of households in process of the 1990s.the EU-15 amount to 215 % of GDP on average,in Eastern Europe they range between 52 % The importance of life insurance andof GDP in Latvia and 100 % of GDP in Estonia. pension assets in household portfoliosThis means in per capita terms that each varies considerably in the differentcitizen of an EU-15 country has average countries. In countries like Poland, Slovakia,financial assets of EUR 57,200. In contrast, the Czech Republic, Hungary and Slovenia,Latvians have assets worth EUR 2,965 at they account for 10 % of financial assets, but2 Comparable data for financial assets were not available for Bulgaria, Croatia and Romania. 19
    • Introductionare of minor importance in the Baltic states. pensions may gain a foothold in someThis indicates that there is considerable countries. Romania has also just establisheduntapped potential for the life insurance occupational pensions as the third pillar,business in CEE countries. In Western making it the fourth country to add such aEurope, life penetration, defined as the ratio dimension to its pension system. Whileof life premiums to GDP, stands at 5.6 % on employers in most CEE countries canaverage. In contrast, it amounts to 1.1 % in voluntarily contribute to their employees’the CEE countries. The CEE country with the private pension schemes, occupationalhighest life penetration is Slovenia with schemes would give them an additional1.7 %, followed by the Czech Republic (1.5 %), employee retention tool, particularly ifHungary (1.4 %), Slovakia (1.4 %) and Poland unemployment rates continue to decrease.(1.3 %). Still, the values for these countries They are also interesting for multinationalare considerably higher than in Greece, the companies active in the region.EU-15 country with the lowest penetration(1.0 %). The introduction of occupational schemes has partly been driven by the EU’sThe predominant position of bank deposits Institutions for Occupational Retirementin household financial assets is a pattern Provision (IORP) directive. This directive hasquite typical for countries at the beginning generally been problematic for CEEof an accumulation process. The preference countries, as it mirrors Western Europeanfor consumption and the limited experience practices and is hardly compatible with theand availability of more sophisticated systems in place. Following years offinancial products result in holdings of discussion, the directive was approved inliquid assets. However, over time and as 2003. Its aim is to enable a pan-Europeanhigher-yielding financial instruments are market for occupational pensions byintroduced, this is likely to change. creating the conditions for IORPs to operate across borders. The problem for the CEE states is that the directive takes Western European pension systems with their well-Regulatory trends in CEE established employer-sponsored occupational schemes (mostly of theMoving toward four pillar systems and defined benefit type) as a starting point,the IORP directive which do not exist in Eastern Europe.Very recently, several CEE countries began toestablish a fourth pillar of pension provisionto complement the existing system. Fourth The IORP directivepillars of various shapes have beenintroduced in Bulgaria, Hungary, Lithuania EU member states were obliged toand Poland. They are based on very different implement European Union directiveobjectives. In Bulgaria, the fourth pillar is 2003/41/EC on the activities andintended to enable voluntary occupational supervision of IORPs by September 23,schemes similar to those in operation in 2005. The main goal of the directive isWestern Europe. The Hungarian fourth to enable cross-border occupationalpillar has been established primarily to pension schemes. IORPs are defined aspush the development of the domestic fully funded, separate legal entitiesequity market. Lithuania established the that provide retirement benefits. Theylegal framework for occupational pension must be authorised and registered onlyschemes, whereas in Poland its introduction by home country supervisors; hostwas driven by the unpopularity of such country social and labour laws apply.schemes in the third pillar. While the prudent person principle applies, host states may prescribeWhile most of these schemes have just been additional investment regulations.established or are still in the process ofbeing introduced, it is remarkable thatEastern European pension systems are In this sense, the directive is not tailored tobroadening in scope, and occupational Eastern European systems, which generally20
    • Introductionhave individual DC accounts without Hungary, this requirement will beemployer involvement in the second pillar. mandatory from 2009 onwards. In the otherIn Bulgaria, the establishment of the fourth CEE countries, pension funds are onlypillar was directly related to the directive. allowed to offer a single fund. Slovakia, forRomania has also adapted to the demands instance, follows the lifecycle concept quiteof the directive with its newly established closely. Pension fund members are free tothird pillar of occupational pensions. Other choose which of the three funds on offercountries, however, are lagging behind. In they would like to join. When they are lessmid-2006, Slovenia was referred to the than 15 years away from retirement, theyEuropean Court of Justice for not having can no longer be enrolled in the fund withwritten the IORP directive into its national the highest equity share. Seven years beforelaw. In October 2006, the European retirement, they are obliged to switch to theCommission announced that it would start conservative fund with no equity exposure.proceedings against the Czech Republic, The trend towards pension funds withHungary and Poland due to incomplete different risk/return profiles and automaticimplementation and sent reasoned opinions assignment to less risky funds as people getto these countries. In March 2007 it again older increases the security of pensionsent reasoned opinions to the Czech savings in CEE by minimising theRepublic and Hungary. At the moment, the investment risk of funded pensions.topic of how cross-border pension funds willwork in Eastern Europe remains a sensitiveand currently unfinished matter. The future development ofIncreasing choice in pension funds pension assetsRetirement savings in defined contributionplans have some characteristics that set Since most CEE countries introducedthem apart from other types of savings, as mandatory funded elements (second pillar)they face the risk that the time of retirement into their pension systems and begancoincides with bear markets. To prevent this sponsoring voluntary systems, a substantialfrom happening, the concept of lifecycle build-up of capital has started, which makesinvesting has been developed. One variant of CEE an attractive market for asset managerslifecycle investing advocates automatically and insurance companies. Although it isadjusting asset allocation to the age of the still in the early stages of development, thefuture retiree. This set-up reduces the market has shown annual growth of 37 % inproportion of high-risk assets as the the last few years, up from a volume of EURbeneficiary ages, making it less likely that 13.5 billion in 2002 to EUR 47.4 billion infinancial market fluctuations will have a 2006 (excluding Bulgaria, Romania andnegative effect on pension benefits. This Croatia). And there is still considerableapproach therefore presents a argument growth potential.against a „one-size-fits-all“ approach inpension savings. This study includes the newest EU members, Bulgaria and Romania, as well as Croatia. InSome Eastern European countries have this broader group of countries, pensiontaken first steps in this direction and now assets amounted to EUR 50.8 billion at therequire providers to offer funds with end of 2006. With EUR 30.1 billion, Polanddifferent types of asset allocation, also holds the biggest piece of the pie, followed byknown as lifestyle or balanced funds. Hungary and the Czech Republic. NotLifestyle funds have different combinations surprisingly, the countries with smallerof equities, bonds and money market populations show much lower levels ofinstruments and usually come in three pension assets. Croatia is the exception toforms: conservative (only bonds and money this rule: with assets amounting to EUR 2market instruments), balanced (modest billion, the country has surpassed the largerequity share) and progressive (high equity Slovakia, which has accumulated EUR 1.3share). In Estonia, Latvia, Lithuania, Poland billion. And the most recent additions to theand Slovakia, pension funds can or must EU are still in the process of reforming theiroffer funds with different risk profiles. In pension systems. With its 7.7 million people, 21
    • IntroductionPension assets in CEE countries in 2006 (EUR 50.8bn in assets undermanagement in the 2nd und 3rd pillars) Poland: 60% Hungary: 17% Czech Republik: 10% Slovak Republic: 3 % Latvia: 0,5 % Lithuania 0,5 % Estonia: 1 % Bulgaria: 2 % Slovenia: 2 % Croatia: 4 %Sources: National Statistics, Allianz Dresdner Economic ResearchBulgaria ranks fifth in terms of population easier in this updated study of CEE marketsamong the CEE countries included in this than they were in the original study of 2004.study, but only holds 1.5 % of pension assets Our initial projection generated a pension(rank 7). Romania, which has 21.7 million potential of EUR 54 billion for 2006. For twoinhabitants, is set to initiate its funded reasons, this projection turned out to besystem in 2008. higher than the actual volume of EUR 47.4 billion. First, contribution rates in LatviaDifferences in pension asset development have not been increased as much as theycan be attributed to varying dates of reform were initially meant to be. Second, theimplementation, different designs (age Slovakian system was introduced a year latergroup participation, contribution rates) and than originally planned.whether the system is mandatory orvoluntary. In some countries, the funded The forecasted volumes of pension assetssystem has been accepted more quickly will be urgently required to supplement thethan in others, which explains why the state pensions that have been reduced andnumber of (mostly) older employees who partly transferred to the new systems. Ascould join the new pension system described above, funded pensions are avoluntarily is higher (i.e. Poland, Slovakia). fixed part of the old-age provisioning system to generate appropriate pension levels. ForTo estimate the market potential of CEE this reason, they are extremely important incountries, we followed the regulations for securing retirees’ futures, and assets are setsecond and third pillar pension schemes. to grow considerably. Driving forces areWithin mandatory systems, young people income growth, which we expect to developwere obliged to participate upon entering the more or less in parallel with the high GDPlabour market, while older employees could growth in most CEE countries (exceptopt in. In most countries, portions of the Poland), widening participation and thecontributions to the state system have been built-in process of increasing contributionredirected into the new funded systems. In rates in some countries.these countries, acceptance and growth rateshave been very high (Estonia, Lithuania, Given the history of the asset build-upSlovakia). The attractiveness of voluntary process in many countries, we expect assetssystems also depends largely on tax breaks to grow by 19 % p.a. until 2015, amounting tofor contributions and employer participation. EU 245 billion. The lion’s share will emanateSince the funded systems have been in place from Poland, Hungary and the Czechin all countries except Romania for two years Republic. The three countries together willor more, statistics on membership make up 80 % of the expected market volume,development, assets and contributions are even though they account for only 55 % of thenow available. This has made estimates population. They will be followed by Slovakia22
    • Introductionand Croatia. While the Baltic states, together conservative investment policies in most CEEwith the new EU members, are showing the countries impede major equity exposure. Inhighest growth rates, their small size makes most countries, the calculated minimumthem unlikely to accumulate large pension scenario is the most likely. In addition, peopleasset volumes. The Baltic states will hold 5.8 % in CEE countries still tend to set little moreof total assets by 2015. Bulgaria and Romania than the mandatory contribution aside. Thewill still have small pension markets by 2015, preference for consumption is still strong.but they remain very attractive due to the This may change, however, as the catch-upsize of their populations. process continues, which would imply a very positive long-term outlook for assetThe projected volume is the sum of the accumulation. Since the markets are stilldifferent country scenarios and a more or less in their infancy, the increase inconservative assumption based on an asset assets is mostly based on net inflows ofperformance of 5 % per year. In this view, the money from mandatory contributions.prospect of joining EMU drives yields on CEEcapital markets to converge at the euro level. Dr. Alexander Börsch,The restrictive investment regulations and Allianz Global Investors AGDevelopment of pension assets under managementCAGR 2006–2015 60 % 50 % 40 % SR 30 % 20 % CZ H P CR 10 % 0% 0 5,500 20,000 40,000 60,000 80,000 100,000 120,000 The size of the bubbles reflects the estimated asset volume in 2015 net increase in EURmDevelopment of pension assets under management – smaller markets 60%CAGR 2006–2015 50% 40% RO LIT LA BG 30% ES 20% SLO 10% 0% 2,000 2,500 3,000 3,500 4,000 4,500 5,000 5,500 The size of the bubbles reflects the estimated asset volume in 2015 net increase in EURmSource: Allianz Global Investors, Allianz Dresdner Economic Research 23
    • Introduction Estimation procedure To make projections, information is needed about the number of employees, average income and participation rates per age group. These data are generally not available and, in most cases, must be estimated. Using benchmark figures for the total population and cohorts provided by Eurostat, for the workforce/activity ratio (Eurostat, national statistical offices), for unemployment (national statistical offices) and for average gross income (national statistical offices; Allianz Dresdner Economic Research: Investing in Central and Eastern Europe, Special Report, 10/2006), we based our estimates on the assumption that the unemployment rate for the 25- to 44-year olds is the lowest, whereas they have the highest income. We also assumed that the workforce and its structure will undergo adjustments in line with demographic change as projected by the EPC. Second (third) pillar penetration varies according to national membership rules. In most countries, total membership figures were provided by national supervisory institutions. The age structure was set according to national pension system regulations (e.g. high participation for younger age groups, lower participation rates for older groups). For 2006, the starting data sets for all countries were calculated based on our assumptions so that the total amounts of pension assets as recorded by national supervisory institutions were met. We used these amounts as the starting point for our projection. We then factored in an increase in participation in most countries, resulting from the shift of already participating younger employees into the next age group. Estimates for the third pillar were made along the same lines, except for the participation rates. We assumed much lower rates and only participation of middle-aged groups, mainly men, as they likely have higher incomes and a more continuous working life than women. This allows them to engage in regular savings plans. In line with variations in the outlook for economic growth, we also expect differing increases in wages, varying between Poland (2 %) and Latvia (8 %) up to 2010, and half of these increases thereafter.24
    • IntroductionLife Cycle Asset Allocation –A Suitable Approach for DefinedContribution Pension PlansChallenges for defined these findings by carrying out sensitivity analyses and show how the results change ifcontribution plans further investor characteristics such as risk preference, time preference, and bequestWhile Eastern Europe is a prominent motives are taken into account.example of the importance of definedcontribution (DC) plans in pensionprovision, it certainly isn’t the only one.Many emerging economies have introduced How to invest retirementDC plans – often as a mandatory pillar with savingsindividual accounts – as part of pensionsystem reform. Chile was the first country to According to modern finance theory, ado so in 1981. In the industrialised countries, diversified investment portfolio is key to anthe shift from DB to DC in occupational efficient risk-return trade-off in the longpensions is particularly pronounced in run. The long-term portfolio returnsAnglo-Saxon countries. Given that most strongly depend on strategic assetinvestors are not financial market experts, allocation, i.e. on the risk exposure of theDC pension providers should offer products investment portfolio. This is especially truewith appropriate asset allocations to for retirement savings. Due to their longprevent plan members from making investment horizon, small differences in thesuboptimal decisions. average annual return will result in significant changes of the average financialLife cycle models, which are related to life wealth available at retirement. If onecycle funds but are far from being the same, considers that a higher annual return isaim to do just that. The concept has its roots usually accompanied by increasing risk, twoin modern finance theory, and its goal is to questions must be asked: What level of riskachieve optimal asset allocation as a can or should the investor accept, and howfunction of investor characteristics. In this should age or the current life situationway, asset allocation can be tailored to influence the optimal investment strategy?individual needs. To do this, human capitalof investors and the (future) income Investors are generally told that they shouldstreams derived from it are of fundamental shift their portfolio allocation over the lifeimportance. cycle from risky assets like stocks to less risky assets such as bonds. As a rule ofBased on a life cycle model developed by thumb, the percentage of wealth invested inrisklab germany, we will take human capital bonds should not be greater than theinto account and derive optimal asset investor’s age. Decreasing equity exposureallocations as a function of different human with age is supposedly the „optimal“capital levels. First, we will present the basic strategy, regardless of the investor’s riskconcept of life cycle models and the risklab preferences or particular life situation. Twomodel that incorporates human capital. We popular arguments support this advice:will then show how the optimal asset Time diversification and targeting for largeallocation differs depending on different liquidity needs in midlife. Timehuman capital levels. Lastly, we will analyse diversification means that equity risk is 25
    • Introductiondecreased by long holding periods. Over · The investor’s human capital (the status oflonger periods of time, short-term stock his career) and financial wealthmarket fluctuations are assumed to be less · The investor’s preferences (risk preference,important. According to this argument, one time preference of consumption and hiscan “diversify away“ the riskiness of stocks bequest motive)simply by extending the holding period.Targeting for liquidity needs is based on the The impact of human capital andidea that when individuals save towards a financial wealth on asset allocationspecific goal, such as buying a house or Merton’s classical asset allocation theorypaying college tuition fees, having higher relies on the rather restrictive assumptionequity exposure at the beginning of the that the investor’s consumption issavings period will lead to higher average determined by financial wealth, but not byreturns. As the target date approaches, human capital, meaning future income. Theinvestors should decrease risk exposure to theory argues that under certainminimise the likelihood of missing their assumptions about the capital market atarget. specific allocation to equities is optimal in the long-term (i.e. the equity ratio α withinWhile these arguments may seem like an investor’s overall wealth should becommon sense, they are not valid according constant over time). It equals the ratio of theto the restrictive assumptions of Merton’s equity risk premium and the constantclassical asset allocation theory.1 Merton relative risk aversion multiplied by theargued that investing a constant proportion variance of stock returns. The equity riskof wealth into stocks was the optimal premium is defined as the average return ofstrategy, irrespective of time horizon. In this stocks minus the return on the risk freemodel, the capital market and the investor asset; the investor is assumed to haveare modelled in a very simplified way. In constant relative risk aversion.recent years, academics have focused theirefforts on analysing the consequences of Equity Risk Premiummore realistic models that are based on αOverall = Risk Aversion · Variance ofmore accurate definitions of the capital Stock Returnsmarket and the investor. A realisticmodelling of investors is the main goal oflife cycle models, which aim to develop The optimal overall equity ratio is 16 % if we„optimal“ asset allocation policies. assume an equity risk premium of 4 %, a relative risk aversion of 10 and a standard deviation of equity returns of 15.8 %. Despite the theoretical rigour of the result, in realAn advanced life cycle life most people finance consumption withapproach earned income, and not with financial wealth alone. Hence, a more realistic modelTo derive an optimal asset allocation the should incorporate current and futureeconomic model should take individual life labour income.situations into account. In economic theory,more recent life cycle models do this by Future labour income can be considered anincluding human capital and investor- implicit asset. It can be equated with aspecific characteristics. person’s „human capital“, which delivers stochastic cash flows over the lifetime.Some of the findings of an enlarged life cycle These stochastic cash flows cannot usuallymodel developed by risklab germany are be traded in financial markets. Especiallypresented below. The model builds on for young investors with little financialcurrent economic research and considers capital, „human capital“ and the incomethe following parameters: streams derived from it represent the main1 Merton, R.C. (1969), Lifetime Portfolio Selection Under Uncertainty: The Continuous-Time Case, Review of Economics and Statistics, Vol. 51, 247-257.26
    • Introductionpart of their total wealth, which is the sum with low deterministic growth rates,of financial wealth and human capital. salaries in public administration are less risky. Investors with a college education onTo clarify the impact of non-tradable labour the other hand can anticipate higher growthincome, consider a stylised example with rates of labour income and a relatively lowdeterministic and thus risk-free salary risk of unemployment.streams. In this way, Merton’s outlinedsolution can be transformed rather simply. The results presented herein focus onThe share of total wealth invested in stocks investors who work in the construction andshould be constant over time, but not the public administration sectors. We will alsoshare of financial wealth. This fraction show the results for a sub-sample ofdepends on the evolution of financial wealth investors with a college education. Overalland total wealth, i.e. the sum of financial estimates for all sub-groups are indicatedwealth and human capital, as stated in the by „Benchmark“.following equation: The results are based on the assumption that the investor receives deterministic Investment in Stocks pension income equivalent to 68 % of the αOverall = = Total Wealth last labour income. The risk aversion coefficient and the equity risk premium αFinancial Wealth . Financial Wealth have been chosen in such a way that the = Financial Wealth + Human Capital optimal equity ratio without human capital equals 16 %. We assume a medium time preference and no bequest motive.Whenever the ratio of financial wealth to The sensitivity of the results in light oftotal wealth increases, the fraction of these assumptions is analysed in the nextfinancial wealth invested in stocks decreases section. Figure 1 shows that the resultingto obtain a constant overall equity ratio. If we equity ratios are well above this levelassume that the investor’s overall optimal throughout the entire lifetime and for allequity ratio is 16 %, he is fully invested in sub-samples. Investors would even preferequity as long as the value of his human to borrow money in their twenties to buycapital is more than five times his financial more stocks, because the present value ofwealth. In general, financial wealth increases their labour income outweighs theirthroughout the investor’s working lifetime, financial wealth by far. Over time, thewhereas human capital decreases as people present value of human capital decreasesage. Under this assumption, decreasing the and financial wealth increases since theequity ratio of financial wealth over time is investors start to save for retirement,optimal, as it allows to keep a constant meaning that equity ratios of financialoverall equity ratio. wealth decrease.Deterministic labour income is obviously a At retirement age (65), the equity ratiosubstitute for risk-free bond holdings, as invested in financial wealth should still bedeterministic human capital is equivalent roughly 40 % for all sub-groups, which mayto a non-tradable bond. But is this still true seem surprising at first glance. Again, theif income is modelled in a more realistic, reason lies in the implicit asset humanstochastic manner? risklab germany’s capital, which now comes in the form oflifecycle model defines labour income as a pension annuity payments. Once this hasstochastic process with permanent and been taken into account, the overall equitytransitory shocks as well as a deterministic ratio is 16 %, as implied by the assumed riskgrowth term. The process parameters are aversion and equity risk premium. Afterestimated for different groups of employees, retirement, the equity ratio should evenas level of education and sector of slightly increase because of the relativeemployment imply different risk and growth evolution of financial wealth and humancharacteristics for labour income. While, for capital. Due to the increasing risk ofexample, the construction sector is mortality, the investor increases his utilitycharacterised by volatile income streams by consuming more of his financial wealth. 27
    • IntroductionFigure 1: The impact of human capital and financial wealth on asset allocation 1Equity Ratio 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 20 30 40 50 60 70 80 90 Age in Years Benchmark Public Administration No High School Construction College Merton StochasticOptimal equity ratios throughout the lifecycle for different labour income groups. The graphs showthe median of the optimal equity ratios for 10,000 simulation paths. A single stochastic path is alsoshown to illustrate the volatility of the solution.As a consequence of this reduction of retirement. During retirement, however, thefinancial wealth, the investor has to optimal equity ratio is slightly increasing,increase his relative equity exposure of his depending on the specific modelling.financial wealth in order to keep up a stableoverall equity ratio. The impact of further investor-specific characteristicsIn addition to these general results, we found Besides the different labour incomethat investors with riskier labour income characteristics, various other factorsstreams (e.g. the construction sub-group) influence optimal lifecycle asset allocation.should invest less of their financial wealth in The results shown here are based on theequity. This is due to higher buffer stock following assumptions: the retirementsavings to compensate for reductions in income replacement ratio is approximatelylabour income. Investors with stable labour 68 %, the correlation between labour incomeincome (e.g. the public administration sub- and equity returns is zero, the investor hasgroup) have a smaller need to save financial an optimal overall equity ratio of 16 percent,wealth for this purpose, and should therefore a medium time preference for consumptionhave a lower ratio of financial wealth to total and no bequest motive. The sensitivities ofwealth, resulting in higher equity ratios. the results in light of these assumptions areInvestors with college degrees also have a shown in figure 2.higher amount of implicit human capital,and thus a higher equity ratio within their Lower retirement income replacement ratesfinancial wealth. result in higher retirement savings. In addition, the present value of future labourIn conclusion, this shows that realistically income decreases. Both effects imply lowercalibrated labour income processes still equity ratios. If the retirement income ismimic the risk-free asset. For this reason, it stochastic and not deterministic, theis indeed reasonable for investors to investor accumulates higher savings anddecrease equity exposure as they approach has lower equity ratios (not depicted).28
    • IntroductionFigure 2: The impact of further investor-specific characteristicsEquity Ratio 1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 20 30 40 50 60 70 80 90 Age in Years Low Replacement Rate High Risk Aversion Benchmark Correlation High Time Preference Bequest MotiveOptimal lifetime equity ratios for different investor-specific characteristics. The results are themedian over 10,000 simulation paths.A correlation between labour income shocks Conclusionand equity returns can result in much lowerequity ratios, as the investor tries to hedge his With the advent of DC plans in many parts oflabour income risk with reduced equity the world, including Central and Easternholdings. This can even result in equity ratios Europe, individual choice in retirementbelow the Merton solution as shown in Figure savings has become much more important2, where we assume a correlation coefficient than it used to be. A new line of research,of 0.3. As soon as the investor enters the namely behavioural economics and finance,retirement phase, the (correlated) labour directly addresses the issue of how peopleincome risk is no longer relevant and the can handle their new-found freedom ofinvestor strongly increases his equity ratio. choice when it comes to retirement saving instruments. Contrary to traditionalA higher risk aversion has two effects. First, it economics, which sees people as fullyreduces the optimal overall equity ratio. rational agents who use their completeSecond, the investor accumulates more information to maximise self-interest,financial wealth due to buffer stock savings. behavioural finance and economics focusesBoth effects result in lower equity ratios. on how „real“ people make decisions, incorporating insights from psychology intoAn increased time preference for consumption economics. While behavioural approachesresults in decreased savings and higher also acknowledge that people try toequity ratios. If the investor wants to pass his maximise their self-interest, they considerwealth on to his heirs, he is less likely to be rationality to have its limits, leaving peoplehasty in consuming his retirement savings, in a quandary when they are faced withwhich results in a constant equity ratio solving complex problems and processingthroughout retirement. The equity ratio information. Put differently, people are onlybegins to decrease when the investor fears boundedly rational and often achievethat he has to consume the savings he would suboptimal outcomes.otherwise pass on. 29
    • IntroductionBehavioural finance and economics has The lifecycle investment approach is able tocome up with findings that are vital in the protect retirement investors from many ofrealm of asset allocation for retirement the common problems that can have aplans. People usually tend to stick to the negative impact on their retirement income.choices they have made and very rarely Since asset allocation changes dynamicallymake active changes to their contribution and automatically depending on age or onrates or asset allocation. To a high degree, other characteristics that are part of thethe initial choice is to a very high degree presented model, investors can ensure thatinfluenced by what is given as the default their asset allocation suits their needs. Thechoice. Moreover, people tend to rely on past danger of investing in assets that are tooperformance much too strongly and fail to risky or conservative is therefore limited, asproperly consider expected risks and is the likelihood of making ill-informedreturns. They also have a tendency to be decisions.overconfident in their own skills andexcessively optimistic. Kai Fachinger, Dr. Wolfgang Mader risklab germany GmbH30
    • Country Reports
    • BulgariaBulgariaCEE-Style reform and anew occupationalpension pillarShape of the pension system Demographics and macroeconomicsOver the last 12 years, the Bulgarian pension Population [m] 2006: 7.7system has been gradually reformed. The 2050: 5.1first step was taken in 1995, when voluntaryprivate pensions were introduced. From Population over 65 [ %] 16.82000 onwards, parametric reforms in the Dependency ratio * 2006: 24.9first pillar were implemented; the same 2050: 60.9year, a mandatory second pillar system forworkers in hazardous occupations was GDP [EUR] 25.1bnimplemented. It was followed in 2002 by a GDP per capita [EUR] 3,270 (13 % of EU-Ø)mandatory second pillar for all employees. GDP growth 2001–2006 [av. in % p.a.] 5.1In 2006, Bulgaria decided to establish areserve fund to support the financial GDP growth 2007–2012 4.4stability of the first pillar system, which has [av. in % p.a., est.]not yet started operating and will be Unemployment rate [ %] 9.0financed by proceeds from privatisation and Data from 2006 or latest available year50 % of any general budget surplus. On * Ratio of over 65-year-olds to 15–64-year-oldsJanuary 1, 2007, a fourth pension pillarstarted operating that comprises voluntary Pension assets in 2006 amounted to EUR 523occupational pensions and is similar to million in the second pillar and EUR 253those in Western countries. In brief, the million in the third pillar. Until 2015, wesystem now in place is a four-pillar systemwith a public pillar, with mandatory andvoluntary private pensions as well asvoluntary occupational pensions. expect an annual growth rate of around 24 % for second pillar and 20 % for third pillar pension assets. First PillarIn coming years, demographic changestands to become a major challenge for The first pillar – public pensionsBulgaria. Between now and 2050, thecountry’s population will drop from 7.7 to 5.1 The pre-reform system in Bulgaria was amillion, and it is ageing rapidly. While the pure PAYG system, the design of whichcurrent dependency ratio stands at 24.9 %, suffered from various problems. Theby 2050 it will have skyrocketed to 60.9 %, retirement age of 55 for women and 60 forhigher than the 52 % average that has been men was quite low. Employees in variousforecasted for the EU-25. Still, according to occupations could retire even earlier, andthe convergence programme Bulgaria early retirement was used as a means ofsubmitted to the European Union, public cutting the workforce during the transitionpension expenditure is expected to decrease period. Evading social securityfrom 9.1 % of GDP today to 7.9 % in 2050. In contributions was a widespread practise,contrast, the EU-25 average will increase and the dramatic rise in unemployment ledfrom 10.6 % of GDP to 12.8 % over the same to a fall in the number of contributors. Theperiod. link between contributions and benefits32
    • Bulgariawas weak, as pension benefits were based on environments and are meant to make earlythe three best earning years. retirement possible. They are fully-funded, defined contribution schemes with individualTo remedy the situation, the government accounts. Contributions to occupationaldeveloped a reform strategy that was pension funds are made exclusively byimplemented in 2000. Key measures employers and depend on the employee’s jobincluded lowering the overall contribution category. Additional voluntary contributionsrate and gradually increasing employee are not allowed. Contributions and investmentcontributions. The government also decided income are exempt from taxes levied underto gradually raise retirement age – to 60 for the Personal Income Tax Act and thewomen within a 10-year period, and to 63 for Corporate Income Tax Act.men within a 6-year period. In addition,early retirement provisions for special There are different classes of hazardousgroups are set to be phased out by 2010, and occupations with different early retirementthe benefit formula has been changed to rules. Workers receive the occupationalestablish a stronger link between pension until they are entitled to retirement Second Pillarcontributions and benefits. benefits under the public and universal pension schemes. Due to the narrow targetThe current contribution rate is 8.05 % of group, occupational pension funds are notgross income for employees, and employers nearly as widespread as universal pensioncontribute 14.95 %. Benefits are adjusted funds.annually at a rate between the previousyear’s inflation and average real wage Institutional frameworkgrowth. To qualify for a state pension, the Universal pension funds (UPFs) coversum of the person’s age and the number of employees (regardless of their job category)years of participation in the pension scheme and the self-employed. Participation ismust be at least 100 for men and 91 for compulsory for all workers born afterwomen (increasing to 94 by 2010). If length- December 31, 1959; older workers areof-service requirements are not met, the excluded from the system. Universalretirement age is 65 for both men and pension funds are fully-funded definedwomen with 15 years of contributory service. contribution schemes with individual accounts. 5 % of participants’ social securityIn Bulgaria, there is a social and a minimum contributions are redirected to the fundedpension. The social pension is available to pillar, members choose their provider.people aged 70 and over whose annualincome per family member was less than UPFs are independent legal entities createdthe national guaranteed minimum income and managed by a licensed joint stockfor the 12 months preceding retirement. The company, otherwise known as a pensionminimum pension is 115 % of the social insurance company. The same applies topension; the minimum pension is paid to occupational and voluntary pension fundsindividuals with low income and/or an in the third pillar. Each company is allowedincomplete work history. The maximum to manage one universal, one occupationalbenefit from the earnings-related pillar is and one voluntary pension fund only.four times the amount of the social pension. Pension insurance companies are subject to First pillar designThe second pillar – mandatory Contribution rate [ % of gross salary] Employers: 14.95individual accounts Employees: 8.05There are two types of pension schemes in Net replacement rate n.a.Bulgaria’s second pillar: occupational and Legal retirement age 63 men/59 womenuniversal pension funds. Public pension expenditure [ % of GDP] 2005: 9.1Occupational pension funds (OPFs) are 2050: 7.9targeted to employees working in hazardous Data from 2006 or latest available year 33
    • Bulgariaa minimum capital requirement of EUR 2.5 Second pillar statistics 2006 (universal pension funds)million. Since 2005, pension insurancecompanies must have a board of trustees Members 2.4mcomprising an equal number of employer Assets under management [EUR] 523mand trade union representatives plus onemember of the pension insurance company. Number of pension fund providers 8Proposals and decisions made by thetrustees have an advisory function for the pension insurance company managing thepension insurance company. fund is obliged to cover the difference within ten days using reserves that haveContributions to UPFs amount to 5 % of been established specifically for thissalary; the upper earnings limit for purpose. Where the rate of return achievedcontribution purposes is BGL 1,400 (EUR by a universal or occupational pension fund719). The self-employed must pay the entire exceeds the average rate of return by more5 % contribution themselves. Additional than 40 % or exceeds the average by threevoluntary contributions are not permitted. percentage points – whichever of the two figures is higher – the fund must transferInvestment regulations the additional resources to its reserves.Bulgaria regulates mandatory pensionfunds with investment limits and a Disclosure and fee regulationminimum return guarantee. Investment Members must be provided with an annualregulations for mandatory funds are account statement and can requestcurrently under review, and the main limits additional information on details such ascurrently in place are as follows: fees. The maximum management fee for mandatory pension funds is 1 % of assets.· Up to 20 % can be directly invested in equities Moreover, a maximum of 5 % of· A maximum of 15 % can be invested in contributions can be charged as a front-end collective investment schemes fee, and switching fees amount to BGN 20 (EUR 10.3).· No more than 5 % can be invested in property or securities issued by a single company Benefits and withdrawal Benefits are paid as a life-long pension andThe requirement that at least 50 % of fund are based on the capital accumulated in theassets must be invested in securities issued individual account and on life expectancy.or guaranteed by the government was lifted Annuities are paid by the pension fund.in 2006. There is also a limit for internationalinvestments. Pension funds can invest a Asset management and allocationmaximum of 15 % of assets abroad. In 2006, there were eight universal pension funds available on the market, and anotherPension insurance companies are obliged to fund entered the market in 2007. Theseachieve a minimum rate of return when companies also offer funds in themanaging fund assets, which is determined occupational and voluntary pillars. Theby the Financial Supervision Commission at universal pension funds have 2.4 millionthe end of each quarter. The minimum rate members, or almost 82 % of employed people.of return is stated separately for universal The market is concentrated, with the twoand occupational pension funds, and is biggest funds holding 64 % of all assets. Totalbased on the return achieved for all funds of assets in the UPF system stood at EUR 523the same type in the previous two years. The million at the end of 2006.minimum rate of return for each type ofpension fund is 60 % of the average rate of Asset allocation is fairly conservative.return achieved, or three percentage points Government bonds and bank deposits makelower than the average, depending on which up 65 % of pension fund assets. Shares andof the two figures is lower. corporate bonds account for 13 % of assets each. International investments have a shareIf a mandatory fund achieves a rate of return of only 2 %. The asset allocation of mandatorythat is lower than the minimum, the occupational funds is almost identical.34
    • BulgariaUniversal pension fund asset allocation 2006 Bonds issued by public administration: 44% Investments abroad: 2 % Other assets: 1 % Mortgage bonds: 6 % Shares: 13% Corporate bonds: 13% Bank deposits: 21% Third & Fourth PillarSource: OECD, Allianz Global InvestorsTaxation (EUR 24), and participants do not have aEssentially, Bulgaria runs an EEE system in choice of portfolios. Information on thewhich contributions to UPFs (and to value of personal pension accounts isoccupational funds), investment income published every day. The pension fund paysand benefits are exempt from taxes. out benefits either in the form of a lump sum, phased withdrawals or periodic payments.The third and the fourth pillar – Member contributions of up to 10 % ofvoluntary pension savings pensionable income are exempt from personal income tax. The same applies toVoluntary pension funds – employer contributions and investmentthe third pillar income. Benefits used to be taxed, but fromVoluntary private pension funds (VPFs) were January 2007 onwards they are also exemptintroduced in the mid-1990s. They marked within certain limits. Clearly, Bulgaria runsthe first step of a comprehensive pension an EEE system in the voluntary pillar as well.reform program that aimed to increaseprivate pension savings. Voluntary personal While investment regulations for voluntaryschemes are fully-funded defined pension funds resemble those of theircontribution schemes with individual mandatory counterparts, they are slightlyaccounts. Participation currently stands at more generous. The maximum limit for557,000 and assets under management investment property is 10 % rather than 5 %amount to EUR 253 million. There are now and the limit on international investmentsnine pension funds on the market and the is 20 % rather than 15 %. The minimum limitlargest two companies have a combined for government securities of 30 % was liftedmarket share of 75 %. in 2006. Actual asset allocation is as follows: Government securities make up 39 % of assetThe pension fund managing company and allocation, bank deposits account for 23 %,the fund it manages are separate legal shares and corporate bonds for 13 % andentities. Participation is open to all citizens mortgage bonds for 8 %.over 16. Contribution levels are freelydetermined in a contract between the Members can switch their funds once a yearpension fund managing company and the for a fee of BGN 20 (EUR 10.3). There arecontributor (an individual or an employer). several caps on fees. The annualThe average monthly contribution is BGN 47 management fee must not be higher than 1 %, 35
    • Bulgariathe entrance fee may not be higher than BGN Third pillar statistics 2006 (voluntary pension funds)10 (EUR 5.1), performance fees may notsurpass 10 % of the investment return and the Members 566,000front load may not exceed 7 % of Assets under Management [EUR] 253mcontributions. Number of pension fund providers 8Voluntary occupational schemes –the fourth pillarThe latest development in the Bulgarian Fast asset development stems mainly frompension system is the introduction of contributions rather than performance, asvoluntary occupational schemes, which are the market is still in its infancy. Given theset to start operating in 2007. They are very already high participation rate, furthersimilar to occupational schemes in Western growth will mainly come from wageEurope, and coverage is determined by increases. Membership will develop at acollective bargaining agreements or slower pace and will largely depend on newcollective employment contracts. Voluntary labour market entrants.schemes provide benefits in the form offixed-term pensions, lump-sum payments Participation in OPFs is low because of theiror phased withdrawals to participants when narrow focus on people in hazardousthey reach the age of 60, in accordance with occupations. In 2006, there were 192,800the rules stipulated in collective bargaining members in occupational pension funds,agreements or collective employment and assets under management amounted tocontracts. Voluntary occupational schemes EUR 161 million. Growth prospects areare managed by pension fund managing limited due to the small group of targetedcompanies. Benefits are taxed in the same workers.way as under voluntary personal pensions;the same is true for investment and all other Given that wages are expected to increaseregulations. However, at the time of substantially and participation ispublication, there were still no voluntary developing slowly, the future of these twooccupational schemes in operation. mandatory systems looks promising. With a conservative assumption of 5 % average performance, assets under management are expected to reach EUR 3.6 billion by 2015.IORP This scenario implies an average annual volume growth of 24 %. Since there is noThe IORP directive became a part of national indication that contribution rates willlegislation in 2006 and came into force on change and significantly higherJanuary 1, 2007. The main law enabling the participation rates are not realistic, it wouldactivity of IORPs is the Social Insurance not make sense to calculate a second OutlookCode. Additional legislation on technical scenario.provisions and capital adequacy has alsobeen passed. The obligation to make the Third-pillar VPFs had 566,000 members inIORP directive part of national law was the 2006 and EUR 253 million in assets undermain reason that Bulgaria introduced management. As income levels increase, it isvoluntary occupational pension schemes. likely that more people will join, though we assume that new participants will mainly be in the prime of their working lives.Outlook Increasing participation rates and higher wage hikes will support growth in the thirdFuture pension assets pillar pension market. In our projection,UPFs show impressive growth rates. assets under management will reach EURIntroduced in 2002, they covered almost 82 % 1.27 billion by 2015 (+20 % p.a). Given theof the workforce, or 2.4 million participants, by existence of the mandatory system, chancesthe end of 2006. Assets in 2006 stood at EUR for even faster market growth are very523 million, and the contribution rate was limited. This is why we opted not toraised to 5 % of gross salary in January 2007. calculate a more optimistic scenario.36
    • Bulgaria Pension reform in Bulgaria has been Discussions are ongoing in Bulgaria with a gradual, step-by-step process that regard to further funded pillar reforms.has resulted in a four-pillar system with a Topics include relaxing investmentreformed first pillar, a highly accepted restrictions, introducing individualmandatory second pillar, an investment choice in mandatory andunderdeveloped voluntary third pillar and a voluntary pensions and the financing of thebrand new fourth pillar. The introduction of reserve fund. Bulgaria is likely to remain athe fourth pillar with voluntary fast-growing market for asset managers; itoccupational pensions is a very interesting will become even more attractive asexperiment, as it could become a valuable income levels increase.instrument for employee retention, not leastfor multinational companies withoperations in Bulgaria.Bulgaria: Pension assets under managementEURm6,000 4,8894,000 2,1612,000 776 0 2006 2010e 2015e Second pillar assets Third pillar assets Source: Financial Supervision Commission of Bulgaria, own calculations 37
    • CroatiaCroatiaIntroducing reforms inexceptionalcircumstancesShape of the pension system Demographics and macroeconomicsIn the 1990s, the Croatian pension system Population [m] 2006: 4.4underwent similar types of reforms to thoseof most other CEE states. The country 2050: 3.7reformed its first pillar and introduced Population over 65 [ %] 17.2mandatory and voluntary pillars. In the case Dependency ratio* 2006: 25.6of Croatia, these reforms took place in the 2050: 49.6midst of even more dramatic social andeconomic changes than elsewhere in the GDP [EUR] 31.1bnregion. GDP per capita [EUR] 6,989 (28 % of EU-Ø) GDP growth 2001–2006 [av. in % p.a.] 4.6Croatia and its pension system not only hadto cope with the deep structural GDP growth 2007-2012 3.8transformation that came with the [av. in % p.a., est.]transition from communism to capitalism Unemployment rate [ %] 12.6in the early and mid-1990s, but also with the Data from 2006 or latest available yeardisastrous consequences of the war in the * Ratio of over 65-year-olds to 15-64-year-oldsformer Yugoslavia. Apart from human andmaterial losses, the war also led to adramatic increase in the number of the Institute of Economics in Zagreb, publicpensioners and a drop in the size of the pension expenditure will fall (in theactive workforce.The PAYG system in place until 1998 was notable to deal with these shocks due to low baseline scenario) from currently 13.1 % of GDP to 6.3 % in 2050. The EU-25 average will increase from 10.6 % of GDP to 12.8 % over the same period. First Pillarretirement age, a weak link betweencontributions and benefits, and generous Pension assets in Croatia currently add up tobenefits. This is why major pension reforms EUR 2.2 billion in the second and EUR 54were initiated in a gradual, step-by-step million in the third pillar. Until 2015, wemanner. The Croatian government expect to see annual growth of 19 % forimplemented parametric reforms of the second pillar and 24 % for third pillarPAYG system in 1999 and introduced pension assets.mandatory and voluntary pension funds in2002.Demographic development in Croatia is The first pillar – public pensionscomparable to that in the rest of the region.The old-age dependency ratio is projected to The pre-1998 system was purely PAYG. It wasrise from 25.6 % today to 49.6 % in 2050. This organised in three different funds for workers,means that Croatia will be doing only the self-employed and farmers; benefitsslightly better than the forecasted EU-25 differed for each group. What’s more, certainaverage of 52 %. According to a study from groups, among them World War II veterans,38
    • Croatiaformer political prisoners, academics, police The current contribution rate is 20 % of grossand military personnel, enjoyed a privileged salary, paid by employees alone. Minimumstatus; their benefits were determined by a earnings for contributions are HRK 2,270special law. In the late 1990s, almost 200,000 (EUR 309), maximum HRK 37,194 (5,066). Forpeople belonged to these privileged groups. people who joined the mandatory pillar, 5 %Retirement age was low at 60 for men and 55 of contributions are directed into theirfor women. Early retirement was fairly easy individual accounts. For those who had to orand there were various supplements for years chose to stay in the old system, the fullwithout contribution. contribution is used for first pillar pensions. Initially, 10 % of contributions were to be re-The war, economic transformation, directed into the mandatory pillar, but therecession and privatisation put the system amount was reduced to 5 % due to fiscalunder pressure. Between 1990 and 2003, the problems.number of contributors to the system fell byroughly 525,000, whereas the number of “Pensioners’ debt” represents a specialpensioners grew by 360,000. The war added burden that arises from the first pillar. Into these difficulties because of the loss of 1998, the Constitutional Court ruled that thepopulation that it caused and the large state was liable for unpaid pensionnumber of people with disabilities and indexation entitlements for the period ofsurvivor pension beneficiaries that resulted 1993 to 1998. During that time, pensionsfrom it. To make matters even worse, were legally indexed to nominal wages, buteconomic restructuring resulted in governments capped indexation paymentsincreased rates of early retirement. at lower levels. The Court decided that pensioners are entitled to nominal wageThe 1999 reform was the first step towards indexation through mid-1998. The state isintroducing a three-pillar system. That year, liable for up to HRK 13.8 billion (EUR 1.9Croatia reformed the public pillar and billion or 5.75 % of 2006 GDP). In 2005, aaimed at financial sustainability and cost decision was made on how to repay thiscontainment. By 2009, retirement age will debt. Each entitled pensioner will be offeredhave gradually been increased, reaching 65 a choice between payments of half thefor men and 60 for women. The minimum amount in 2006-2007, or full repaymentearly retirement age has also been raised, as from 2008 to 2013. The debt is to be paidhave benefit deductions for early retirement. from privatisation receipts. The IMF estimates that approximately 70-75 % ofOther changes included considering full eligible pensioners would choose the firstworking life as a basis for pension benefits option. If this assumption proves to berather than the 10 best consecutive years (a accurate, repayment could amount to HRKreform being introduced gradually until 2-2.5 billion (EUR 273-342 million, or about2008); eliminating the possibility to retire one percentage point of GDP) in 2006 andregardless of age after 40 years of service for 2007.men and 35 years for women; and replacingthe old pension formula with generousaccrual rates by a point system. The pointsystem establishes a stronger link betweencontributions and benefits by creditingpoints for contributions, which determinethe benefit level. First pillar design Contribution rate [ % of gross salary] Employers: 0A version of “Swiss indexation” is applied inCroatia in which benefits are adjusted every Employees: 20six months according to a joint index based Net replacement rate n.a.on changes to the cost of living and the Legal retirement age 63.5 men/59 womennational average gross salary. Furthermore, Public pension expenditure [ % of GDP] 2005: 13.1the formerly separated funds have beenmerged to form the Croatian Pensions 2050: 6.3Insurance Institute. Data from 2006 or latest available year 39
    • CroatiaThe second pillar – mandatory Second pillar statistics 2006individual accounts Members 1.3mInstitutional framework Assets under management [EUR] 2.2bnThe mandatory second pillar system with Number of pension fund providers 4individual accounts started operating in2002 with defined contribution schemes. Allpeople under 40 at the time of the reformhad to participate. People between the agesof 40 and 50 could choose between staying · 15 % for foreign securities issued in OECDin the old PAYG system and joining the new countries and for bonds issued by OECDsecond tier, while people over 50 had to countriesremain in the old system. · 10 % for corporate bonds and shares issued in OECD countriesSavings in this pillar are created and · 5 % for shares of open domestic investmentadministered by mandatory pension fund funds or foreign investment funds that aremanagement companies that must be primarily invested in bonds issued bylicensed joint stock or limited liability governments of OECD countries, and forcompanies. Managing the pension fund is cash and bank depositstheir exclusive business, and each pensionfund management company may only set up Investing in real estate and derivatives, self-one fund, the assets of which must be kept investment (investing in the pension fundby a custodian. The fund itself is not an management company) and investing inindependent legal entity, but a vehicle to related companies of the pension fundinvest members’ assets. management company is prohibited. Croatia has a limit for internationalPension fund management companies may investments: 15 % of pension fund assets canbe established by Croatian or foreign Second Pillar be invested abroad.natural and legal persons and must belicensed by the Agency for Supervision of Pension fund management companies mustPension Funds and Insurance (HANFA). credit a minimum rate of return to thePension funds must have a management individual accounts. The reference rate ofand supervisory board, whose members return is defined as a weighted arithmetichave to have a certain level of education and mean of all mandatory pension fund averageexperience. Within two years of being rates of return in the previous three years,founded, compulsory pension funds must reduced by two percentage points. Eachhave at least 80,000 members. mandatory pension fund member is guaranteed the rate of return that equals oneInvestment regulations third of the reference rate of return, if theJust like in most other CEE countries, Croatia reference rate is positive. If the reference rateapplies investment limits and a minimum of return is negative, each pension fundrate of return to the mandatory pension member is guaranteed a rate of return thatfunds. A special characteristic of Croatian equals a triple reference rate of return for theregulation is that a minimum of 50 % of last three years. To offset losses if the pensionassets has to be invested in Croatian fund falls below the minimum rate of return,government bonds. Maximum investment it must have a guarantee fund, which islimits include the following: funded with part of the „success“ fee.· 30 % for Croatian shares; for shares of If the fund’s actual rate of return falls below domestic open investment funds; for the minimum rate, the shortfall must be Croatian municipal bonds, for Croatian covered with assets from the guarantee corporate bonds traded on organised fund. If these assets are insufficient, up to exchanges in Croatia 20 % of the pension fund management company’s own capital must be used. If both sources are insufficient to compensate for40
    • Croatiathe low rate of return, the state guarantees pension account’s value during the first yearthe remainder. of membership. The fee is then reduced annually to 2.5 %, 1.25 %, 0.61 % and to finallyDisclosure and fee regulation 0.31 % in the fifth year of membership.Regos, the public institution that collectscontributions and keeps records, must Benefits and withdrawalprovide members with annual information At retirement, the accumulated capital in aon the capital accumulated in their member’s individual account must be usedindividual accounts. The pension fund to buy a life annuity from an authorisedmanagement company itself must publish an pension insurance company of theinformation prospectus annually containing member’s choice. If married at the time ofinformation on the investment strategy, retirement, retirees must opt for jointmembers of the management and survivor annuities (unless spouses havesupervisory board and the amount of capital accumulated their own rights under athat the company holds. The information mandatory private pension scheme).must be provided to members upon request. Annuities must be indexed to prices.Moreover, pension funds have numerousreporting requirements with regard to the Asset management and allocationregulatory authority (HANFA); these include The initial take-up rate of the mandatorydaily portfolio reports as well as quarterly scheme was very high. Between Novemberand annual performance reports. 2001 and the end of 2002, nearly one million people joined the mandatory system. By thePension fund fees are regulated in Croatia. end of 2006, the system had 1.3 millionThere are five types of fees: an entry fee, a participants and assets worth EUR 2.2management fee, an exit fee, a success fee billion. The mandatory pillar now coversand a custody fee. The entry fee can amount 83 % of persons in employment.to a maximum 0.8 % of contributions. Themaximum limit for the management fee was Four mandatory pension funds arereduced from 1.2 % to 0.95 % in early 2007. Exit operating on the Croatian market, and all offees can only be charged during the first them are linked to international financialthree years of membership; the success fee institutions. In terms of members, the twocan at most amount to 25 % of the fund’s real biggest funds share 71 % of all membersreturn. The custody fee that pension funds between them.are charged can be no higher than 0.1 % of themanaged assets. Transaction fees and costs Assets are allocated in a fairly conservativeare charged based on fund assets. way, even considering the restrictive investment limits. 91 % of assets are investedMembers are free to change pension funds, domestically. Of these, over 70 % are investedbut fees discourage switching. Switchers in domestic government bonds, 7 % in open-have to pay a fee of 5 % of their individual end investment funds, 5 % in domesticMandatory pension fund asset allocation 2005 Government bonds: 72% Other assets: 1 % Foreign assets: 9 % Open-end funds: 7 % Corporate bonds: 3 % Cash and deposits: 3 % Shares: 5 %Sources: OECD, Allianz Global Investors 41
    • Croatiashares and 3 % in corporate bonds. Foreign Third pillar statistics 2006 (open pension funds)shares amount only to 1.4 % of assets.Croatian pension funds do not exploit the Members 65,30015 % limit on foreign assets; only 9 % are Assets under Management [EUR] 54minvested outside Croatia. Number of pension fund providers 4TaxationTaxation of the mandatory pension schemeis of the EET type. Contributions andinvestment income are tax-exempt, whereas 53 %. Investment regulation of voluntarybenefits are taxed. The tax allowance for pension funds is very similar to that ofpensioners is 1.7 times higher than for mandatory funds, but slightly more liberal.employees, meaning that pensions are only For example, the limit for internationalmodestly taxed. investments is 20 % rather than 15 %. In geographical terms, voluntary pensionThe third pillar – fund asset allocation is slightly more conservative than that of mandatory funds:voluntary pension savings 94.5 % of assets are invested domestically. Investments in domestic bonds are lowerVoluntary pension funds (51 % of assets) than in the mandatory pillar,Voluntary pension funds were also corporate bonds and open-end fundsintroduced in 2002 and complete the three- account for 12 %, deposits for 6 %. Foreignpillar system. These schemes are DC plans assets (5.5 %) are almost exclusively investedbased on voluntary pension savings. in open-end funds.Voluntary pension schemes are eitheroffered by voluntary pension funds, or can Closed voluntary funds are offered by threebe set up by trade unions and employers, companies, which are also active in themaking open and closed funds possible. mandatory and/or open voluntary pensionVoluntary pension funds need to have at fund market. There are currently 10 closedleast 2,000 members two years after being pension funds with 10,700 members andestablished. HRK 60.3 million (EUR 8.2 million) in net Third Pillar assets.Participants in voluntary schemes benefitgreatly from tax incentives. The stateprovides an annual subsidy of up to HRK1,250 (EUR 171) and allows a tax deduction Outlookof up to HRK 1,050 (EUR 151) per month.Employer contributions are not subject to Future pension assetstax breaks; they are treated like salary At the end of 2006, 1.3 million people hadpayments. Benefits are paid as annuities or joined the mandatory pension funds,as periodic payments. Contrary to the representing almost 83 % of Croatia’smandatory pillar, voluntary pension fund workforce, and assets stood at EUR 2.2companies can offer more than one fund. billion. Given the high participation rate, further growth will mainly come from wageThere are currently six open pension funds on growth; membership will increase at a slowthe market, provided by four pension pace and depend on new labour marketcompanies. Voluntary pension companies entrants.overlap strongly with the mandatory pillar;three of the four pension companies offering In our projection period, assets undermandatory funds also provide voluntary management in the second pillar arefunds. 65,300 members participate in expected to reach EUR 10.2 billion based onvoluntary pension funds, which have assets of the conservative assumption of 5 % averageEUR 54 million under management. The two performance (the rate of return was 5.3 % inbiggest voluntary funds have a market share 2005). In this scenario, volumes willof 80 %; the biggest fund alone has a share of increase by 19 % p.a. until 2015. An42
    • Croatia Outlookalternative scenario would not be useful, as With its three-pillar pensionthere is no indication that contribution rates system, Croatia has followed thewill be changed or that participation will CEE pension reform trend. Repayingincrease significantly. pensioners’ debt is an ongoing burden that will continue in years to come.The voluntary pension pillar, excluding Participation in the second pillar – someclosed funds, had 65,300 members in 2006 population groups were given the choice ofand EUR 54 million in assets under joining – is remarkably high. The numbersmanagement. While participation is very for the third pillar are less impressive, butlow, this could change as income levels this might change with growing wealth.increase. Our projection assumes that only a Regarding investment regulations, thesmall group of people, mainly those aged 25 requirement that at least half of the assetsto 54 in the prime of their working lives, will must be invested in Croatian governmentsave an extra portion of their income and bonds could lead to suboptimalbuy third pillar products. The voluntary geographical diversification and asystem will therefore be slow to develop. In concentration of risks according to capitalour projection, assets under management market theory.will reach EUR 363 million by 2015, whichimplies a CAGR of 24 %. Calculating a second In terms of market attractiveness,optimistic scenario would not make sense, Croatia has the biggest pension marketas it is unlikely that markets will grow any among the smaller CEE markets, and thefaster given that large parts of the fourth largest pension market in thepopulation rely on the other pillars. region. It will therefore remain an attractive market with considerable growth potential.Croatia: Pension assets under managementEURm12,000 10,52710,000 8,000 6,000 5,063 4,000 2,212 2,000 0 2006 2010e 2015e Second pillar assets Third pillar assets Source: Croatian Financial Services Supervisory Agency, own calculations 43
    • Czech RepublikCzech RepublicDoing without a fundedpillarShape of the pension systemAlong with Slovenia, the Czech Republic isthe only country in Eastern Europe that has Demographics and macroeconomicsnot established a funded second pillar. It Population [m] 2006: 10.2runs a two-pillar system with a public PAYGpension system in the first pillar and a 2050: 8.9voluntary supplementary pensions pillar, Population over 65 [ %] 14.1which is comparable to the third pillar in Dependency ratio* 2005: 19.8other CEE and Western European countries. 2050: 54.8The Czech Republic very quickly reformed GDP [EUR] 117bnits pension system after the fall of the Iron GDP per capita [EUR] 11,450 (47 % of EU-Ø)Curtain. A few months after the collapse of GDP growth 2001–2006 [av. in % p.a.] 4.3the communist regime, it started to reformits PAYG system. The foundation of the GDP growth 2007–2012 4.3current system was laid in 1989. This was [av. in % p.a., est.]followed by major reforms in 1996 that Unemployment rate [ %] 7.1marked the beginning of an ongoing Data from 2006 or latest available yearprocess of parametric reforms in the first * Ratio of over 65-year-olds to 15– 64-year-oldspillar. Voluntary supplementary pensionswere introduced in 1994 and now cover 45 %of the workforce. Pension assets in the Czech Republic’s thirdThe Czech Republic faces one of the mostsevere demographic challenges among OECDand EU countries; its dependency ratio willrise from 19.8 % today to almost 55 % by 2050. At pillar currently total EUR 5.3 billion, and we expect annual growth between 14 % and 19 % until 2015. First Pillarthe same time, contribution rates to the publicpension system are among the highest in theOECD. The Czech Republic’s public pension The first pillar – public pensionsexpenditure is 8.5 % of GDP, which is lowerthan the EU-25 average of 10.6 %. However, it is The first pillar, which comprises basicexpected to increase substantially and reach pension insurance, is a defined benefit PAYG14.0 % by 2050, compared with 12.8 % for the system that covers employees and the self-EU-25. To cope with these challenges, the main employed. The scheme is administered bypolitical parties developed proposals for the Czech Social Security Administrationfurther pension reform in 2005. These (CSSZ). In its current form, the system wasproposals differed substantially from one introduced by the Pension Insurance Act,another and covered the whole range of which entered into force on January 1, 1996.reform patterns found in OECD countries, Since then, a number of changes has beenfrom parametric reforms to introducing initiated, among them the gradualnotional accounts. However, due to political extension of the periods used to determinedeadlock, substantial changes are not to be pensionable earnings – from five years inexpected anytime soon. 1996 to 30 years by 2016.44
    • Czech RepublikFurther reforms ensued in the years that low level. The relative poverty risk for peoplefollowed. In 1997, the government cut aged 65 or more is only 22 % of the EU-25eligible periods for non-contributory average. This is because the system focusespensions and incentives for early on providing adequate old-age income. Theretirement, which were further decreased in net replacement rate of the first pillar is 79 %a 2001 reform. A 2003 reform implemented a for average earners.gradual increase in retirement age to 63 formen and women without children; the In response to future fiscal pressureincreases will be reached in 2016 and 2019, resulting from demographic change, allrespectively. At the moment, retirement age major political parties have developedis 61 years and 8 months for men, and it pension reform proposals. Their mainranges between 56 years and 4 months and suggestions include introducing a system of60 years and 4 months for women, notional accounts, introducing a mandatorydepending on the number of children second pillar similar to those in other CEEraised. countries, further parametric reform of the existing system, flat rate pensions and anThe contribution rate for the public pension „add-on“ DC system. All parties suggested Third Pillarsystem is 28 % of gross income, up from 26 % raising the retirement age, but at veryin 2004; this increase was offset by a decrease different rates. The proposals have been onin contributions to funds dedicated to active the table since 2005, but political deadlocklabour market policy. Employers contribute after the general elections in mid-2006the equivalent of 21.5 % of gross salaries, and made forming a new government a ratheremployees pay 6.5 % of their income. The self- cumbersome endeavour. Given that it tookemployed contribute 28 % of their income more than seven months to build athemselves. There is no ceiling, and coalition, fundamental pension reforms arecontributions are calculated based on the not to be expected in the short-term. Atfull wage. present, the new government is proposing another retirement age increase, while otherThe public scheme has two components: A sensitive issues have been put on theflat-rate basic pension and an earnings- backburner.related part. The flat-rate part is a basicpension for all entitled citizens and currentlyamounts to CZK 1,470 (EUR 52). The earnings- The third pillar – voluntaryrelated component has a redistributivecharacter. The first CZK 9,100 (EUR 321) per pension savingsmonth are fully replaced, the income portionbetween CZK 9,100 and 21,800 (EUR 770) is Institutional frameworkreplaced at 30 %, and the replacement rate is Introduced in 1994, the Czech Republic’s10 % for any amount beyond that. Since 1996, third pillar got off to a slow start. In order topensions have been indexed annually in line push voluntary pension savings, thewith inflation (consumer price index), plus government enhanced tax incentives andone-third of the real wage increase from theprevious year.Pensions are only taxed from a sum that isfour times higher than the normal tax-free First pillar designallowance for workers. In 2005, the minimum Contribution rate [ % of gross salary] Employers: 21.5old age pension was CZK 2,240 (EUR 75) amonth, which was made up of CZK 1,470 from Employees: 6.5the basic component and CZK 770 from the Net replacement rate [ % of last income] 79minimum earnings-related component. Over 61.8 men/56.4–60.499 % of Czech pensioners receive more than Legal retirement age womenthe minimum pension. Public pension expenditure [ % of GDP] 2005: 8.5This strongly redistributive system has 2050: 14.0managed to keep old-age poverty at a very Data from 2006 or latest available year 45
    • Czech Republikstate subsidies in 1999. The voluntary Third pillar statistics 2006supplementary pension scheme is run bypension companies that offer DC plans Members 3.3mexclusively. The pension companies are joint Assets under Management [EUR] 5.3bnstock companies, incorporated in the Czech Number of pension fund providers 10Republic under the provisions of theCommercial Code. The purpose of pensioncompanies is limited to providingsupplementary pension insurance. Pensioncompanies must be licensed by the Ministry the currency in which liabilities forof Finance (in agreement with the Ministry participants are stated. Compliance to thisof Labour and Social Affairs and the rule can be achieved by hedging. ASecurities Commission). maximum of 70 % of assets can be invested in bonds from a single OECD state, from aPension companies are not authorised to single OECD central bank or fromoffer more than one pension plan. In the international financial organisations ofCzech Republic, there is a single legal entity which the Czech Republic is a member.combining members’ contributions andpension companies’ assets. This is unlike Besides quantitative restrictions, Czechmost other countries that have defined regulations stipulate that pension fundscontribution schemes with individual must generate a positive return every year. Ifaccounts, which require an asset they miss this target, the losses must bemanagement company to be separated from covered by the reserve fund – formed witha fund that holds member contributions. 5 % of the pension company’s profit – andCurrent regulation does not separate further funds must be created from thepension company shareholders’ assets from fund’s profits. This means that members arepension holder contributions, neither from a sheltered from losses as long as the pensionfinancial nor a legal perspective. fund does not become insolvent. The downside of this regulation is that assetInvestment regulations allocation is necessarily very conservativeInvestment regulations in the Czech with low returns. For example, betweenRepublic have two main components: 2001 and 2005, the average investmentportfolio allocation is regulated, and return of pension funds was 3.7 %. Long-positive returns must be generated every term strategies, which accept short-termyear. Maximum investment limits losses in the interest of better long-termdetermine that a maximum of 10 % can be performance, are not possible under thisinvested in real estate, in bank deposits and regulation.in securities issued by a single issuer.Investing in loans is not permitted. There is Disclosure and fee regulationno limit on investment in bonds, and the The minimum monthly contribution to a25 % limit on equity investments was pension fund is CZK 100 (EUR 3.5). Ifcompletely lifted in 2004. Other regulations participants have joined the system, theyinclude a maximum limit of 10 % for can switch pension funds without charge byinvestment in a single property or movable giving two months’ notice. The fund has toasset. publish information on its financial performance, asset allocation,When it comes to international investments, contributions and balance twice a year. FeesCzech regulations do not foresee any legal are not regulated.restrictions. However, foreign investment ispermitted only for securities traded in OECD Benefits and withdrawalmarkets. There is no limit placed on The minimum age at which payments caninvestment in euro-denominated products, be received from a pension fund is 60, underas long as the fund complies with the the condition of a minimum number ofgeneral restrictions set out in the law. contributory years determined by eachNevertheless, at least 70 % of total assets fund. Money can be withdrawn as a lumpmust be invested in assets denominated in sum or in the form of annuities. Most46
    • Czech Republikbenefits are paid as lump sums; when since 1999 and is insufficient to pay outannuities are paid out, the pension fund reasonable amounts of life annuities; this is adoes so itself. If members wish to withdraw major challenge for Czech pension policy.money from the account before the setminimum age, state grants have to be A sizeable number of employers makerepaid and payments are subject to contributions on behalf of their employees.additional taxation. Around 27 % of all employers make contributions, on average CZK 4,800 (EURAsset management and allocation 170) per year and employee. ForeignWhile 44 pension fund companies were multinational companies operating in theinitially registered in the Czech Republic, Czech Republic are more inclined to paythe market for pension funds has been voluntary contributions: around 50 % ofconsolidating over the past decade, just as them do so.it has in other CEE countries. Today, thereare 10 pension companies operating in the Contrary to other CEE countries, where oldercountry that hold EUR 5.3 billion in assets. people cannot take part in the mandatory3.3 million participants are enrolled in system, the average age of participants inthese plans. The majority of the pension the Czech voluntary pension is high.funds is run by international financial Participants aged 60 and over account forservices providers. 20 % of all members, and 28 % are aged between 50 and 59. In general, the age groupIn light of the requirement to generate between 40 and 59 represents 52 % of thepositive investment performance every year, Czech Republic’s population.Czech pension funds allocate assets in avery conservative manner. 82 % of assets are Czech pension funds compete with lifeinvested in bonds, 7.9 % in cash and deposits insurance companies, as there are also taxand 7.6 % in shares. incentives for life insurance products on the condition that policies are taken out for atAlthough membership in the Czech least 5 years and are paid out after the age ofRepublic’s voluntary pension funds is fairly 60. Employers can deduct their premiumshigh, the contribution level is low. On average, up to CZK 8,000 (EUR 292). These are notemployees pay contributions of CZK 5,700 subject to social security contributions;(EUR 201) per year, roughly 2 % of the average employee contributions are tax-deductiblesalary. This figure has remained the same up to CZK 12,000 (EUR 424).Voluntary pension fund asset allocation 2005 Bonds issued by public administration: 82% Cash and deposits: 8 % Shares: 8 % Lands and buildings: 1 % Other assets: 1 %Sources: OECD, Allianz Global Investors 47
    • Czech RepublikTaxation growth and investments in housing areTax breaks were introduced in 2000 as a widespread.means of encouraging retirement savings.Employers can deduct their contributions Czech households keep the bulk of theirup to 3 % of an employee’s assessment base. financial assets in deposits. The contributionEmployer contributions of up to 5 % of wages of bonds and shares to asset formation is low.are exempt from income tax for the This could be the result of problemsemployee. This contribution is not associated with the privatisation process inconsidered part of the member’s income, the 1990s, which may have discouragedboth for income tax purposes and for people from making equity investments. Thecalculating social security contributions. importance of equity in household assets has fallen in recent years despite an increase inThe state matches employees’ contributions share prices. In contrast, the share ofdepending on their level. For annual insurance and pension products is growing,member contributions between CZK 1,200 to amounting to 12 % in 2004. Although life2,400, the state adds CZK 600 plus 40 % of the premiums only grew by 1.5 % in 2005, themember contribution above CZK 1,200. If the market has considerable potential. Lifepension plan member contributes between premiums in the Czech Republic currentlyCZK 2,400 and 3,600, the allowance is CZK account for 1.5 % of GDP. While this is the1,080 plus 30 % of the sum above CZK 2,400. second highest figure in CEE, it is 4.1The allowance increases gradually, with the percentage points below the EU-15 average.highest allowance set at CZK 1,800 formember contributions above CZK 6,000. If a Future pension assetsparticipant contributes more than CZK Membership in the voluntary system has6,000 a year, he can deduct the contributions exceeded all original expectations. Almostpaid in excess of CZK 6,000 from his tax base 3.3 million Czechs – 45 % of the workforceup to a limit of CZK 12,000 a year. and a third of the country’s population – currently have a private pension plan. InParticipants’ contributions are paid from 2006, assets under management amountednet wages. Investment income is taxed at to EUR 5.3 billion.15 %, as are lump sum payments andannuities. Early withdrawals are subject to a In the coming years, further growth will25 % tax. mainly result from wage increases and possibly from higher contributions and/or membership rates. In the conservative scenario, assets under management areIORP expected to reach EUR 17.5 billion based on the assumption of 5 % average performance.The IORP directive has only been partially In this scenario, volumes will increase byimplemented. For this reason, the European Outlook roughly 14 % p.a. in the projection periodCommission started legal proceedings ending in 2015. The optimistic scenarioagainst the Czech Republic in October 2006, could boost the volume to EUR 24.8 billionsending a letter of formal notice to the Czech (+19 %). Assuming that the currentgovernment. discussion about pension reform leads to a growing awareness among Czech citizens that higher private pension savings areOutlook necessary, we expect the optimistic scenario to be more realistic.Current household asset allocationIn 2004, financial assets totalled EUR 72 The Czech Republic’s two-pillarbillion, or 79 % of GDP. Per capita financial pension system is an exceptionwealth has reached roughly EUR 7,600, the among Eastern European countries.third highest figure in the CEE countries Whereas other countries without aand about 13.5 % of the EU-15 average. mandatory second pillar – Lithuania andProspects for further growth are moderate, Slovenia – run a voluntary second or anas average wage growth lags behind GDP occupational pillar, the Czech Republic48
    • Czech Republikrelies exclusively on voluntary third pillar of the largest and wealthiest countries insavings as a supplement to the state pension CEE makes it an attractive market for assetsystem. Given the massive demographic managers. This will still be true if assetchallenges that the Czech Republic will face growth rates do not keep up with other CEEin the next decades, it is doubtful that the countries due to the lacking mandatorycurrent form of pension provision will funded system. Even if major pensionsuffice. Several proposals for pension reform reforms take some time, small-scaleare on the table, and the fact that every party reform is likely to continue. The reformscame up with a proposal is a step forward being discussed include removing thethat could mark the beginning of significant guarantee of annual positive returns in thereforms in the medium-term. third pillar, introducing ways of encouraging employers and employees toDespite uncertainties surrounding pension save more and achieving higher employerreform, the Czech Republic’s status as one involvement.Czech Republic: Pension assets under managementEURm30,000 24,77420,000 17,466 12,161 9,62510,000 5,263 0 2006 2010e min. 2010e opt. 2015e min. 2015e opt. Third pillar assets Source: Association of Pension Funds of The Czech Republic, own calculations 49
    • EstoniaEstoniaA small market withliberal regulationsShape of the pension systemEstonia’s economic performance has beenimpressive in recent years. In 2005 and 2006, Demographics and macroeconomicsGDP grew by more than 10 %. In the EU-27, Population [m] 2006: 1.3only Latvia has had a comparable economicgrowth rate. Until the country’s 2050: 1.1independence in 1990, the Estonian pension Population over 65 [ %] 16.5system was part of the Soviet system. The Dependency ratio* 2006: 24.1most important pension reforms were 2050: 43.1initiated in the late 1990s and have sincethen proceeded gradually. In 1998, voluntary GDP [EUR] 13.1bnsupplementary pensions were introduced; GDP per capita [EUR] 9,745 (40 % of EU-Ø)the first pillar was modernised in 1999/2000 GDP growth 2001–2006 [av. in % p.a.] 8.0and the mandatory pension pillar waslaunched in 2002. GDP growth 2007–2012 5.8 [av. in % p.a., est.]Demographic developments are less Unemployment rate [ %] 5.9dramatic in Estonia than in other CEE Data from 2006 or latest available yearcountries and the EU as a whole. Although * Ratio of over 65-year-olds to 15– 64-year-oldsthe dependency ratio will worsen from24.1 % to 43.1 % in 2050, the figure is ninepercentage points lower than the EU average flat rate national pension amounted to EEDforecast for the same year. Public pension 1,269 (EUR 81) per month in 2005. Adjustedexpenditure is expected to decrease from6.7 % of GDP to 4.2 % in 2050. The current EU-25 average is 10.6 % and will increase to12.8 %. annually by Parliament, the flat rate is payable to everyone regardless of the number of contribution years. In contrast, the full pension is linked to the employee’s First Pillar length of service before 1999 andIn 2006, Estonian pension assets in the contributions paid after 1999. To qualify forsecond pillar amounted to EUR 475 million. a full pension, an employee must haveAccording to our estimates, they will grow worked in Estonia for a minimum of 15by at least 25 % p.a. until 2015. Third pillar years. The full pension is indexed annually,assets stand at EUR 49 million, and are based on consumer price increases andexpected to grow by 13 % per year until 2015. social contribution revenues. Estonian pensions are financed by socialThe first pillar – public pensions contributions of 22 % of gross salaries; employers pay 20 %, employees 2 %. InThe first pillar is a PAYG defined-benefit addition to this, employers must pay 13 %scheme with universal coverage. It is contributions for health insurance. Thecomposed of two different schemes: a flat retirement age is 63 for men and 59.5 forrate national pension, which is meant to women, though it will be raised to 63 forguarantee a minimum pension, and an both by 2016. Early retirement is possibleearnings-related full pension scheme. The three years prior to legal retirement age, but50
    • Estoniais discouraged by a 0.4 % pension reduction First pillar designfor every month taken. Deferred retirement,on the other hand, is encouraged with a 0.9 % Contribution rate [ % of gross salary] Employers: 20increase for every month worked beyond the Employees: 2legal retirement age. Net replacement rate 41 Legal retirement age 63 men/59.5 womenThe second pillar – mandatory Public pension expenditure [ % of GDP] 2004: 6.7 2050: 4.2individual accounts Data from 2006 or latest available yearInstitutional frameworkThe pension plans in the second pillar areDC schemes. Participation is mandatory for · Conservative funds with no equityemployees born in 1983 or later; workers exposure and a 100 % share of bond andborn between 1942 and 1982 can choose money market instrumentswhether to remain in the state-run social · Balanced funds with up to 25 % of equitiessecurity system or to join the mandatory and at least 50 % bonds and money marketpillar. Once the decision to join has been instrumentsmade, it is irreversible. Workers older than · Progressive funds with an equities limit of60 cannot join the system. up to 50 % and no limit on bond and money Second Pillar market instrumentsIndividual accounts are managed byspecialised pension fund managing Members are free to choose the pensioncompanies. These companies are private fund that suits them best regardless of theirinstitutions with the exclusive aim of age, but can only be members of one fund atadministering their members’ accounts, a time.managing pension funds as well as grantingand administering benefits. The pension Besides investment regulations for thefunds themselves have no legal personality; respective funds, there are investmenttheir assets must be held independently from limits on certain instruments. The mainthe resources of the managing company. maximum investment limits are as follows:When Estonia implemented its second pillar · 40 % in real estate or real estate fundsmandatory accounts in 2002, it took adifferent approach than other CEE · 35 % for securities issued and guaranteedcountries. Most other CEE used a carve-out by the Estonian government, a Europeanmethod through which contributions were Union member country or states with asplit between the first and second pillars. similar risk profileEstonia also used this method, but · 30 % for investment funds of companiesintroduced employee contributions on top, belonging to the same group as themaking it the only country with higher pension management companycontribution rates after pension reform. · 10 % for investments in fixed assetsParticipants in the second pillar nowcontribute 2 % of their gross salary, whereas · 5 % for securities issued by the same group;employers contribute 4 % (out of their 20 % for securities issued by a single investmentpension contributions). fund; for the pension management company’s investment funds and for depositsInvestment regulations at credit institutions of the same groupPension fund managing companies canoffer more than one fund, provided that Second pillar statistics 2006investment policies differ significantly andthat one of these funds is invested in fixed- Members 517,000income products only. Three types of funds Assets under management [EUR] 475mwith different risk/return characteristicsare on offer and admissible: Number of pension fund providers 5 51
    • EstoniaRegulations concerning international Pension plan members tend to prefer theinvestments are distinctly liberal. There are higher-risk variant to balanced andno limits on investments in the European conservative pension funds. Over 75 % haveEconomic Area, OECD countries and certain chosen the progressive fund, while only 15 %other countries. have opted for the balanced fund and 10 % have selected the conservative fund. ThisDisclosure and fee regulation preference can be considered an outcome ofShould members request them, pension favourable stock market development asmanagement companies must provide well as of the participants’ age structure –annual and bi-annual reports on the almost 70 % are under 40. Similarly, thepension fund in which they invest. Members majority of progressive fund members arecan also request account statements at least younger: 80 % are under 40, 16 % are betweenonce a year. The fee levels that pension funds 40 and 50 and only 4 % are over 50.are allowed to charge are regulated. Thereare two types of fees: Overall asset allocation for mandatory funds shows the impact of the preference for riskier Third Pillar· The unit redemption fee, which is funds. In 2006, 37 % of assets were invested in calculated as a percentage of the net asset equities or equity funds, 42 % were allocated value of redeemed units, can amount to a to bonds and 12 % were placed in units of non- maximum of 1 % equity investment funds.· The management fee, determined as a proportion of the market value of pension Taxation fund assets, has a maximum limit of 2 % Estonia has an EET system in place. Contributions and investment returns areA third type, the unit issue fee, was tax-exempt. Benefits from the first andabolished in 2007. second pillars are tax-exempt up to EEK 5,500 (EUR 320). Beyond this threshold, benefits areSwitching between the funds of a pension taxed at the normal income tax rate.fund managing company and changing toanother company is possible, but limited toonce a year. There are no switching fees as The third pillar – voluntarysuch, but a unit redemption fee must be paid. pension savingsBenefits and withdrawal Voluntary pension fundsThe first benefit payments will commence Voluntary pension funds were introduced inin 2009. Benefits are paid out as life 1998 and can take two forms: pensionannuities, or – if the accrued rights amount insurance policies provided by life insuranceto less than a quarter of the national flat rate companies or voluntary pension fundspension – as programmed payments. managed by asset managers. Public policyAsset management and allocationThere are five pension fund management Mandatory pension fund asset allocation 2006companies in Estonia that offer 15 funds inthe mandatory pillar (six conservative, three Bonds: 42 %balanced, six progressive). The two largest Other assets: 1 %companies count 80 % of members and 70 %of the assets. By the end of 2006, 517,000 Money market: 3 %employees were enrolled in the second Other investmentpillar, which corresponds to roughly 80 % of funds: 12%the workforce. Given that it was justimplemented in 2002, the new system’s Equity funds: 23%growth and acceptance are impressive. Equities: 14%Assets under management amounted to Cash and deposits: 5 %EUR 475 million in 2006. Sources: OECD, Allianz Global Investors52
    • Estoniadoes not promote occupational pension Third pillar statistics 2006provision. Employers can make contributionsfor their employees in the third pillar, but Members 24,000unfavourable tax treatment is an obstacle. Assets under Management [EUR] 49mEmployees, on the other hand, are given tax Number of pension fund providers 4incentives to participate. Contributions canbe deducted from taxable income up to 15 % Outlookof the annual income. What’s more, pensionbenefits are taxed at the reduced rate of 10 %. Current household asset allocationBenefits can be paid out in a variety of In 2005, financial assets in Estonia totalledforms, ranging from lump sums to life EUR 11 billion. This amounts to 100 % of GDP,annuities. Life annuities are exempt from which is the highest value in CEE, but is wellincome tax, provided that they are paid below the EU-15 average of 215 %. Prospects forperiodically in equal or increasing amounts. financial asset growth are good because ofInvestment income is not taxed. strong income growth at almost all levels. However, the current saving rate in EstoniaInvestment restrictions for voluntary stands at -1.1 %. This negative rate can partiallypension funds are not as strict as those for be explained by the fact that investments inmandatory funds. For example, there are no financial assets are competing strongly withmaximum limits for equity investments real estate investments.and there are no limits for securities issuedby low rating issuers. Limits for securities by Estonian households keep the bulk of theira single issuer and real estate investments financial assets in stocks and investmentare also less strict. Fees for voluntary funds – a result of the privatisation process.pension funds are not regulated, but there Insurance and pension products are not yetare certain information requirements. significant saving instruments. In 2004, they accounted for just 4 % of total financial assets.At present, four pension fund management But their share should grow fast as thecompanies offering 15 voluntary pension volume of pension assets increases. Fromfunds are operating in Estonia. Employees 2004 to 2005, life premium growth rates incan also choose from 11 pension insurance Estonia reached 60 %, which can partially beproducts. Participation in the voluntary attributed to a very low starting level. Givenpension funds remains low. They counted strong economic development, however, this24,000 members at the end of 2006, indicates the start of a catching up process.representing 4 % of employees. In 2006, Currently, the market penetration of life75,000 people purchased life insurance. premiums in Estonia represents only 0.77 % ofVoluntary pension fund assets under GDP. In contrast, penetration in Westernmanagement currently stand at EUR 49 European countries is around 5 %. Outlookmillion. 38 % of assets are invested in equityfunds, 26 % in equities, 15 % in bonds and 12% Future pension assetsin non-equity investment funds. In 2005, 517,000 subscribers had registered to second pillar pension funds. This coversAssets can only be withdrawn after the age of more than a third of the population and55. If members withdraw their assets before roughly 80 % of employed people. Pensionretirement, income tax advantages are lost. assets in the mandatory second pillar amounted to EUR 475 million by the end of 2006. The high participation rate marks theIORP end of the fast growth period during which the quickly increasing number of membersEstonia has implemented the IORP directive. and high wage growth fuelled the pensionSince there are no occupational pension market. Market growth was 76 % in 2005,schemes operating in Estonia, the directive’s mainly a result of double-digit wage growthmain impact will be that foreign IORPs can at almost all income levels and decliningoperate in the country. unemployment among younger workers. 53
    • EstoniaThis growth process will inevitably slow 2015 (+13 % p.a). The optimistic scenariodown in coming years. Further development foresees EUR 198 million (+17 % p.a.).will be based mainly on wage increases,which are expected to remain high for the Pension reform in Estonia is widelynext five years as the economic outlook considered to be a success. Theremains positive. In the minimum scenario, extraordinarily high participation rate inassets under management are expected to second pillar pension funds is evidence ofreach EUR 3.44 billion based on the this, as most people could choose whether orconservative assumption of 5 % average not to join. In terms of public finance, theperformance. Even in this scenario, volumes system is also well-balanced and will remainwill increase by roughly 25 % p.a. in the sustainable in the decades to come.projection period until 2015. The optimistic Transition costs are moderate, and accordingscenario could boost the volume to EUR 4.3 to the EU, additional subsidies are onlybillion, which would imply a CAGR of 28 %. required until 2012. Future challenges for theGiven the preference for real estate first pillar include preventing old-ageinvestments at the expense of financial poverty, as replacement rates are fairly lowsavings, the minimum scenario seems more and the national pension and other benefitsrealistic. do not necessarily keep retirees above the poverty line.As mentioned, participation is low in thethird pillar, reaching roughly 4 % of the The huge success of the second pillar has ledworkforce. Assets under management stood to a rapid build-up and impressive growthat EUR 49 million at the end of 2006. With rates. As the system matures, however,increasing income, more people may join growth is likely to slow down. The biggestthe voluntary pension scheme. For our challenge for the second pillar is designingprojection, we assumed that people would the benefit phase currently under discussioncontinue to contribute only a small portion and starting in 2009. As seen, pension fundof their income, and that mainly people with regulation in Estonia differs from other CEEhigh income levels in the prime of their countries. There are no minimumworking lives will set more money aside for guarantees and almost no restrictions onretirement. In brief, growing participation international investment; funds withrates and high wage increases are likely to different risk/return profiles can be provided.develop the third pillar pension market in Estonia is not a big market for asset managersthe future, but at low volumes. In the due to the size of the country, but it isminimum scenario, assets under certainly a market with innovative regulatorymanagement will reach EUR 146 million by approaches.Estonia: Pension assets under managementEURm5,000 4,5434,000 3,5893,000 1,9522,000 1,5961,000 524 0 2005 2010e min. 2010e opt. 2015e min. 2015e opt. Second pillar assets Third pillar assets Source: Financial Supervisory Authority of Estonia, own calculations54
    • HungaryHungaryPension reform pioneerShape of the pension systemHungary is Eastern Europe’s pension reformtrailblazer. In 1998, it was the first country tointroduce a mandatory second pillar with Demographics and macroeconomicsindividual accounts. It also restructured its Population [m] 2006: 10.1first pillar PAYG system substantially andintroduced voluntary individual schemes in 2050: 8.91994. In so doing, it followed the World Bank Population over 65 [ %] 15.7model of pension reform very closely and set Dependency ratio* 2006: 22.7a standard for other CEE countries. Morerecently, in 2006, it introduced a fourth 2050: 48.3pillar that consists of voluntary individual GDP [EUR] 93.6bnretirement accounts and aims at GDP per capita [EUR] 9,290 (38 % of EU-Ø)broadening investment opportunities andencouraging more retirement savings. GDP growth 2001–2006 [av. in % p.a.] 3.8 GDP growth 2007–2012 3.1Hungary faces demographic change quite [av. in % p.a., est.]similar to that in other CEE countries. Unemployment rate [ %] 7.5Between now and 2050, its population will Data from 2006 or latest available yeardrop from 10.1 to 8.9 million people. At the * Ratio of over 65-year-olds to 15– 64-year-oldssame time, its dependency ratio willincrease from 22.7 % to 48.3 %. The EUaverage will be 52 % at that time. Publicpension expenditure will increase sharplyfrom today’s 10.4 % of GDP to 17.1 % in 2050. The first pillar – public pensionsThis means that while Hungary is currentlyin line with the EU-25 average of 10.6 % ofGDP, its pension expenditure in 2050 will bemuch higher than the projected EU-25 The public pension system is a PAYG, defined-benefit scheme that covers all First Pillaraverage of 12.8 % of GDP. employees and the self-employed. Reforming the public pillar in the mid-1990sSince mandatory pension schemes were was urgent not only because of demographicintroduced early and were widely accepted development, but also due to financialfrom the outset, Hungary is now the second pressure on the pre-reform, pure PAYGbiggest pension market in the region, with system. The financial pressure stemmedEUR 5.9 billion assets under management in from generous benefits and lax eligibilitythe mandatory pillar and EUR 2.7 billion in rules. High unemployment, early retirementthe voluntary pillar. Mandatory pension policies and evasion resulting from one ofassets will grow by 20 % p.a. until 2015, and the world’s highest contribution rates alsovoluntary pension assets are expected to played an important role.grow between 15 % and 18 %. Before the reforms of the 1990s, Hungarian pensions were calculated as a percentage of a reference wage, which benefited low-wage earners and had a strong redistributive impact. Reforms in 1995 increased the 55
    • Hungaryretirement age from 60 for men and 55 for First pillar designwomen to 62 for both sexes (for men by 2002,for women by 2009). In order to be eligible to Contribution rate [ % of gross salary] Employers: 18receive a pension, a contribution history of Employees: 8.5at least 20 years is also required. From 2013 Net replacement rate 102onwards, the link between contributionsand benefits will be made stronger by Legal retirement age 62 men/61 womenintroducing linear accrual rates in the Public pension expenditure [ % of GDP] 2004: 10.4pension formula. This measure aims to 2050: 17.1enhance transparency and provide the Data from 2006 or latest available yearworkforce with incentives to work longer.When the mandatory second pillar wasintroduced in 1998, it was made compulsory pension from the first pillar, a partialfor new labour market entrants under the pension is paid after 15 contributory years.age of 42. Existing employees were given the In 2004, the minimum pension amounted tooption of voluntarily joining the mandatory 40 % of the average old-age pension.tier, and about 50 % of the labour force optedin. Those who chose not to participateremain enrolled in the first pillar only. The The second pillar – mandatory Second Pillarcurrent overall contribution rate to thepension system stands at 26.5 %. Employers individual accountspay 18 % into the Pension Insurance Fund forthe first pillar, while employees contribute Institutional framework The mandatory second pillar is a DC system8.5 %. For employees participating in the with individual retirement accounts. Allmandatory second pillar, the contribution is covered people – those who have opted tosplit; 8 % go to the individual retirement join the system and new labour marketaccounts and 0.5 % is allocated to the public entrants below the age of 42 – must becomepension system. members of a mandatory private pension scheme by joining a mandatory pensionBenefits from the first pillar equal 33 % of fund of their choice.average income for the first 10 years ofcoverage, plus 2 % for each additional year Mandatory pension funds, also known asbetween 11 and 25 years, plus 1 % for each private pension funds (PPFs), areadditional year between 26 and 36 years, independent legal entities owned by theirand 1.5 % for each additional year exceeding members. They take the legal form of36 years of coverage. The minimum monthly mutual foundations and may be founded bypension for those who have completed the employers, financial institutions, chambers20-year service period is HUF 25,800 (EUR of trade, professional associations, employee98). The maximum old-age pension is equal interest organisations or regional self-to average earnings. Old-age pension governments. Membership may be open orbenefits are indexed annually by 50 % of the closed. In order to remain in operation, a PPFpredicted increase in the CPI for the running must be licensed and have a minimumyear and 50 % of the predicted increase in net number of members. Pension funds mayaverage monthly earnings. The indexation is manage the investment of fund assetsadjusted at the end of each year in line with internally or outsource it partially orthe actual annual changes to the CPI and entirely.the net average monthly earnings.The reforms gradually decreased totalcontribution rates from 31 % of gross wages Second pillar statistics 2006to 26.5 %. Employer contributions droppedfrom 24 % to 18 % and employee Members 2.6mcontributions rose from 6 % to 8.5 %. Assets under management [EUR] 5.9bnAlthough a contribution history of 20 yearsis required to qualify for a minimum Number of pension fund providers 1856
    • HungaryThe main decision-making body of permitted to invest in businesses in whichHungarian pension funds is the general the fund founders, the fund members’assembly of members, where all members employers, or the fund’s service providersenjoy equal voting rights regardless of the own more than 10 % of the shares.money accumulated in their accounts. Thegeneral assembly elects a board of directors Disclosure and fee regulationresponsible for managing the fund for five Pension funds must disclose annualyears. The board of directors is obliged to information such as number of members,appoint an investment adviser, an actuary, revenues, operational costs and investmentan auditor, a lawyer and a custodian. Other performance. The balance sheet and theduties include reporting to the Financial profit and loss statement must be publishedServices Authority, disclosing information to in a national daily newspaper; pension fundmembers and setting up internal asset members must be notified annually and atmanagement regulations and asset their request about their accumulatedvaluation. The general assembly of members capital and fees.also appoints a supervisory committee, onwhich the members’ representatives must Annual fees payable for asset managementform the majority. This committee controls services, excluding trading expenses, havethe accounting, financing and operations of just been reformed and may not exceed 0.9 %the pension fund. in 2007 and 0.8 % in 2008. Maximum front- end operational fees will be reduced fromInvestment regulations 6 % in 2007 to 4.5 % in 2008. As a result ofUntil 2002, Hungarian mandatory pension these new regulations, specific entry orfunds were subject to a relative minimum switching fee regulations have beenreturn guarantee. The minimum return was abolished. Members are allowed to switcha percentage of the official return index of funds provided that they have been withlong-term government bonds. Now pension their current fund for at least three months.funds need to disclose a target rate ofreturn, but missing it has no consequences. Hungary runs a guarantee fund to protect thePortfolio regulations set the following accumulated individual capital of pensionmaximum limits for asset classes: fund members from insolvency. If a pension fund is liquidated, the guarantee covers· 50 % for investment funds beneficiaries’ total benefit amount and· 30 % for bonds (except government bonds) contributing members’ accumulated capital. To this end, all pension funds must currently· 25 % for mortgage bonds contribute 0.35 % of the contribution paid by· 10 % for real estate investment funds, for members. unquoted equities, and for securities issued by the same issuer (except Benefits and withdrawal government bonds) Benefits are paid out as a life annuity when· 5 % for hedge funds, private equity funds the beneficiary reaches the legal retirement and direct investment in property age. Withdrawing funds before retirement is not possible. Pension fund members whoPension funds are not allowed to hold loans have contributed for less than 15 years havein their portfolio. There are no portfolio their assets paid out as a lump sum. If thelimits for quoted equities, government contribution period is longer than 15 years,bonds and bank deposits. members must buy a life annuity. Individual and joint life annuities are available andForeign investment is allowed for up to 30 % permissible.of assets, but investment in non-OECDcountries may not exceed 20 %. Regulations Annuities can either be bought from anconcerning equities have been relaxed. The insurance company or are provided by the50 % limit on equities was abolished in 2005, pension fund. Whether or not a pensionand options to invest in hedge funds and fund provides annuities has an impact onprivate equity were introduced in 2005 and how it is regulated. If it pays annuities itself,2006, respectively. Pension funds are not a pension fund must have at least 25,000 57
    • Hungarymembers. Annuities are indexed in the left until retirement. From 2007 onwards,same way as in the public system (50 % pension funds can offer these threeconsumer price index, 50 % change in portfolios on a voluntary basis. Membersaverage earnings). will be allocated in line with the following rules:Asset management and allocationBy the end of 2006, second pillar funds · Members with five years until retirementcounted 2.6 million members – 25 % of the will be allocated to the conservativepopulation and two-thirds of the workforce. portfolio with a maximum equity share ofAssets under management amounted to 10 %EUR 5.9 billion in 2006. Members can choose · Members who have between 5 and 15 yearsamong 18 different pension funds and two until retirement are assigned to a balancedadditional pension funds are scheduled to portfolio with an equity share betweenstart operating in 2007. The market has been 10 % and 40 %consolidating since the late 1990s. In 1998, · Members who will retire in more than 15there were 38 pension funds available on the years time are assigned to the dynamicmarket. Today, there are only 18, 10 of which portfolio, which has an equity share of atare owned by banks or insurance least 40 %, with the possibility of puttingcompanies. 5 % in derivatives and a maximum of 20 % in real estateAssets in Hungarian pension funds tend tobe allocated conservatively. 74 % of assets Fund members may switch from the categoryare invested in government bonds. Equities to which they are assigned, depending on theaccount for 8 %, corporate bonds also for 8 %, time remaining until retirement age. Thecash and deposits for 1 %, and other assetshave a 9 % share. The strong reliance on growth portfolio is the only exception, as it is not available during the last five years beforebonds will change in the years to come, retirement age. For the time being, offeringsince Hungary decided to introduce new these portfolio possibilities is optional.regulations for mandatory pension fundasset allocation in 2006. From 2009onwards, pension funds will have to offer Taxation Taxation of second pillar pensions followsthree different portfolios (growth, balanced, the TEE concept. 25 % of employeeconservative) with varying risk profiles. contributions are tax deductible;Previously, each pension fund ran one fund investment income is not taxed and benefitsfor all of its members without any additional are tax-exempt.choices. The fund will assign members toone of the portfolios depending on the timeMandatory pension fund asset allocation 2005 Government securities: 74% Other assets: 9 % Equities: 8 % Corporate bonds: 8 % Cash and deposits: 1 %Sources: OECD, Allianz Global Investors58
    • HungaryThe third and the fourth pillar – Third pillar statistics 2006Voluntary pension savings Members 1.3m Assets under Management [EUR] 2.7bnHungarians have several options to save forretirement aside from the mandatory Number of pension fund providers 70system. They – or their employers – canvoluntarily make additional contributionsof up to 2 % to the mandatory pension funds.They can also contribute to voluntarypension funds (VPF) or join the so-called consisted of 75 % bonds, 8 % stocks, 7 %fourth pillar, which was launched in 2006. investment notes and 10 % cash and other assets. Third & Fourth PillarVoluntary pension fundsVoluntary pension funds were introduced in Portfolio choice is not a very widespread1994. After a slow start, they counted 1.3 principle, even though VPFs can have moremillion members by 2006, roughly half as than one investment strategy. There are nomany as in the mandatory system. VPFs regulatory limits on the options that can beprovide individual DC accounts and have offered. Despite this, only 6 of the 70 VPFs onthe same institutional framework as PPFs. the market offer individual portfolioEmployer-owned pension funds must choices.appoint a trustee to manage their assets.Both employees and employers can Members of VPFs can switch funds at willcontribute. Members can choose to receive every three months without any constraints.benefits either as a lump sum at any age Generally, providers can charge fees forafter 10 years of membership or as an people wishing to join, leave or switchannuity. pension funds. Since the beginning of 2007, there has been a maximum limit of 6 % forSavings in VPFs are tax-favoured. There is a operational fees (4.5 % from 2008). Fees aretax credit of 30 % on contributions up to a also charged for asset management; thelimit of HUF 100,000 (EUR 380) per year. charge depends on the asset managementEmployer contributions are entirely tax- contract.exempt up to the minimum wage of HUF62,500 (EUR 238). Investment income is alsotax-exempt, whereas benefits are only tax- The fourth pillarexempt under certain conditions. Investment In early 2006, Hungary introduced the so-regulations for VPFs are identical to those of called fourth pillar, an additional voluntarythe mandatory funds, with two exceptions: instrument for retirement savings. TheseFirst, there is a maximum limit of 20 % of voluntary individual retirement accountsbank deposits, while mandatory funds have (NYESZ) can be operated by banks orno such limit. Second, 5 % of VPF assets can be stockbrokers. They were set up for two maininvested into loans; mandatory funds are not reasons: to broaden investmentallowed to do so. opportunities and encourage people to save more for retirement, and to boost activity onThe voluntary pension fund industry in the Budapest stock exchange, which seeks toHungary has undergone major attract more interest from private investors.consolidation over the last decade. Today, The law does not lay down investment rules.there are 70 licensed VPFs operating on themarket, down from 250 in the mid-1990s. Subscribers to the fourth pillar receive a taxThe market is concentrated, with the 15 benefit of 30 % on money paid into thelargest companies accounting for around account. The maximum tax benefit is HUF80 % of members and 85 % of assets. Assets 100,000 (EUR 380). Capital gains onunder management amounted to EUR 2.7 investments in stocks will also be tax-billion in 2006. These assets are invested in exempt from 2007 onwards. Fees area fairly conservative way, much like those of capped. There is an annual limit of HUFmandatory pension funds. In 2005, assets 2,000 (EUR 8) for charges, a limit of 90 bps 59
    • Hungary(80 bps in 2008) for asset management fees, billion, making Hungary the second largestwhile operational charges are now limited pension market in Eastern Europe behindto 6 %. When the fourth pillar was first Poland. In recent years, participation hasintroduced, 70,000 workers were expected to increased slowly, growing only 4 % in 2005. Theopen an account. However, the number of ratio of active earners between 20 and 29 tosubscribers was estimated to be only 10,000 the total number of members has decreased,at the end of 2006. Money is invested mainly probably because of the ageing workforce. Forin investment units (about 40 %), shares this reason, we expect participation to build(about 30 %), government securities (20 %), up slowly in coming years.deposits and other (10 %). The inflow of current contributions will support the growth of private pension funds in the years to come. However, benefitIORP payments will also start to rise, suppressing asset growth potential. Future growth canThere are no IORPs in Hungary. The IORP therefore only be generated by price hikes indirective 2003/41/EC has not been financial markets and wage growth. Theimplemented fully in Hungarian law. For latter is expected to be moderate comparedthis reason, the European Commission with other CEE countries. In our projectionstarted legal proceedings against Hungary period, assets under management arein October 2006. In a first step the expected to reach EUR 30.5 billion based onCommission has sent a letter of formal the conservative assumption of 5 % averagenotice to the Hungarian government. performance. In this scenario, volumes will increase by roughly 20 % p.a. until 2015. Given the aforementioned conditions,Outlook calculating a more optimistic scenario would not make sense.Current household asset allocationThe financial assets of Hungarian The growth of voluntary pension funds inhouseholds amounted to EUR 76.4 billion in the third pillar – with 1.3 million current2005, or 88 % of GDP. Assets per capita are members and EUR 2.7 billion in assets underroughly EUR 7,600 – 12 % of the EU-15 management – depends strongly on incomeaverage. In 2005, the value of financial assets development in Hungary, which is likely togrew by 10 %. Securities and shares represent continue growing. Increasing income willa third of household assets, partly a result of lead to growing participation rates, andthe privatisation of formerly state-owned both will support the growth of the thirdfirms in the 1990s. Deposits make up 40 % of pillar pension market. In the minimumtotal assets, which is much lower than in the scenario, assets under management willearly 1990s, when they were by far the reach EUR 9.9 billion by 2015 (+15 % p.a) and Outlookdominant saving instrument. Insurance EUR 12.3 billion in the optimistic scenarioand pension fund assets show the highest (+18 % p.a.).growth rate on the Hungarian market.Hungarian households keep more than 10 % Hungary is one of the key pensionin insurance and pension products. Life markets in Eastern Europe. Its earlypremiums grew 24 % from 2004 to 2005, a moves towards structural pension reformlower growth rate than the other CEE states. have resulted in relatively mature pensionLife premiums as a share of GDP amount to markets, the growth of which has been fuelled1.4 %, which is the third highest value in the by the mandatory nature of the second pillarcountries under investigation; the EU-15 and widespread acceptance of voluntaryhave a life penetration of 5.6 % on average. pension savings in the third pillar. It is too early to make an accurate forecast for theFuture pension assets fourth pillar; however, the initial take-up wasThere are currently 2.6 million subscribers to lower than expected.second pillar pension funds – 25 % of thepopulation and two thirds of the workforce. Asset managers and pension fund membersAssets under management amount to EUR 5.9 can benefit from recent moves to relax60
    • Hungaryinvestment regulations. By lifting caps on diversified. The obligation to introduceequities and making it possible to invest in funds with different risk profiles in theprivate equity and hedge funds, investors second pillar follows the recommendationsnow have access to a broader range of of modern finance theory and combinesfinancial instruments and can see their retirement saving security with the upsideperformance improved and investment risk potential of financial markets.Hungary: Pension assets under managementEURm50,000 42,758 40,34940,00030,000 18,688 19,45620,00010,000 8,667 0 2006 2010e min. 2010e opt. 2015e min. 2015e opt. Second pillar assets Third pillar assets Source: Hungarian financial supervisory authority, own calculations 61
    • LatviaLatviaImplementing fundamentalpension reformsShape of the pension systemIn recent years, Latvia’s economicperformance has been impressive. Its Demographics and macroeconomicsgrowth rate is among the highest in Europeand the country and its neighbours are Population [m] 2006: 2.3often referred to as the Baltic Tigers. 2050: 1.7 Population over 65 [ %] 16.9Soon after its independence in 1991, Latviastarted to reform its pension system. It was Dependency ratio* 2006: 23.2the first CEE country to fundamentally 2050: 44.1restructure its first pillar. Today, Latvia runs a GDP [EUR] 16.2bnthree-pillar pension system. The first pillar is GDP per capita [EUR] 7,051 (29 % of EU-Ø)a PAYG, notional defined contribution (NDC)system, the second is a funded mandatory GDP growth 2001–2006 [av. in % p.a.] 7.7pillar and the third pillar consists of private GDP growth 2007–2012voluntary occupational and individual 5.5 [av. in % p.a., est.]pension arrangements. By introducing an Unemployment rate [ %] 6.8NDC system combined with a mandatorypillar, Latvia arguably made the most radical Data from 2006 or latest available yearand far-reaching pension system reforms in * Ratio of over 65-year-olds to 15– 64-year-oldsthe region, alongside Poland.The demographic situation in Latvia ismixed. While the population will shrinkfrom 2.3 million to 1.7 million between nowand 2050 – one of the fastest populationdecreases in the EU – the population is notageing as quickly as elsewhere. The Latvian The first pillar – public pensions Reform of the first pillar took place in 1996 First Pillardependency ratio will indeed worsen from and was needed because low retirement23.2 % today to 44.1 % in 2050, but this is a ages, widespread early retirement, socialconsiderably better outlook than the security contribution evasion andprojected EU average of 52 %. Nevertheless, demographic change made the old systemLatvia will feel the blow of an ageing unsustainable. The new NDC systempopulation, albeit to a smaller extent. Public established a strong link betweenpension expenditure in Latvia is projected contributions and benefits. NDC systemsto decrease. While it currently stands at transfer the logic of funded pensions to6.8 % of GDP, it will be 5.6 % in 2050. The public pensions by giving participants acurrent EU-25 average is 10.6 % of GDP and hypothetical or virtual account, whichwill increase to 12.8 %. contains all contributions made throughout working life. These notional individualLatvia’s second pillar pension assets accounts are accumulated at a given rate ofcurrently amount to EUR 183 million, and to return. At the time of retirement, benefitsEUR 74 million in the third pillar. The former are calculated by dividing the amountis expected to grow by at least 46 %, the accumulated in the notional account bygrowth rate of the latter will be at least 20 %. cohort life expectancy.62
    • LatviaLatvia’s first pillar covers pensioners from First pillar designboth the old and new systems. Participationin the NDC arrangements is mandatory for Contribution rate [ % of gross salary] Employers: 14.5all employed and self-employed people over Employees: 5.5the age of 15; it is voluntary for those who do Net replacement rate 78not work. To receive pension benefits,participants must have contributed to the Legal retirement age 62 men/61 womensystem for at least 10 years upon reaching Public pension expenditure [ % of GDP] 2004: 6.8the statutory minimum retirement. 2050: 5.6 Data from 2006 or latest available yearThe statutory minimum retirement age isgradually being increased and will reach 62for both men and women in 2008. Currently,it stands at 62 for men and 61 for women The second pillar – mandatory(61.5 from July 2007 onwards). Retirees are individual accountsallowed to continue working while they arereceiving a full pension. Early retirement Institutional framework(up to two years prior to the established The mandatory second pillar startedretirement age) is possible under specific operating in 2001. The scheme operates on aconditions. However, early retirement defined contribution basis. Participation inpossibilities will be eliminated from 2008 Second Pillar the scheme is mandatory for new labouronwards. Since 2002, pensions have been entrants and employees aged under 30 at theindexed to changes in the consumer price time of introduction. Joining was optional forindex and to increases in average wages. those aged between 30 and 40; these peopleIndexation differs depending on pension could choose between staying in the NDClevels, which favours low pensions. PAYG system only and switching a portion of their contributions to the funded part. PeopleTotal contributions to the social security older than 50 were not allowed to join. In latesystem amount to 33 %. Employers pay 24 % 2006, the number of people who decided toof employees’ gross salaries, while join the second pillar reached 900,000.employees contribute 9 %. The share ofpensions in social security contributions is In 2007, the contribution rate for the20 %. This means that employees pay 5.5 % of mandatory scheme has risen to 4 % (at thetheir salary for pensions, employers 14.5 %. same time, contributions to the public pillarIn 2007, 16 % are allocated to the PAYG have fallen); it will increase to 8 % in 2008, tosystem and 4 % to the funded mandatory 9 % in 2009 and finally to 10 % by 2010. At thissystem. Since 1997, benefits paid under the point, the first two pillars will receive anstate pension scheme have been subject to equal share of contributions.income tax. However, old-age pensions thatwere already being paid out before January During the first 18 months of operation, only1996 are not subject to taxation. the State Treasury was allowed to manage second pillar assets. Rules have changedIn order to prevent poverty among since then, and private asset managers canpensioners, there is a minimum guaranteed now also do so. The state has increasinglypension. Since 2006, the minimum pension withdrawn from managing pension assets,has been the equivalent of social security as the State Treasury will cease managingbenefits and multiplied by 1.1 for people mandatory pension plans and distribute thewith a social insurance record spanning assets under management to privateless than 20 years. For people who havecontributed for 20 to 30 years, basic benefitsare multiplied by 1.3, and by 1.5 if people Second pillar statistics 2006have contributed for more than 30 years. Members 900,000 Assets under management [EUR] 183m Number of pension fund providers 8 63
    • Latviamanagers. This transfer is expected to be · Balanced funds with an equity share of upcompleted by November 1, 2007. to 15 % and a bond and money market instrument share of at least 50 %Investment regulations · Active funds with an equity share of up toIn Latvia, investment regulations differ, 30 % and no limits on investments in bonddepending on whether pension plans are and money market instrumentsmanaged by the State Treasury or by privatecompanies. The State Treasury is only allowed Contrary to many other CEE countriesto invest in Latvian government securities, running mandatory pension systems, therebank deposits, mortgage bonds and deposit is no requirement for pension funds tocertificates. Moreover, it can only invest in guarantee a certain minimum return. Onfinancial instruments denominated in the the contrary, doing so is explicitly forbidden.national currency. In contrast, privatemanagers are allowed to invest in a much Disclosure and fee regulationbroader range of financial instruments. The There are no entry or exit fees in Latvia. Untilmain investment limits include the following: recently, administration fees were capped at 2.5 % of total annual contributions. However,· 35 % for securities guaranteed by a state or the maximum cap has been abolished. Other an international financial institution fees, such as asset management fees, are not· 5 % for securities issued or guaranteed by a regulated, but each management company local government must publish fee levels in its prospectus. Plan· 10 % for securities of a single issuer, except members can participate in only one plan at government securities; for deposits at one a time. They can switch between different credit institution (investments in debt and investment plans twice a year, but only if capital securities of the same credit both investment plans are managed by the institution and derivative financial same asset management company. If instruments may not exceed 15 %); and for members want to switch management securities issued by one commercial companies, they can do so once a year. There company (or group of commercial are no switching fees. companies) Benefits and withdrawal· 20 % for investments in non-listed securities The second pillar is considered to be a part· 5 % for investments in a single fund (10 % of of the state pension system in Latvia. For the net assets of the investment fund) this reason, lump-sum payments are not allowed. When reaching retirement age,There is no maximum limit for international participants have to choose between usinginvestments, as long as pension funds invest their accumulated capital to purchase anin securities listed on stock exchanges in annuity from an insurance company or usethe Baltics, other EU member countries or the „refunding“ option. This means thatthe European Free Trade Area. However, the investors move their capital to the NDClaw stipulates a 70 % currency matching pension scheme and receive a payout basedrule. There is also a 10 % limit for each non- on a slightly modified NDC pension formula.matching currency (since 2005, the euro has If the participant decides to take out abeen exempted from investment contract with an insurance company, therestrictions on foreign currencies). State Social Insurance Agency (SSIA) signsInvestments in real estate, loans, and self- the contract and transfers the accruedinvestment are not permitted. capital. Detailed provisions on the payout phase have not yet been defined, as pensionPrivate asset management companies can benefits will start to be paid out only in 2014.offer three funds with different risk/returnprofiles: Asset management and allocation Eight investment management companies· Conservative funds with no equity are operating in the Latvian market. These exposure and a 100 % share of bonds and companies and the State Treasury currently money market instruments offer a total of 24 investment plans. The64
    • Latviasystem currently counts 900,000 The third pillar – voluntary Third Pillarparticipants, 77 % of the working population,and EUR 183 million in assets. The assets pension savingsmanaged by the State Treasury havedeclined to 18 % and will drop to nothing in Voluntary pension funds The voluntary private pillar in Latvia hasNovember 2007, when the state stops been operating since 1998. Pension plans inmanaging pension assets and distributes the third pillar can by be concluded directlyexisting assets to the private pension funds. between participants and providers, or with the involvement of the employer. However,The market is concentrated, with the three occupational plans are far from beinglargest funds managing almost 80 % of popular among Latvian employers. Only 5 %assets. Most companies are linked to of Latvian companies, mainly large ones,Latvian banks to take advantage of the offer their employees voluntary occupationalparent company’s branding. The key to arrangements. Voluntary pension schemessuccess in the Latvian market appears to be are operated by private pension funds, whichthe distribution network. are non-profit joint stock companies. Under Latvian law, they are obliged to appointOverall asset allocation in Latvia is fairly management companies and custodians forconservative despite the possibility of their pensions plans. Pension plan assets canchoosing a plan according to risk be managed by credit institutions, lifepreference. In late 2006, 55 % of assets were insurance companies, investment firms andinvested in debt securities, 26 % in time asset management companies. Both DC anddeposits, 14 % in investment funds and 5 % DB plans can be offered.in equities. Active pension funds do oftennot exploit the 30 % equity limits foreseen At present, six private pension funds areby Latvian investment regulations. Out of operating on the market. Five of these arethe 10 active funds on the market, only one open and one is closed, and a total of 15really has a 30 % equity share, while four different pension plans are offered. Membershave an equity exposure between 20 % and can join a pension scheme directly or via30 %, three hold equities between 10 % and their employer, who can set up a closed20 %, and two have less than 10 % equity in pension fund, possibly in cooperation withtheir portfolio. other employers, or conclude a collective membership contract with an open or closedTaxation fund.Contributions are income tax deductibleand investment income is tax-exempt. Voluntary pensions offer tax advantages forPension benefits are taxed at the ordinary both employers and employees.income tax rate beyond the limit of LVL Contributions from employers and1,200 (EUR 1,730) per year.Mandatory pension fund asset allocation 2006 Debt securities: 55% Time deposits: 26% Investment funds: 14% Equities: 5 %Sources: OECD, Allianz Global Investors 65
    • Latviaemployees of up to 10 % of the employees’ equity market is the result of voucher Outlookannual income are tax-deductible. privatisation in the 1990s. By comparison,Investment income is taxed, while benefits life insurance products have a very loware tax-exempt up to a certain limit. share in the household portfolio. Latvia saw 60 % growth in life premiums in 2004 toPrivate voluntary pensions have not gained 2005, but this largely reflects a very lowa strong foothold in Latvia. There are only starting level. Nevertheless, it could markabout 90,000 members enrolled in voluntary the beginning of a catching up process.plans, and assets under management Penetration of life premiums as a share ofamounted to EUR 74 million in 2006. The low GDP stands at only 0.12 % in Latvia,participation rate is the result of relatively compared with 5.6 % in Western Europe.low income levels and insufficientmarketing efforts. At the moment, it seems Future pension assetsthat the voluntary pension pillar is mainly Over the past five years, the second pillarused by middle-to-high income households. market has recorded very high growth ratesBenefits can be paid as a lump-sum, phased due to a rapid take-up process. In 2005, thewithdrawals or life annuities. market grew by roughly 70 % and pension assets amounted to EUR 183 million in 2006.Investment rules for private pension fundsare similar to those for mandatory funds, but The number of participants reached 900,000are more flexible. For example, investment in at the end of 2006, meaning that about 40 %real estate is permitted (with a limit of 15 %), of the population and 77 % of the labour forcethe currency matching rule is only 30 % and are covered by second pillar pensions. In thelimits for some asset classes are higher. coming years, this process will slow down, with further participation increases mainlyAs is the case of mandatory pension funds, resulting from new labour market entrants.their private counterparts are not allowed to The market will also be boosted byguarantee a rate of return. Fee levels are not substantial wage growth and contributionregulated. rate increases from 4 % today to 10 % by 2010. In the minimum scenario, assets under management are expected to reach EUR 5.4IORP billion based on the conservative assumption of 5 % average performance. Even in thisLatvia has transposed the IORP directive scenario, volumes will increase by about 46 %into national law. p.a. in the projection period until 2015. The optimistic scenario could boost the volume up to EUR 5.6 billion. However, we considerOutlook the minimum scenario to be more realistic.Current household asset allocation The development of third pillar voluntaryFinancial assets in 2005 amounted to EUR pensions plans has occurred on a much6.8 billion, or 52 % of GDP. This is the lowest smaller level. Although they were up andratio in the EU-25; the EU-15 average is more running three years before second pillarthan 4 times higher than the Latvian level. pension plans, participation has onlyThe same is true for per capita values; reached about 8 % of the workingLatvian households possess only 5 % of the population. Assets under managementfinancial assets of the EU-15 average. stood at EUR 74 million at the end of 2006.Even though Latvian households are justbeginning to accumulate financial assets,they hold a surprisingly high share of riskier Third pillar statistics 2006 (open pension funds)assets such as stocks and mutual funds. Members 90,000Bank deposits are the most popular form of Assets under Management [EUR] 74msaving, but shares and mutual funds come aclose second. The prominent role of the Number of pension fund providers 666
    • LatviaWith income levels increasing, more people pension savings in the third pillar is stillmay join the voluntary system. In the past underdeveloped, but this may change asthree years, there have been signs of this income levels rise. There are alsohappening, as the number of members in indications that public policy will promoteprivate pension plans has more than the third pillar by improving tax policy,tripled. Despite this, it is realistic to enhancing the monitoring and supervisionassume that members will continue to of voluntary pensions, setting up financialcontribute only a small portion of their education programmes and supportingincome. In the minimum scenario, assets information campaigns about all parts ofunder management will reach EUR 385 the retirement system.million by 2015 (+20 % p.a). The optimisticscenario foresees EUR 546 million (+25 % Further issues under consideration includep.a.). relaxing investment regulations in the mandatory system, establishing a reserve Latvia has managed to build a fund, making changes to pension sustainable pension system over the indexation and introducing minimumlast decade with impressive growth in guarantees for interest rates in thesecond pillar funds. Acceptance of voluntary mandatory pillar.Latvia: Pension assets under managementEURm7,000 6,167 5,8196,0005,0004,0003,000 1,8632,000 1,6831,000 257 0 2006 2010e min. 2010e opt. 2015e min. 2015e opt. Second pillar assets Third pillar assets Source: Latvian Financial and Capital Market Commission, own calculations 67
    • LithuaniaLithuaniaCEE-style reformwithout a mandatorypillarShape of the pension system Demographics and macroeconomicsLithuania’s first steps towards pensionreform were taken in 1995, following a major Population [m] 2006: 3.4economic crisis in the early 1990s. The first 2050: 2.9reform focused on making parametric Population over 65 [ %] 15.5changes to the first pillar and increasing the Dependency ratio* 2006: 22.5system’s sustainability. Another two pillarswere added to the system in 2004, 2050: 44.9comprising funded schemes and GDP [EUR] 23.7 bnsupplementary pension provision. GDP per capita [EUR] 6,957 (28 % of EU-Ø)Contrary to most other CEE countries, GDP growth 2001–2006 [av. in % p.a.] 7.4Lithuania’s second pillar is not mandatory. It GDP growth 2007–2012 5.5is made up of individual DC accounts, but [av. in % p.a., est.]employees are free to choose whether to join Unemployment rate [ %] 5.6or not. Acceptance of second pillar pensions Data from 2006 or latest available yearhas been strong and participation has * Ratio of over 65-year-olds to 15– 64-year-oldsincreased rapidly. The third pillar is fairlyunderdeveloped and consists of voluntarypension funds or life insurance products.Recently, Lithuania introduced thepreconditions for occupational voluntarypensions, but occupational plans have yet tobe created.In demographic terms, Lithuania will suffer Assets in Lithuania’s second pillar pension market total EUR 306 million and are likely to grow by at least 33 % p.a. until 2015. In the third pillar, assets amount to EUR 15 million First Pillarfrom a declining and ageing population. The and are expected to increase by at least 25 %absolute number of Lithuanians will drop per year.from 3.4 million today to 2.9 million in 2050. Inaddition to low fertility rates, negative netmigration will have a serious impact. In 2004, The first pillar – public pensionsLithuania saw the highest rate of emigrationamong the EU member states that joined the Just like the other Baltic states, Lithuaniasame year. The dependency ratio will climb inherited a Soviet-style pension system thatfrom 22.5 % today to 44.9 % in 2050, which is was characterised by generous earlyseven percentage points lower than the EU-25 retirement provisions, privileges for certainaverage. Public pension expenditure in occupational groups and a weak linkLithuania will increase from 6.7 % of GDP today between contributions and benefits. Whento 8.6 % in 2050. These values are roughly four the reform process began in 1995,percentage points lower than the retirement age was gradually increased tocorresponding values for the EU-25 average. 62.5 years for men and 60 years for women68
    • Lithuania(reached in 2006). The number of First pillar designcontributory years required for pensionbenefits was also raised. Early retirement Contribution rate [ % of gross salary] Employers: 21.2provisions were abolished, and a strong link Employees: 2.5between contributions and benefits created. Net replacement rate 55The reform implemented a two-tier system Legal retirement age 62.5 men/60 womenin the first pillar. Today, there is a basic Public pension expenditure [ % of GDP] 2004: 6.7flatrate pension that depends on years of 2050: 8.6service. Benefits were increased in early Data from 2006 or latest available year2007 and currently amount to LTU 266 (EUR77) per month. The second part of the publicsystem is supplemental and earnings- began in the mid-1990s, but no politicalrelated. It is based on a formula comprising consensus could be reached. In 2002, theyears of service, individual wages and decision was made to make the second pillaraverage income. Adjustments for the voluntary. Public response was extremelyearnings-related component are made in positive. By late 2003, 38.3 % of eligibleline with average economy-wide earnings, persons had decided to join, and that figurewhile the basic pension is determined by the rose to 610,000 members in late 2005, moregovernment in an ad-hoc manner. than 50 % of the labour force. Once the Second Pillar decision to join the voluntary system hasIn principle, all employees are covered by been made, it is irreversible.the system, but the actual coverage rate is83 % of the workforce. Some categories of the The only conditions for joining are thatself-employed are free to join. In order to members are insured by the state socialreceive a full pension, 30 contributory years insurance scheme and are below theare required and the minimum qualifying retirement age. Pension funds areperiod is 15 years. Those who do not reach established as companies. They have athe minimum qualifying period are entitled supervisory board, a management boardto a social assistance pension, which and a shareholder assembly.amounts to 90 % of the basic pension. Similar to mandatory second pillar systemsSocial contributions in Lithuania are high, in other Eastern European states,amounting to 30.7 % of gross wages. 23.7 % of contributions to the second pillar arethese contributions are allocated to diverted from social security contributionspensions. Employers pay 21.2 % of gross to pension funds. In 2004, 2.5 % of grosswages for pensions, and employees wages were redirected into the fundedcontribute 2.5 %. Possibilities for early pillar, and this share has been graduallyretirement were re-introduced in 2004 after increased to 5.5 % in 2007. Totalhaving been abolished in 1995, but they only contributions have not changed. Theapply to people who have been unemployed reduced contribution to the public systemfor a long time. If people retire early, their does not affect basic pension entitlement,pension benefits are reduced. Staying in the but only the earnings-related,workforce longer than the minimum supplementary part of first pillar pensions.retirement age is rewarded with 8 % benefitincreases per extra year. Investment regulations Pension plan assets must be invested in a diversified investment portfolio. This meansThe second pillar – voluntaryindividual accounts Second pillar statistics 2006Institutional framework Members 610,000Second pillar pension funds were Assets under management [EUR] 306mintroduced in 2004. Discussions on whetherthe second pillar should be mandatory Number of pension fund providers 6 69
    • Lithuaniathat the assets of every pension scheme between plans at one company was. Frommust be invested in a portfolio comprising 2007 onwards, members can choose to go tosecurities, real estate, commercial bank another provider once a year for a fee thatdeposits and deposit certificates issued by cannot exceed 0.2 % of the assets in thebanks. This portfolio is subject to the account. If changes are made more thanfollowing maximum limits: once within a year, a fee of up to 4 % applies. Transferring to another fund once within· 30 % for assets of the same issuer, provided the same pension management company is they are issued or guaranteed by the free of charge, while subsequent changes central or local government may incur a fee of up to 0.2 % of the value of· 30 % for debt securities of a single issuer, the account. A pension management with the exception of government securities company is not allowed to charge more than 10 % of pension fund contributions and 1 % of· 20 % for real estate pension accounts per year.· 25 % for investments in securities issued by persons related to the pension fund Benefits and withdrawal When they reach retirement, pension fundOther regulations deal mainly with limits members must use their accumulatedfor securities of a single issuer. With regard assets to buy a life annuity from a pensionto international investments, Lithuania has company. Lump sum payments or ataken a very liberal stance. There are no withdrawal plan are only possible if therestrictions for foreign investments of amount remaining in the participant’spension funds, nor are there minimum account is sufficient to buy an annuity equalrates of return. to the state social insurance basic pension.Pension funds are not allowed to invest in Asset management and allocationthe following financial instruments: In 2006, the second pillar system counted 610,000 members. Participants can choose· Securities issued by pension funds from 21 pension funds that are provided by· Securities issued by a management six companies. The market is extremely enterprise with which the pension fund concentrated. The largest company has a has concluded an asset management market share of 56 %, and the two biggest agreement companies have a combined market share· Securities issued by enterprises or other of slightly over 90 %. organisations related to the management enterprise Pension companies must provide one· Derivative financial instruments, with the conservative fund with investments in exception of instruments recognised by government bonds. They are otherwise free the Securities Commission and used for to offer other funds with riskier portfolios. risk management Of the 21 funds, seven are conservative funds, three have a small equity portion (upDisclosure and fee regulation to 30 %), eight have a medium equity portionDisclosure requirements include publishing (30-70 %) and three offer 70-100 % equityan annual report in a daily newspaper, investments. Funds with medium equityinforming members about the status of their exposure are the most popular, accountingaccounts once a year and announcing the for 58 % of members, followed by funds withvalue of pension fund account units every low equity exposure (27 %), conservativeday. At the member’s request, pension funds funds (13 %) and those with high equitymust provide information about assets in his exposure (2 %).accounts, investment options and otherinformation related to any of the company’s Direct investment in shares is relativelyactivities that affect the participant. modest in all types of pension funds; indirect investments via mutual funds are theBetween 2004 and 2006, the system’s first preferred route. Pension funds with littletwo years in operation, switching pension equity exposure hold 3 % in shares and 45 % inproviders was not possible, but switching mutual funds; pension funds with medium70
    • Lithuaniaequity exposure invest 8.5 % in shares and Second pillar pension fund asset allocation 200645 % in mutual funds, whereas funds with thehighest equity exposure invest 39 % in shares Governmentand 43 % in mutual funds. Across all pension bonds: 43 %funds, assets are allocated in the followingway: 43 % government bonds, 39 % mutual Shares: 7 %funds, 7 % shares and corporate bonds and3.6 % cash and deposits. Corporate bonds: 7%Taxation Cash and deposits: 4 %Employee contributions are tax deductible. Ifemployers pay employee contributions, they Mutual funds: 39 %are tax deductible up to a limit; employercontributions are considered as tax-free Sources: OECD, Allianz Global Investorsincome for the employee. Investment incomeis tax-free, whereas pension benefits aresubject to ordinary income tax. directive in Lithuania, the European Commission has not referred the country to the Court of Justice.The third and the fourth pillar –Voluntary pension savings OutlookThird pillar pensions are fairlyunderdeveloped in Lithuania. Private Current household asset allocationindividual pensions were introduced in 2004. The financial assets of LithuanianIndividuals and their employers can households amounted to EUR 10.8 billion in Third Pillarcontribute to voluntary pension funds. 2005, or 53 % of GDP. This is only slightlyContributions are tax-free up to 25 % of higher than the Latvian level, which is theannual income, and any amount above that lowest of the EU-25. However, Lithuania sawlevel is taxed at a reduced rate of 15 % (rather increases in its financial assets of 24 % inthan the regular rate of 27 %). At the end of 2004 and 17 % in 2005. Prospects for further2006, 20,100 participants had joined growth are good thanks to an unparalleledsupplementary voluntary pension funds; low unemployment rate, strong incomeassets under management amounted to EUR growth and solid consumer confidence.15 million. As is the case for second pillarfunds, the market is greatly concentrated. The Lithuanian households keep almost half oftwo leading pension providers account for their financial assets in bank deposits,94% of total third-pillar assets. The bulk of regardless of low interest rates and newassets is invested in mutual funds (50 %), financial instruments. Stocks andfollowed by government bonds (15 %), equity investment funds have gained a(13 %) and corporate bonds and deposits (8 % considerable share of household assets ineach). the past few years, but insurance and pension products are not yet widespreadIn 2006, the Lithuanian parliament passed a investments. In 2004, their share of totallaw that enables the creation of financial assets amounted to only 4 %.occupational pension schemes and group However, these products should grow fast aslife contracts. This could become something the volume of pension assets increases. Inof a fourth pillar in the future, but a scheme 2005, assets of second and third pillarhas yet to be created. pension funds grew more than threefold. Third pillar statistics 2006IORP Members 20,100 Assets under Management [EUR] 15mThough doubts have been expressed aboutthe correct implementation of the IORP Number of pension fund providers 4 71
    • Lithuania OutlookLife premiums grew by 23 % from 2004 to assumed that mainly high-income earners2005, but still represent just 0.43 % of GDP. in the prime of their working lives will saveGrowth and penetration in this area has additional money for retirement,been much lower than in most other CEE contributing 5 % of their income until 2010countries. and 8 % thereafter. Increasing participation rates and high wage increases will push theFuture pension assets third pillar pension market in the future,Contrary to initial expectations, the take-up but at low volumes. In the minimumof second pillar pensions has been fast. At scenario, assets under management willthe end of the first year, about 44 % of reach EUR 110 million by 2015 (+25 % p.a.).employed people participated in the system. The optimistic scenario foresees EUR 203In 2006, there were 610,000 members. Assets million (+34 % p.a.).currently stand at EUR 306 million. Andsince wages are expected to continue It took Lithuania almost ten years toincreasing, future growth prospects are put the basic parameters of its three-bright. pillar pension system in place. Due to the recent introduction of voluntaryIn the minimum scenario, assets under occupational pensions, Lithuania couldmanagement are expected to reach EUR 4.05 have a four-pillar system in the future.billion based on the conservative Contrary to all other CEE states with aassumption of 5 % average performance. funded second pillar, Lithuania chose not toEven in this scenario, volumes will increase make its second pillar mandatory. The fastby 33 % p.a. in the projection period until take-up of second pillar pensions, which2015. In the optimistic scenario, the volume was supported by a massive advertisingcould reach EUR 4.6 billion (35 % growth per campaign, shows that voluntary solutionsyear). Considering that the system is widely can also work.accepted, the latter is likely to be the morerealistic scenario. To achieve a balanced structure, the third pillar needs to be developed further. ItsThe development of third pillar voluntary development might be a question of timepensions plans took place on a much lower and rising income, but tax incentives arelevel. At the end of 2005, assets under currently too weak to get it off the ground.management stood at EUR 15 million, with Nevertheless, pension reforms in Lithuaniaonly 20,100 members contributing. With have resulted in a much more sustainableincreasing income, more people may join system with a widely accepted fundedthe third pillar. For our projection, we element.Lithuania: Pension assets under managementEURm6,0005,000 4,826 4,1564,0003,0002,000 1,570 1,5451,000 321 0 2006 2010e min. 2010e opt. 2015e min. 2015e opt. Second pillar assets Third pillar assets Source: Securities Commission of Lithuania, own calculations72
    • PolandPolandThe biggest pensionmarket in CEEShape of the pension systemPoland was one of the first countries in CEE toreform its pension system. The country’s Demographics and macroeconomicsreforms went very far. Not only was a Population [m] 2006: 38.1mandatory second pillar introduced, the firstpillar was also reformed in line with the 2050: 33.7principles of a notional defined contribution Population over 65 [ %] 13.2(NDC) system. This established a strict Dependency ratio* 2006: 18.7equivalence between contributions and 2050: 51.0benefits. In 1999, these reforms replaced theold PAYG system, which was under GDP [EUR] 274.3bnsubstantial financial pressure due to the GDP per capita [EUR] 7,204 (29 % of EU-Ø)rising number of pensioners. GDP growth 2001–2006 [av. in % p.a.] 3.4The first and second pillars are GDP growth 2007–2012 4.4complemented by voluntary occupational [av. in % p.a., est.]pension savings, which were also Unemployment rate [ %] 13.8introduced in 1999, and personal voluntary Data from 2006 or latest available yearschemes. The latter started operating in * Ratio of over 65-year-olds to 15– 64-year-olds2004 and are sometimes referred to as thefourth pillar. In 2002, Poland established ademographic reserve fund to cover futuredeficits. the latter will show annual growth rates between 17 % and 23 % during the samePolish demographics are similar to the otherCEE states. Over the next four decades, thepopulation will shrink from 38.1 million to period. The first pillar – public pensions First Pillar33.7 million; the dependency ratio willworsen from 18.7 % to 51 %, which is slightly The first pillar has replaced the previousbelow the EU-25 average of 52 %. defined benefit PAYG system. It is aNevertheless, Poland’s public pension mandatory PAYG scheme based on NDCexpenditure will decrease over the next accounts and run by the state-owned Socialdecades. In 2004, it stood at 13.9 % of GDP. By Insurance Institution (ZUS). The old system2050, it will have dropped to 8.0 %. The ran into difficulties due to an earlycurrent EU-25 average is 10.6 % of GDP and retirement wave that resulted fromwill increase to 12.8 % by 2050. economic restructuring. From 1989 to 1995, pension spending increased from 6.5 % toPoland’s size and its early move towards 15.6 % of GDP.funded pensions have made it the biggestmarket in the region, representing 60 % of CEE NDC accounts mimic the principles ofpension markets. Polish second pillar assets funded pensions in the public system, asamount to EUR 30 billion and third pillar benefits depend strictly on contributions. Inassets to EUR 571 million. The former are a NDC system, participants have virtualexpected to grow by 17 % p.a. until 2015, while accounts that contain contributions made 73
    • Polandthroughout their working lives. The value of First pillar designthese virtual accounts increases with wagegrowth. Benefits are calculated taking Contribution rate [ % of gross salary] Employers: 9.75average life expectancy at the time of Employees: 9.75retirement into account. This reduces the Net replacement rate 78incentives for early retirement and ensuresan actuarially neutral basis for pension Legal retirement age 65 men/60 womencalculation. The government pays Public pension expenditure [ % of GDP] 2004: 13.9contributions for extraordinary life 2050: 8.0situations, including military service, Data from 2006 or latest available yearperiods of unemployment and maternityleave. The Demographic Reserve Fund is intendedThe reforms left the retirement age the same to cover these deficits. It is financed by aat 65 for men (with 25 years of employment) portion of old-age contributions (0.2 % ofand 60 for women (with 20 years of wages in 2005, increasing to 0.4 % by 2009).employment). Retirement age itself is not asrelevant in an NDC system as in pure PAYG Apart from its public system, Poland runsschemes, as benefit payments depend on several schemes for certain occupationalaccumulated contributions. Hence, early groups, including farmers and certain civilretirement does not imply a financial servants, judges, policemen, militaryburden for the state. Nevertheless, early personnel and prosecutors. More than 90 %retirement has been an issue for people who of the farmers’ pension is subsidised by thehave remained in the old system, but this state. These payments account for 1.8 % ofsystem will be eliminated in 2008. At GDP. Both contributions and benefits arepresent, real retirement age is 59.4 years for flat-rate and amount to roughly half themen and 56.1 years for women. average of public pension benefits. Second PillarWhen the NDC system was implemented,joining was made compulsory for allemployees younger than 50. Those over 50 The second pillar – mandatorywere obliged to stay in the old system. Past individual accountsaccrued rights were transferred to the NDCsystem by crediting „initial capital“ based on Institutional frameworkactuarial valuation of social insurance Mandatory individual accounts in Polandcontributions as of the transition date. The take the form of open pension funds (OPF)self-employed are obliged to participate in and are of the DC type. The Social Insurancethe new system. Institution passes on the 7.3 % mandatory system rate to OPFs. When the new secondThe total contribution rate is 19.5 % of the pillar system was introduced in 1999, thoseemployee’s taxable income, split equally born between 1949 and 1968 could choosebetween employers and employees. Of the between opting into it or remaining in thetotal contribution rate, 12.2 % go into the reformed first pillar only. Once a decisionpublic, notional DC scheme. The remaining was made, it was irreversible. Membership7.3 % are credited to the second pillar was made mandatory for those entering theaccounts operated by pension funds. labour market and born in or after 1969. TheContributions are paid up to the limit of 2.5 accounts are managed by specialisedtimes the average Polish salary. For pension fund companies. Open pensionmembers who contributed for the minimum funds are independent legal entities createdamount of time but whose total pension and managed by a joint stock company, a so-from the first and second pillars is below the called general pension fund society.guaranteed minimum pension, the statecovers the difference with public funds. Until 2004, each pension fund society could create and manage one open fund only.Due to transition costs, the first pillar will Since 2004, each pension fund society haslikely generate a deficit until the mid-2030s. been allowed to run two open funds, one of74
    • Polandwhich must be invested conservatively, Second pillar statistics 2006while the other can have a higher share ofequity investments. The creation of a Members 12.4mpension fund society requires permission Assets under management [EUR] 30bnfrom the Insurance and Pension FundsSupervisory Commission (KNF). The Number of pension fund providers 15pension fund society must have amanagement board (which is also the · The average real annualised rate of returnmanaging body of the OPF), a supervisory for all pension funds over the last 36board and a general meeting. OPFs created months, minus four percentage points, orby the pension fund society must beindependent legal entities. · The average real annualised rate of return for all pension funds over the last 36Investment regulations months, minus 50 % of this average rateLike most other CEE countries, Polishpension funds are subject to quantitative The pension fund society must establish ainvestment restrictions and minimum reserve account for the open fund from itsreturn guarantees. own resources. This account is used to offset deficits arising from investment returnsOpen pension funds are subject to the below the mandatory minimum return. Iffollowing maximum investment limits: the reserve account is not sufficient to offset the deficit, the pension fund society must· 40 % for equities from the regulated stock cover it using its own resources. If it is exchange market unable to do so, its management board is obliged to file for bankruptcy. In this case,· 40 % each for mortgage bonds, municipal the national guarantee fund (the resources and corporate bonds of which may not exceed 0.1 % of the· 20 % for bank deposits and bank securities cumulative net asset value of all open· 15 % for units of open-ended investment funds pension funds) stands in for the pension fund. Deficits that cannot be covered by the· 10 % for equities in the regulated non- guarantee fund are offset by the Polish exchange market Treasury.· 10 % for certificates of closed-end investment funds Disclosure and fee regulation· 2 % (5 %) for investment certificates of a OPFs have to publish the fund’s articles of single closed-end (open-end) investment association, information on the fund’s fund investment performance and the fund’s approved annual report in a national dailyThere are no limits on investments in state- newspaper at least once a year. They alsoissued bonds. Foreign investment is have to send a report at least annually torestricted to 5 %. Investment limits for each member containing account balancemortgage, municipal, and corporate bonds information, contribution receipt dates andhave been relaxed in recent years, while information on the fund’s investmentother restrictions have remained stable. performance. The annual report must beFurther restrictions apply to investments in approved by the regulatory authority. OPFsfinancial instruments from a single issuer, are obliged to disclose further informationsuch as securities, investment certificates or to the authorities, including dailymortgages. Open pension funds may not performance and financial status updatesinvest in shares or other securities of the as well as monthly portfolio allocationpension fund managing society. reports.In Poland, minimum return guarantees are There are three types of fees that OPFs canrelative. The minimum rate of return is defined charge: distribution, management andas the lower of the following two values: transfer fees. The distribution fee must not exceed 7 % of the value of contributions; this limit will be reduced to 3.5 % in 2014. The 75
    • Poland Third & Fourth Pillarmanagement fee is meant to cover expenses for 35 % and bank deposits for 2 %. Therelated to fund management and has two international investments of OPFs arecomponents, which are capped. The fixed extremely low, amounting to 0.4 % of assets;component must be lower than 0.045 % of net OPFs do not even exploit the low 5 % cap onassets, while the variable component international investments.depends on investment returns generatedand must not exceed 0.005 % of net assets per Taxationmonth. A transfer fee for switching between Poland runs an EET system in theopen pension funds is charged if mandatory pillar, in which contributionsmembership has been shorter than two are tax-deductible, investment income isyears and ranges from PLN 80 to PLN 160 tax-exempt and benefits are taxed.(EUR 21 to EUR 42), depending on the lengthof membership. Members are free to switchfunds at any time. The third and the fourth pillarBenefits and withdrawal – voluntary pension savingsWhile members have to buy a life annuity atretirement, regulations concerning which Third pillar pensions had a slow start intypes they can choose have not been defined Poland. In 1999, voluntary occupationalyet. Draft regulations propose several types pension plans (PPE) were introduced in theof annuities, including: country. In 2004, personal voluntary schemes (IKE) were established.· Life annuities for the member only Voluntary occupational pension plans· Life annuities with guaranteed benefits for The idea behind the introduction of PPEs, survivors for a period of at least 10 years which are DC plans, was to create an· Life annuities paid until the spouse’s additional layer of pension provision. death, with the survivor’s pension 260,000 employees currently participate in equalling at least 75 % of the original the system and assets under management benefits amounted to EUR 571 million in 2006.Annuities must be indexed in line with Participation is low for two reasons. First,inflation. The first benefits of the new tax incentives are quite limited. PPEsystem will be payable from 2009. The set-up contributions are mandatory for employersof the pay-out phase is still being discussed, and on an after-tax basis for employees,the main issue being whether the state- making the scheme unpopular. There is onlyowned Social Insurance Institution should a capital gain tax exemption for planbe responsible for it, or whether OPFs should members and an exemption from socialpay out benefits themselves. security contributions up to 7 % of employees’ salaries. Second, due to Poland’sAsset management and allocationThere are 15 pension companies operating Mandatory pension fund asset allocation 2006in the Polish mandatory pension market,down from 21 in 1999. Membership Treasury bonds: 62%currently stands at 12.4 million, or 85 % ofthe working population. Assets undermanagement amounted to EUR 30 billion in Other assets: 1 %2006. Compared to many other CEEcountries, the degree of marketconcentration is modest; the three biggestOPFs account for 56 %, the five biggest OPFs Bank deposits: 2 %for 70 % of all members.The overall asset allocation of OPFs is quite Equities: 35%conservative: Bonds and treasury billsaccount for 62 % of assets, domestic equities Sources: OECD, Allianz Global Investors76
    • Polandhigh unemployment rate, the highest in the voluntary schemes (IKE). The IKEs areEU, employers have not seen the necessity to individual accounts and are managed byestablish incentives for staff retention. In investments funds, broker companies, life2004, PPEs were reformed. Registration and insurance companies or banks. They canoperations were simplified, the self- take the form of investment funds, bankemployed were allowed to participate, and accounts or life insurance schemes.greater individual choice was implemented.Suspending contributions for a specific Employer contributions are tax-deductibleperiod was also made possible, which is for the employer and taxable for theimportant for employers in financial employee. Similar to the PPE scheme, IKEsdistress. are on an after-tax basis for the employee. To qualify for tax exemption, contributionsIf an employer establishes a PPE, it is obliged may not exceed 150 % of the average monthlyto pay contributions for its employees. The wage. Pre-retirement withdrawals arecontribution is tax-exempt up to 7 % of the allowed, but there are tax penalties, just likeemployee’s salary. Employees may make there are with PPEs. IKEs can offer portfolioadditional contributions to supplement choice and several pension product options.those of the employer. These are fully taxed They are exempt from capital gains tax,and cannot exceed 450 % of the average provided that the account is maintainedmonthly salary, which is now around EUR until retirement age. Contrary to the630. There are no rules on how pension mandatory pension’s EET system, Polandbenefits must be paid out, but they cannot applies a TEE system in the voluntary pillars.be withdrawn before the member reaches The government estimated that up to 3.5retirement age. Employers are restricted in million people would open IKE accounts, butplan design, with minimum requirements only 677,000 had done so by mid-2006. Ofincluding a legally defined „basic employer these, 70 % chose life insurance, 18 %contribution“. The fund must be offered to investment funds, 8 % bank products and 4 %more than 50 % of a company’s employees. broker company offers. It should be notedPlan conditions must be negotiated with the that switching from PPE schemes to IKEunions or employee representatives. accounts is possible. A number of participants in the IKE scheme are thereforeThere are 27 companies managing a total of switchers who do not save additionally, but Outlook906 schemes. All the managed schemes only in a different scheme than before.must be based in Poland. Investment funds,life insurance companies, speciallyestablished company pension funds or IORPforeign management companies managevoluntary occupational pension schemes. The IORP directive has been transposedThere are no regulations regarding fee caps. fully into Polish law.PPEs enjoy more investment freedom thanOPFs. Portfolio regulations do not foreseeany limits on equities, certificates of open- Outlookand closed-ended investment funds or bankdeposits. There is a 10 % limit on mortgages, Current household asset allocationmunicipal and corporate bonds. In 2005, Polish financial assets totalled EURInvestments in real estate are prohibited. A 145 billion. At 57 % of GDP, this is rather low;major regulation is that there is a 5 % cap on per capita values barely reached 7 % of theinvestments in OECD securities markets, EU-15 average. However, growth is quitejust as there is for OPFs. Third pillar statistics 2006 (voluntary occupational plans – PPE)Personal voluntary schemes Members 260,000The unpopularity of PPEs led the government Assets under Management [EUR] 571mto introduce an additional scheme for private Number of pension fund providers 27pension savings in 2004, the personal 77
    • Polandstrong, albeit on a low level. The value of future, however, growth can only befinancial assets grew by 30 % in 2005, and generated by price hikes in financialgrowth prospects are good thanks to lower markets and wage growth. The latter isunemployment. expected to be moderate in the coming years compared to wage increases in otherPolish households keep more than 50 % of CEE countries. Second pillar pension assetstheir financial assets in bank deposits. The amounted to EUR 30 billion at the end ofsecond largest portion in households’ 2006, making Poland the largest pensionportfolios comprises shares and mutual market in Eastern Europe by far.funds, the result of voucher privatisation inthe 1990s. Insurance and pension products The comparatively moderate wage increasesmake up about 10 % of the portfolio. Life and stagnating participation will slow downpremiums in Poland grew by 22 % from 2004 the growth process. In our projection period,to 2005, a much larger increase than in assets under management are expected toprevious years, which was mainly the result reach EUR 127 billion based on theof „bancassurance“ offers’ popularity. Even conservative assumption of 5 % averagethough growth is not as strong as in other performance. In this scenario, volumes willCEE states, Poland is already further ahead in increase by roughly 17 % p.a. until 2015. Sincethe process of catching up. Life premiums as contribution rates are fixed and will nota share of GDP stand at 1.3 %, 23 % of the EU-15 likely change, calculating a second scenarioaverage, but higher than the CEE average. would not make sense.Future pension assets Third pillar voluntary pension plans haveIn 2006, 12.4 million employees subscribed developed to a much smaller extent. Onlyto second pillar pension funds, covering 260,000 people are currently participating85 % of employed people. In recent years, in PPE schemes. At the end of 2006, assetsparticipation has decreased as inactive under management amounted to only EURaccounts have been cleaned up. 571 million. As wages increase, more people may join the voluntary scheme. For ourThe inflow of contributions and the minor projection, we assumed that people willbenefit payments in the years to come (first continue to contribute only a small portionpayments are due in 2009) support the of their income, and that mainly high-growth of open pension funds’ assets for at income groups will set more aside forleast the next decade. In 2005, OPFs retirement. Increasing participation ratesbenefited from high equity exposure; assets and modest wage increases will give thegrew by 44 % thanks to a bull market. In the third pillar pension market a boost in thePoland: Pension assets under managementEURm140,000 130,656 129,431120,000100,000 80,000 66,989 67,469 60,000 40,000 30,587 20,000 0 2006 2010e min. 2010e opt. 2015e min. 2015e opt. Second pillar assets Third pillar assets Source: Insurance and Pension Funds Supervisory Commission of Poland, own calculations78
    • Polandfuture, but volumes will continue to be low. cap on international investments inIn the minimum scenario, assets under particular hampers an appropriatemanagement will reach EUR 2.4 billion by international diversification of assets,2015 (+17 % p.a). The optimistic scenario which means that participants either haveforesees EUR 3.6 billion (+23 % p.a.). Both to accept higher risks or lower returns. Thescenarios exclude IKEs due to the relative minimum guarantee of mandatorydominance of life insurance schemes. pension funds results in conservative asset allocation, which meets the guarantee in The Polish pension system has been the short-term, but misses long-term transformed. Structural reforms opportunities and higher returns in theresulted in fewer long-term financial burdens capital market.for the state and contribution-oriented pillars.In the first pillar, transition costs remain an The outlook for the voluntary pension pillarsissue, as does the separate and costly system is mixed. Participation has been far belowfor farmers. The transformation entails high expectations so far, partially due tocosts, which will have to be covered by the insufficient tax incentives. However,state or the demographic fund. voluntary occupational schemes may well become more popular in Poland ifIn the mandatory and voluntary pension unemployment continues to decrease andpillars, regulation impedes more efficient staff retention initiatives gain inlong-term investment strategies. The low importance. 79
    • RomaniaRomaniaA pension system intransitionShape of the pension systemThe road to pension reform in Romania hasbeen a bumpy one. Throughout the 1990s, Demographics and macroeconomicsthere were several attempts to reform the Population [m] 2006: 21.7pension system, but a law was first approvedin 2000, focusing on reforms in the public 2050: 16.8system. Four years later, laws were passed Population over 65 [ %] 14.8that paved the way for the introduction of a Dependency ratio* 2006: 21.7voluntary pension pillar and a mandatory 2050: 49.6second pillar. Implementation was delayed,however, and the voluntary pillar became GDP [EUR] 101.6 bnoperational in 2007, while the mandatory GDP per capita [EUR] 4,686 (19 % of EU-Ø)pillar is expected to be up and running in GDP growth 2001–2006 [av. in % p.a.] 5.62008. In Romania, the voluntary pillardiffers from those of other CEE countries, as GDP growth 2007–2012 4.8it does not feature private pensions. Instead, [av. in % p.a., est.]it comprises Western European-style Unemployment rate [ %] 7.4occupational pensions. Data from 2006 or latest available year * Ratio of over 65-year-olds to 15– 64-year-oldsRomania will not be spared from the effectsof demographic change. Between now and2050, the country’s population will shrinkfrom 21.7 million to 16.8 million. The old-agedependency ratio will rise from 21.7 % to The first pillar – public pensions49.6 %, which is slightly lower than theprojected EU-25 average of 52 %. According tothe convergence programme Romania Romania’s first pillar suffered from the typical problems of an Eastern European First Pillarsubmitted to the European Union, public transition country. Unemployment rose andpension expenditure is expected to increase the number of contributors to the publiconly marginally, from 6.7 % of GDP in 2004 to system fell. In addition, retirement age was7.0 % in 2050. The EU-25 average will increase low and early retirement easy andfrom 10.6 % of GDP to 12.8 % over the same widespread, as it was used as a means ofperiod. avoiding a further increase in unemployment. Transparency was low,Once the second pillar has started especially regarding the link betweenoperating, assets will grow quickly. By 2015, contributions and benefits. Furthermore,second-pillar assets will amount to a there were different pension systems inminimum of EUR 2 billion, or to EUR 3 place for different occupational groups.billion in the optimistic scenario. Third- Emigration was high, which made thepillar assets will reach EUR 869 million. contribution problem even worse. Between 1990 and 2004, the number of pensioners grew from 3.5 to 6.1 million, while the number of contributors fell from 8 to 4.5 million.80
    • RomaniaThe pension reform that was passed in 2000 First pillar designaddressed these problems and created anintegrated system. The new approach Contribution rate [ % of gross salary] Employers: 20.5 %included the self-employed, the Employees: 9.5 %unemployed, policemen and farmers (on a Net replacement rate n.a.voluntary basis), none of whom wereincluded in the previous system. Previously, Legal retirement age 63.1 men/58.1 womenseveral systems for various occupational Public pension expenditure [ % of GDP] 2005: 6.7groups existed alongside the public system. 2050: 7.0These continue to exist for lawyers, military Data from 2006 or latest available yearstaff and the clergy.As of May 2007, retirement age was 63 yearsand 1 month for men and 58 years and 1month for women. It is gradually increasing These parametric reforms in the first pillarand will reach 65 for men and 60 for women managed to ease financial pressure on thein 2015. Early retirement has been made system and incorporate almost all segmentsmore difficult, and the required of the Romanian population. However, sincecontribution period has been increased the reforms led to frequent changes to thefrom 25 to 30 years for women and from 30 law, the confidence in the system has beento 35 years for men. Romania has also reduced. Between 2000 and 2004, the lawintroduced a point system that calculates reforming the public system was changedbenefits based on contributions made 23 times.throughout the entire working life ratherthan taking only the last few years intoaccount. Pension points are calculated asthe ratio of the individual’s monthly gross The second pillar – mandatorywages and other compensation to the individual accounts Second Pillarnational average for that year. Theemployee’s pension is determined by Institutional frameworkmultiplying the pension points with the Following the decision to introduce apension point value, which is determined funded and mandatory second pillar ineach year in the social security budget law. 2004, another law was added in 2007 thatThe reform also created the National House focused on the licensing procedure,of Pensions and Other Social Security Rights, investment limits and classes, thean institution that aims to coordinate and guarantee fund and the role of themanage the public pension system. These supervisory authority. The second pillar isparametric reforms were implemented as a set to start operating on January 1, 2008.means of coping with short-term financial From then on, a portion of social securitypressure. contributions will be directed to funded individual accounts, which are definedEmployers’ pension contributions amount to contribution schemes.20.5 % of gross earnings (higher for workers indangerous occupations); employees During the first year of operation,contribute 9.5 % and the self-employed carry contributions to the funded part of thethe full contribution rate themselves. system will amount to 2 % of wages. They willContributions have to be paid for income up then increase by 0.5 % each year until theyto five times the national monthly average, reach 6 % after 8 years. Contributions to thewhich was RON 1,077 (EUR 307) in 2006. Early first pillar will diminish at the same rate.retirement is possible from five years prior to Participation in the mandatory pillar will benormal retirement, provided that the obligatory for all people under 35 andemployee’s contribution record exceeds the voluntary for the 36 to 45 age cohort.required time period by 10 years or more. Assuming that 50 % of those who can joinPension benefits are indexed to inflation and voluntarily do so, 2.6 million participantsadjusted quarterly if prices have increased by could be enrolled in the scheme from theat least 5 % on an annual basis. very beginning. 81
    • RomaniaMandatory pension funds are not yet in Disclosure and fee regulationoperation in Romania. Once they get going, Disclosure regulations stipulate thatthese funds will be civil companies, defined pension fund administrators must informby Romanian law as non-commercial members of their account status at leastcompanies without legal liability. Such once a year. Fee regulations encompasscompanies can be established by a three areas: first, front-end fees may notminimum of 100 founding members and exceed 2.5 % of contributions paid. Second,must be approved by the Pension Fund annual management fees may not be higherSupervision Commission. A pension fund than 0.6 %. Third, no more than 10 % of themust have a minimum of 50,000 annual investment income can be chargedparticipants one year after it has been as a performance fee.founded. Individuals can only join oneprivate pension fund at a time. In order to secure mandatory pensions, Romania plans to create a nationalSince pension funds have no legal liability, guarantee fund that will be responsible forseparate administrative companies are both mandatory and voluntary pensions.needed to manage them. The exclusive The national guarantee fund will beobjective of administrators is the established within 90 days of the date fromadministration of pension funds, this which at least three voluntary pensionincludes calculating and paying out administrators have been authorised. Thebenefits. An administrator may manage Pension Fund Supervision Commission willonly one mandatory pension fund. establish its legal framework and functioning. The guarantee fund will beInvestment regulations financed by administrators’ contributionsOnce mandatory pension funds start and will step in if pension funds are not ableoperating, the main investment limits will to pay out benefits.be as follows: Benefits and withdrawal· Up to 20 % of assets can be invested in Benefits will be paid out as annuities. Those money market instruments who do not have sufficient assets to qualify· Up to 70 % can be put into state bonds for a pension will receive a lump sum or issued by Romania, EU countries or states periodic payments for up to five years. from the European Economic Area (EEA) Benefits are adjusted based on the consumer price index.· Up to 30 % can be invested in bonds issued by local public administrations in Asset management and allocation Romania, the EU or the EEA. The maximum As of early 2007, no mandatory pension fund for bonds from other states is 15 % had been established. However, banks,· A maximum of 50 % can be invested in financial institutions and pension funds equities listed on Romanian, EU or EEA active in other CEE are expected to enter the markets market. One financial services provider has confirmed that it will apply for a license, andAdministrators must achieve a minimum nine others have expressed interest.rate of return, which is set by the Pension Romanian financial markets remainFund Supervision Commission. The underdeveloped, which could prove to be aCommission also has the power to appoint a challenge for the success of a mandatorySpecial Surveillance Board, which is created pension pillar.when the fund’s profitability rate has beenlower than the minimum rate of all pension Taxationfunds for four consecutive quarters. Private Romania will run an EET system for thepension funds must establish a reserve taxation of future mandatory accounts.fund, which aims to ensure the minimum Employee contributions will be tax-profitability level. The details of this reserve deductible and investment income tax-fund have not yet been finalised. exempt. Pension benefits will be subject to ordinary taxation.82
    • Romania Third PillarThe third pillar – voluntary participants have contributed for more than 60 months. Otherwise, contributions can beoccupational pensions paid out either as a lump sum or in instalments for up to five years. FurtherVoluntary pension funds regulations for the pay-out phase will beIn terms of its institutional structure, developed within the next three years.Romania’s third pillar bears a strongresemblance to the occupational schemes The fund administrator is obliged to publishprevalent in Western Europe. After the basic an annual report containing information ondecision was made to introduce voluntary its assets, fees and participants. It also hasoccupational schemes in 2004, a new law to provide its members with annualreplaced the previous legislation in 2006. information on the status of their accounts.The new law regulates occupational pension The maximum management fee theschemes and determines tax and administrator can charge amounts to 2.4 %.investment regulations. The law was The limit for front-end and performanceadopted to align legislation with EU fees stands at 5 %. Switching fees, theregulations. maximum limits of which have yet to be determined, are payable if the memberEmployers and trade unions can establish transfers to another fund within the firstvoluntary occupational schemes, which are two years. Occupational pensions areDC plans, at the industry, group or plant subject to EET taxation. Employer andlevel through collective bargaining. In the employee contributions are tax-deductibleabsence of a collective agreement, up to EUR 200 a year, investment income isemployers can either establish pension tax-exempt and benefits are subject toschemes individually or at the industry standard taxation.level. Employers can choose whether or notto set up a scheme, as long as they have Once the voluntary pension system ismade the appropriate tax or other operating, it is estimated that 500,000contributions to the state. Participation in people will participate during the first yearoccupational pension funds is voluntary for of implementation. However, no voluntaryemployees. pension funds were operating in early 2007. One financial institution has applied for aContribution levels are established in line license to manage voluntary funds, and twowith scheme regulations. They are collected others have indicated that they are close toand paid by employers or the participants finalising their application.themselves. Contributions are depositedinto the employee’s individual account andcan amount to 15 % of gross salary. They canalso be shared between employers and IORP Outlookemployees, depending on schemeregulations or collective agreements. The IORP directive has been transposed entirely into Romanian law.Voluntary occupational plans are run by anadministrator, which is either a pensioncompany, an investment manager or an Outlookinsurance company. Administrators canmanage as many occupational schemes as Current household asset allocationthey wish. The pension funds are subject to In 2003, the most recent year for whichthe same investment and reserve information is available, the financial assetsregulations as mandatory funds. There will of Romanian households totalled EUR 21.6be also minimum return guarantees for billion. This amounts to 39 % of GDP, faroccupational pensions, the details of which below Latvia’s 52 %, the country with thehave not yet been defined. The funds will be lowest level in the EU-25. At present,obliged to establish reserve funds to cover investments in financial assets competepossible shortfalls. Benefits will be paid out strongly with consumption. Pent-upin the form of annuities, provided that demand for consumer products is 83
    • Romaniaenormous, especially for durable goods. The participation rate of younger workersRomanian households have high debts, will be high, but not 100 % from the start, aswhich continue to rise in anticipation of a certain time period will be required tofurther income growth. introduce the system. We assumed full coverage from 2011 onwards for youngerEventually, financial products will become workers and 20 % for older ones. In theincreasingly popular thanks to a positive minimum scenario, assets undereconomic environment, low unemployment management are expected to reach EUR 2and considerable income growth. The billion by 2015 based on the conservativedelayed introduction of the second pillar assumption of 5 % average performance. Inpension system is impeding the build-up of this scenario, volumes will increase by 60 %long-term savings. The share of life p.a. due to the increasing level of capitalinsurance products is negligible within the inflow (EUR 71 million to EUR 390 million).already small financial portfolio ofRomanian households. Life penetration In the optimistic scenario, we assumed aamounts to a mere 0.3 % of GDP, compared 50 % higher participation rate in the secondwith 5.6 % in the EU-15 and 1.1 % for the CEE pillar, which can either be the result of oldercountries. employees participating more in the labour market or a consequence of acceleratedFuture pension assets industrialisation. According to thisWhile the start of the mandatory second estimate, assets under management willpillar is still uncertain, we assumed that it reach EUR 3.0 billion by 2015. Inflows willwill be up and running in 2008. In the start at EUR 107 million and rise to EUR 590minimum scenario, only part of the million by the end of the projection period.workforce will be able to join the system,mainly urban employees (50 % of the The third-pillar voluntary pension system isworkforce). Urban employees are more likely in the process of being introduced. Capitalto have regular work contracts and a higher accumulation may be hindered byincome than rural workers. This group uncertainties surrounding thecurrently comprises roughly 4.5 million establishment of the second pillar and thepeople. We predicted a shift from rural to related financial cost for employees.urban employment of 10 % within the Moreover, the tax break is limited to EUR 200projection period, so that the urban per year, which is not attractive for higherworkforce will count roughly five million income households, the most likelypeople in the next decade. voluntary savers. The prospects for the newRomania: Pension assets under managementEURm4,000 3,9053,000 2,8932,0001,000 643 482 0 2006 2010e min. 2010e opt. 2015e min. 2015e opt. Second pillar assets Third pillar assets Source: Own calculations84
    • Romaniasystem are therefore not particularly rosy, the long-term. Interestingly, Romania chosealso considering Romania’s low income to introduce voluntary occupationallevels and limited wealth. We assumed low pensions and not voluntary privatecoverage (5 to 10 % for the age group of 25 to pensions. Occupational pension market45) at the beginning, extending to 5 to 20 % development will depend on employers’for groups up to 55 years old. These cohorts willingness to provide occupationalare assumed to use up the maximum tax- schemes, and on whether employees anddeductible amount of EUR 200 a year. Based unions will push for this type of pension.on these assumptions, assets under Potentially, occupational schemes couldmanagement will reach EUR 869 million by become an interesting tool for employeethe end of 2015. The current savings retention.behaviour, consumption priorities anduncertainties about further pension reform Implementing the third pillar before thewill impede private old-age provisioning. second pillar is unfortunate for pensionFor this reason, we consider a more funds, employers and employees, becauseoptimistic scenario to be unrealistic. uncertainties surrounding the second pillar hamper the acceptance and take-up of When it comes to pension reform, voluntary pensions. However, once the Romania is a late bloomer compared system is in place and operating, Romaniawith other Eastern European countries. will become an attractive market for assetFirst-pillar restructuring took place in 2000, managers. It has the second biggestthe introduction of the second pillar has population in Eastern Europe after Polandbeen delayed until 2008 and that of the third and has enormous catch-up potential. Ifpillar is still ongoing. It remains to be seen Romania manages to sustain its currentwhether reforms to the first pillar are growth rates, it may well become one of thesufficient to make the system sustainable in key growth markets in Eastern Europe. 85
    • SlovakiaSlovakiaEstablishing a strongmandatory pillarShape of the pension systemPension reforms in Slovakia wereimplemented quite recently, with a major Demographics and macroeconomicsreform in 2005 that established a stronger Population [m] 2006: 5.4link between contributions and pensions. Italso increased the retirement age and 2050: 4.7created a mandatory second pillar system. Population over 65 [ %] 12.0Slovakia is the latest of the CEE countries to Dependency ratio* 2006: 16.3have created a mandatory pillar, which 2050: 50.6receives high social security contributions.Reforms were initiated mainly to remedy GDP [EUR] 47.5bnthe deficits of the public PAYG system. The GDP per capita [EUR] 8,848 (36 % of EU-Ø)new Slovakian system is a three-pillar GDP growth 2001–2006 [av. in % p.a.] 4.0system comprising a reformed PAYG pillar,mandatory individual accounts and a GDP growth 2007–2012 4.8voluntary supplementary pension saving [av. in % p.a., est.]scheme. Unemployment rate [ %] 13.4 Data from 2006 or latest available yearDemographic development in Slovakia is * Ratio of over 65-year-olds to 15– 64-year-oldsmuch like it is in other Eastern Europeancountries – its dependency ratio will worsenfrom 16.3 % today to 50.6 % in 2050 – slightlybelow the 52 % ratio of the EU-25 in 2050 andthose of several CEE countries. Publicpension expenditure is projected to increasefrom 7.2 % of GDP in 2004 to 9.0 % in 2050,compared with an increase from 10.6 % to rate and low motivation among employees to contribute to the system. The link between contributions and benefits was weak, the retirement age was low and the First Pillar12.8 % for the EU-25 average. labour force was emigrating more and more. The first pillar had been in a deficit situationWhile Slovakia’s second pillar is still very since 1997, causing a steady decline in realnew, pension assets had already grown to pensions. Between 1991 and 2003, theEUR 710 million in 2006. Assets under average pension fell from around 54 % of themanagement in third pillar plans total EUR average wage to 45 %. As a result, pensioners635 million. Annual growth rates for second were increasingly dissatisfied with theirpillar assets will reach more than 30 %, and standard of living.will range between 16 % and 22 % for thirdpillar assets. The main aims of pension reform were to restore the long-term sustainability of public pensions, strengthen the linkThe first pillar – public pensions between contributions and benefits, and promote private pension savings. TheThe system in place before the 2005 reform reform gradually increased retirement age,suffered from serious financial difficulties. which currently stands at 62 for men and 55These resulted from a high unemployment years and 3 months for women. By 2015, it86
    • Slovakiawill be 62 for both sexes. Incentives for early First pillar designretirement were reversed: for each month ofearly retirement, pension benefits will Contribution rate [ % of gross salary] Employers: 14decrease by 0.5 %. Employees who delay their Employees: 4retirement now receive a bonus of the same Net replacement rate 63percentage. Contributions and pensionbenefits are now directly linked, as benefits Legal retirement age 62 men/55.3 womenare calculated based on length of service Public pension expenditure [ % of GDP] 2005: 7.2and wage level. Pension benefit levels are 2050: 9.0based on a point system; the point value is Data from 2006 or latest available yearindexed to average earnings, with acontribution ceiling of triple the averagesalary. Pensions already being paid out areindexed to the arithmetic average of incomegrowth and price inflation.New labour market entrants and the self- The second pillar – mandatoryemployed were automatically enrolled in individual accountsthe new second-pillar system. Employeesyounger than 52 could choose whether to Institutional frameworkjoin the new pillar or remain in the old The mandatory system is of the DC type,system, but the decision had to be made by with 9 % of gross wages directed intothe end of June 2006. Those who decided to individual members’ accounts. The fundsjoin the new system cannot return to the old are managed by single-purpose pensionone, but they keep the benefits acquired in asset management companies (PAMCs). Thethe old system. PAMCs are private sector, joint stock companies with minimum capitalParticipants in the mandatory pillar requirements of about SKK 300 million (EUR Second Pillarredirect a sizeable part of their payroll taxes 7.1 million). Their exclusive business is toto their individual accounts. In Slovakia, this create and administer pension funds. Theyamounts to 9 % of gross wages. The overall must have at least 50,000 members withincontribution rate is 18 % of gross wages, with 18 months of the pension fund’s creation.employers paying 14 % and employees They are governed by a two-tier boardcontributing 4 %. The contribution rate is structure consisting of a board of directorsdivided equally between the public pension and a supervisory board.program and the new mandatory pillar;both receive 9 %. The former also includes Slovak pension funds must offer threedisability insurance and a reserve fund to different funds with different risk/returncover transition costs and possible deficits profiles:in the first and second pillars. · A conservative fund with no equityWhile the relatively radical transformation of exposure and 100 % allocation into bondsthe system will help ease financial pressure and money market instrumentsin the long-term, transaction costs willincrease considerably in the short-term. The · A balanced fund with an equity share of upfirst pillar system has to cope with dwindling to 50 % and a bond/money marketcontributions, making additional transfers instrument share of at least 50 %from the state budget and/or the reserve fund · A growth fund with an equity share of up toseem likely. The Slovak government intends 80 %to use additional revenues from privatisationto cover the impending deficit. According to Each fund has to be managed by a differentEuropean Commission estimates, total fund manager; portfolio managementtransition costs will range from SKK 50 to 70 cannot be outsourced to external assetbillion (EUR 1.3 to 1.9 billion). The exact managers. Individuals can only be membersfigure will depend on the number of people of one fund at a time. Members may choosejoining the mandatory pillar. which fund to join and can switch between 87
    • Slovakiafunds as often as they wish, unless they will Second pillar statistics 2006 (or latest year available)retire in 15 years or less. If this is the case,they can no longer be enrolled in the growth Members 1.1mfund. Seven years before retirement, they Assets under Management [EUR] 710mhave to completely shift balances to the Number of pension fund providers 6conservative fund.Investment regulations return within five days. If the PAMC does notPAMCs are subject to a variety of take these recovery measures, or if it isregulations. The Pension Funds Act defines unable to do so because of insufficientthe range of permissible investment assets, or if the violation occurs for the thirdinstruments and sets maximum limits for time, the supervising authority ordersportfolio allocation. Investment procedures receivership over all of the relevant PAMC’sand valuation are also regulated. Since pension funds and withdraws its operatingSlovak pension funds have to offer three license.types of portfolios, there are no overallmaximum holdings like those in other CEE Disclosure and fee regulationcountries. Upon joining the fund, members must be given an information prospectus describingA very important regulation is that pension the investment strategy, the risk profile andfunds have to invest at least 30 % of their the fund’s investment allocation. At leastassets into instruments issued by Slovak once a year, they must also be provided withissuers. Initially, a 50 % limit was approved, account balance statements, which must bebut it was reduced in 2004. This regulation accessible on the Internet. Fund assets mustaims to prevent capital outflow and support be published in the press weekly, while feesthe Slovak capital market. However, it also must be disclosed monthly.hinders diversification and might result insuboptimal returns and an artificial rise in The monthly management fee for Slovakiandomestic assets. This investment limit takes pension funds must not exceed 0.07 % of neteffect 12 months after the creation of the assets. Charges for maintaining personalpension fund. pension accounts are limited to a maximum of 1 % of contributions for each fund. A PAMCEqually important is that PAMCs have to may not charge any other fees (e.g. forachieve a minimum return for each of the switching funds or PAMCs). In addition, thethree funds. The regulation does not require Social Insurance Agency charges 0.5 % of theabsolute performance goals, but a relative contributions it transfers to the individualperformance guarantee. At any moment 24 account fund manager. Members are free tomonths after the pension management change to a different PAMC every two years.company has begun operating the pension If they do so, they must pay a fee of SKK 500fund, the fund’s minimum return must be (EUR 15) to the Social Insurance Agency.equal to the lower of the two values: Benefits and withdrawal· Conservative: 90 % of the average yield Benefits are paid as annuities on the during the past 24 months, or the average condition that the member has reached yield minus one percentage point retirement age and contributed to the· Balanced: 70 % of the average yield during scheme for at least ten years. the past 24 months, or the average yield minus three percentage points Asset management and allocation· Growth: 50 % of the average yield during the The mandatory pension market is fairly past 24 months, or the average yield minus concentrated. Until 2006, there were eight five percentage points pension companies on the market, all of them linked to international financialIf a pension fund does not meet these services firms. However, due to intenseminimum targets, the PAMC is obliged to competition, the number has dropped to six.transfer assets from its own property to the Consolidation has largely been the result ofrespective fund to ensure the minimum the regulation stipulating that pension88
    • Slovakiafunds have to achieve membership of at assets were invested in deposits and Third Pillarleast 50,000. If they fail to do so, their license treasury bills and 15 % were put into bonds.is revoked and their members are PAMCs obviously prefer to invest in lowertransferred to other providers. The PAMC risk assets, which may be because of thewith the largest market share has 30 % of all novelty of the system.members, and the three largest PAMCs havea combined membership of 70 %. Taxation Mandatory pensions in the Slovak RepublicBefore the start of the mandatory pillar, are not taxed. The system in place is EEE.around 50 % of employees were expected to Contributions are tax-exempt, as arejoin the new system. By the end of 2005, 1.1 investment income and pension benefits.million workers, 47 % of eligible people, hadindeed joined. Since 35 % of Slovakia’spopulation is under 25, participation and The third pillar – voluntarycoverage will continue to grow. Assets undermanagement currently amount to EUR 710 pension savingsmillion. Voluntary pension fundsWith its high equity share, the growth fund Slovakia’s voluntary third pillar pensionis the most popular product. 69 % of the scheme started operating in 1997 and wasenrolled members have chosen it; almost substantially reformed in 2004. Previously,30 % have opted for the balanced fund and participation was linked to employment,only 1 % have chosen the conservative funds. but the third pillar is now open to everyThe popularity of funds with the highest citizen over 18. The modified voluntaryreturn potential and risk can be explained pension tier has been in operation sinceby the strong growth of the Slovak stock 2006. Assets under management currentlyexchange and the age structure of amount to EUR 635 million.participants. 45 % of members are youngerthan 30 and 83 % are under 40. Voluntary pension savings are managed by supplementary pension managementDespite the dominance of the growth fund, companies (SPMCs) that offer DC plans. Theypension funds do not even come close to are obliged to manage at least twoexploiting asset allocation limits. In late supplementary pension funds. From2005, the growth funds had allocated 77 % of January 1, 2005, other financial institutionstheir assets in deposits or treasury bills, 16 % such as banks, life insurance companies,in bonds and only 7 % in equities. The pension fund management companies andbalanced funds held 80 % in deposits or security traders (providing special purposetreasury bills, 15 % in bonds and 5 % in saving programs) have been allowed to joinequities. 85 % of the conservative funds’ the market.Mandatory pension fund asset allocation (growth fund) 2005 Deposits and treasury bills 77 % Equities 7 % Bonds 16 %Sources: OECD, Allianz Global Investors 89
    • SlovakiaThe SPMCs are profit-making, single- Third pillar statistics 2006 (or latest year available)purpose companies established byshareholders. They must have a board of Members 690,000directors and a supervisory board. Assets under management [EUR] 635mEmployers can contribute to the voluntarysavings plans; their contribution rate is Number of pension fund providers 3determined in a contract with the SPMC.Employee contributions to the voluntary Outlookpension pillar are tax-free up to a limit of OutlookSKK 12,000 (EUR 323) per year, whileemployer contributions can be deducted Current household asset allocationfrom the income tax base up to 6 % of the In 2005, financial assets totalled EUR 20.7employee’s salary. Investment income is billion. This amounts to 53 % of GDP, only 1 %taxed at 19 %. Benefits are tax-free. To be above Latvia, the country with the lowesteligible for pension benefits, members must ratio in the EU-25. Per capita values barelyhave contributed for at least 10 years, reach 7 % of the EU-15 average. However, theotherwise benefits are paid as a lump sum. financial situation has improved in recentThere are no legal requirements to purchase years, and financial assets rose by 15 % inan annuity, but annuitisation is possible. 2004 and 2005. Further growth may be spurred by declining unemployment,Plan members must be provided with income growth and increased consumerinformation on their accumulated capital at confidence. The introduction of the secondleast once a year. Moreover, SPMCs must pillar pension system has also contributeddisclose information on assets under to substantial savings growth: pensionmanagement, their balance sheets and savings have quadrupled. Nevertheless, theother fund-related information on their saving rate remains low because Slovakianwebsite. SPMC fees are subject to several households show a strong tendency tomaximum limits. The management fee may consume.not exceed 3 % of asset value, and the fees forswitching SPMCs may not be higher than 5 % Slovakian households keep two-thirds ofof the member’s account balance within the their financial assets in cash and deposits.first three years of membership. After this This is the highest portion in CEE. Butperiod, the switching fee is 1 %. Fees for thanks to increasing investmenttermination settlements must not exceed opportunities through various investment20 % of the member’s account balance. products with higher returns, things appear to be changing. Stocks and investmentThree companies operate in the voluntary funds have become very popular products;pension market; membership stands at their share of total financial assets rose690,000. Asset allocation of third pillar from 2 % in 2002 to roughly 10 % in 2005.funds is quite conservative. In 2006, 56 % of Insurance and pension products make upassets were invested in bonds, 37 % in bank about 12 % of total assets, and their growthdeposits and 6 % in equity. prospects are healthy as pension asset volumes increase. Life premium growth in Slovakia was 13.4 % in 2005, the highestIORP growth in three years due to the introduction of a tax allowance. Penetration,The IORP directive was fully implemented meaning life premiums as a share of GDP, ison August 1, 2006 with an amendment to the already quite high (1.47 %) compared toact governing third pillar institutions. Ring other CEE countries.fencing or other limitations allowed by theIORP directive are not applied in the Slovak Future pension assetslegislation. Given that 50 % of employees joined the mandatory pillar within the first year, its prospects for further growth are fairly promising. The high fixed contribution level90
    • Slovakiaand wage growth are important factors. In Slovakian government harmonised tax2005, assets stood at EUR 239 million. By the treatment for products from banks,end of 2006, they had already grown to EUR investment and insurance companies. For710 million. This rapid growth was the result this reason, our minimum scenario may beof the brief timeframe people were given to the most likely. In this scenario, we assumedjoin the system and the fact that the market that people contribute 3 % of their income. Atis still in its infancy. In the coming years, the end of the projection period, assetsgrowth rates are set to remain high because under management will have reached EURof market development and high 2.4 billion (+16 % p.a.), while the optimisticcontribution rates. However, growth could be scenario foresees EUR 3.8 billion (+22 % p.a.)impeded if the government decides to cut based on a contribution rate of 6 %.contribution rates in the face of financingproblems in the first pillar, from which Slovakia’s recent reforms have madecontributions are taken and shifted to the it an attractive asset managementsecond pillar. market. The reforms have contributed to the long-term sustainability of the pensionIn the minimum scenario, assets under system. However, the short-term burden ofmanagement are expected to reach EUR 7.6 transition costs remains a public policy issue.billion based on the conservative These costs mainly stem from redirecting aassumption of 5 % average performance. portion of contributions to the second pillar,Even in this scenario, volumes will increase which reduces first pillar revenues withoutby 30 % p.a. in the projection period until reducing current liabilities.2015. We did not calculate an optimisticscenario, as contribution rates are already Once Slovakia joins the European Monetaryhigh and participation has been limited to Union, which may happen in 2009, investingnew entrants since the transition period pension assets could become easier forended in July 2006. Slovak pension funds, because the (regulatory) necessity of hedging againstThe development of third-pillar voluntary currency risk for foreign securities wouldpensions plans started about 10 years ago. disappear. From a finance and economicsBy 2006, assets under management stood at perspective, the basic design of the SlovakEUR 635 million, with around 690,000 mandatory pillar is very advanced. Themembers contributing. Since the third pillar regulation that pension funds may offerwas the only system of pension savings until three portfolios with different risk/returnrecently, it covered much of the population. profiles is a step towards the lifecycleHowever, this might change with the concept of pension investing. It minimisesintroduction of the second pillar. investment risk for plan members whileCompetition in the voluntary pension simultaneously exploiting capital marketmarket became more intense after the opportunities.Slovakia: Pension assets under managementEURm12,000 11,381 9,93110,000 8,000 6,000 4,762 4,227 4,000 2,000 1,345 0 2006 2010e min. 2010e opt. 2015e min. 2015e opt. Second pillar assets Third pillar assets Source: Bank of Slovakia, own calculations 91
    • SloveniaSloveniaRunning a WesternEuropean-style systemShape of the pension systemIn per capita terms, Slovenia is the richestCEE country. In 2007, its highly successful Demographics and macroeconomicseconomic transformation made Slovenia Population [m] 2006: 2.0the first CEE country to adopt the Euro. TheSlovenian pension system is very similar to 2050: 1.9its Western European counterparts, which Population over 65 [ %] 15.6is an exception in CEE. Slovenia runs a Dependency ratio* 2006: 21.7three-pillar pension system with a first- 2050: 55.6pillar mandatory PAYG scheme. The secondpillar consists of occupational pensions that GDP [EUR] 29.7bnare mandatory for certain sectors and GDP per capita [EUR] 14,843 (60 % of EU-Ø)voluntary for others. Voluntary personal GDP growth 2001–2006 [av. in % p.a.] 3.6savings constitute the third pillar. GDP growth 2007–2012 3.6The pension system was reformed [av. in % p.a., est.]considerably in 2000. The public pension Unemployment rate [ %] 6.0system was modified with parametric reforms Data from 2006 or latest available yearthat were to be phased in over time. Before the * Ratio of over 65-year-olds to 15– 64-year-oldsreforms, Slovenia had originally planned amandatory second pillar, but chose voluntarysupplementary schemes instead, an optionthe social partners were in favour of. Pension The first pillar – public pensionsissues rank high on the political agenda, as theDemocratic Party of Pensioners (DeSUS) ispart of the four-party government coalition. The mandatory earnings-related PAYG scheme covers employees and the self- employed. The public pension scheme was First PillarSlovenia will be severely hit by demographic reformed considerably in 2000. The reformdevelopment. Its dependency ratio will introduced the principle that each full yearworsen from 21.7 % today to 55.6 % in 2050. in the public scheme accounts for a pensionPension expenses will increase accrual of 1.5 % per year.considerably. While Slovenia’s currentpension expenses amount to 11.0 % of GDP, Before the reform, it accounted for 2 % andthey are projected to increase to 18.3 % by differed for women, who were granted2050. The EU-25 average is currently at 10.6 % higher accrual rights. Age limits were alsoand is expected to increase to 12.8 % by 2050. gradually increased. They currently stand at 62 years for men and 55 years and 8 monthsAssets in the voluntary occupational pillar for women. The target retirement age will bestood at EUR 813 million in 2006, while those 63 for men by 2009 and 61 for women byin the voluntary private pillar amounted to 2023. The age limits increase by four monthsEUR 45 million. We expect that annual each year for women and by six months forgrowth rates until 2015 will be between 19 % men. The pensionable age can be loweredand 25 % for the former and between 22 % due to parenthood or a working life of 40and 27 % for the latter. years for men and 38 years for women. A full92
    • Sloveniapension is payable after 20 years of covered First pillar designemployment. The minimum length ofservice is 15 years. Moreover, the pension Contribution rate [ % of gross salary] Employers: 8.85base was extended from the average of the Employees: 15.5best 10 consecutive years’ earnings to the Net replacement rate 82average of the best 18 consecutive years. Themaximum pension was also reduced and Legal retirement age 62 men/55.8 womencapped at four times the minimum pension. Public pension expenditure [ % of GDP] 2004: 11.0 2050: 18.3Pensions were (re-)indexed to nominal wage Data from 2006 or latest available yeargrowth in 2006; the 2000 reform hadestablished that pensions lag behind wagegrowth. The contribution rate for the publicpension system is 24.35 % of gross wages. · 30 % in equity investments or mutualEmployees pay 15.5 %, employers contribute funds; the same limit applies to bank8.85 % and the self-employed must cover the depositstotal amount. There are additional state · 10 % in real estateallowances to the system. In 2002, 31.6 % oftotal pension expenditure was taken over by · 5 % in unregistered securitiesthe state in order to meet deficits and · 3 % in cash Second Pillarfinance benefits for certain groups. Foreign investment in OECD countries is unrestricted in principle. However, due toThe second pillar – voluntary/ the regulation stipulating that 80 % of assets must be denominated in the same currencymandatory occupational as liabilities, there is an effective limit toschemes non-Euro investments of 20 %.Institutional framework Pension funds are subject to a minimumSupplementary occupational pensions were rate of return, which stipulates that theintroduced in 1992 and tax relief was performance of pension funds may not beexpanded in 2000. Employers and less than 40 % of the average annual interestemployees may contribute to the schemes. rate on government bonds with maturitySetting up occupational plans is mandatory dates of more than one year. If they do notin the public service and banking sectors as meet this target, the difference must bewell as for particularly hazardous offset.occupations. In all other sectors, employerscan set up occupational schemes on a Disclosure and fee regulationvoluntary basis if at least two-thirds of The enrolment fee is a maximum of 6 % ofemployees agree to join. Pension plans, contributions made. The withdrawal feewhich are DC schemes, can be offered by amounts to a maximum of 1 % of theinsurance companies, mutual pension purchase value of units deposited into thefunds that are owned by their members, or personal account. The annual commissionjoint stock pension companies. For large for pension fund management amounts to afirms, pension companies are the preferred maximum of 1.5 % of the average net annualway to provide pension benefits. Funds may asset value. There are no limitations oneither be closed (sponsored by one employer switching providers, which is subject to fees.with at least 1,000 employees) or open. At Pension plan members must be providedpresent, there is only one closed fund forpublic sector workers. Second pillar statistics 2006 (or latest year available)Investment regulationsInvestment regulations are detailed in the Members 427,000Insurance Act and define maximum limits Assets under Management [EUR] 813mfor asset allocation. The key limits are as Number of pension fund providers 11follows: 93
    • Sloveniawith annual information on the status of assets were invested in governmenttheir individual accounts. Recent legislative securities, 34 % in other debt securities, 14 %changes stipulate that pension funds must in bank deposits, 4 % in equities and 3 % inprovide members with a statement of their mutual funds.investment principles and the anticipatedlevel of retirement benefits. Taxation Voluntary occupational plans are taxedBenefits and withdrawal according to the EET principle: EmployersBenefits are paid out as life annuities. Early and employees have joint tax relief up to awithdrawals entail tax penalties. maximum of EUR 2,390. Up to this limit, contributions are tax-exempt, as areAsset management and allocation investment earnings. Pensions in paymentAssets under management in the voluntary are subject to ordinary income tax rules.occupational pension pillar total EUR 813million and membership stands at 427,000.Employees who are not covered are usually IORP Third Pillarfrom small and/or non-unionisedcompanies. In early 2007, there were five Most of the provisions of the IORP directivemutual pension funds, four pension were implemented in mid-2006 by amendingcompanies and two insurance companies the Pension and Invalidity Insurance Act.on the market. The mandatory pensions for However, the European Commission deemedcertain industries are managed by a mutual transposition incomplete and referredfund run by a state-owned financial Slovenia to the European Court of Justice.institution. All employer-sponsoredmembers are enrolled in open pensionfunds; closed company pension funds do notexist. In contrast to pension companies, The third pillar – voluntarymutual pension funds are not allowed to personal plansprovide annuities. According to surveyresearch, employers contribute Schemes for voluntary pension savings canapproximately 3 % of wages. also be offered by mutual pension funds, pension companies or insuranceIn terms of market share, based on the companies. Voluntary private pensions arenumber of members and also including the largely subject to the same rules asprivate pillar, mutual pension funds have a occupational plans. They are also DCshare of 49 %, pension companies have 42 % schemes, and are treated in the same way inand insurance companies 9 %. Asset terms of taxation. The main difference toallocation is quite conservative. According occupational pensions is that they areto the latest available data from 2005, 44 % of established on an individual basis. RoughlySecond pillar pension fund asset allocation 2005 Government bonds 44 % Other 1 % Mutual funds 3 % Equities 4 % Bank deposits 14 % Other debt securities 34 %Sources: OECD, Allianz Global Investors94
    • Slovenia24,000 people participated in the voluntary Third pillar statistics 2006 (or latest year available)personal schemes in 2006. At present, fivepension funds, four pension companies and Members 24,000two insurance companies offer voluntary Assets under management [EUR] 45mpersonal plans. These plans compete withlife insurance policies for individual Number of pension fund providers 11pension savings. Assets under managementcurrently amount to EUR 45 million.OutlookCurrent household asset allocationFinancial assets in 2005 totalled EUR 26.3 In the coming years, further developmentbillion, or 95 % of GDP. This is the second will result mainly from wage increases. Inhighest ratio among the CEE countries and the minimum scenario, assets undernot far behind Finland. Financial assets per management are expected to reach EUR 4.0capita stand at EUR 13,200 – 28 % of the EU-15 billion until 2015 based on the conservativeaverage, by far the highest value among CEE assumption of 5 % average performance. Incountries. this scenario, volumes will increase by 19 % p.a. until 2015. In the optimistic scenario,Slovenian households keep almost half of the volume would grow to EUR 6.0 billiontheir financial assets in bank deposits. Like in (+25 %). This scenario is realistic ifother countries, this share is getting households consume less and theprogressively smaller as wealth increases. government encourages people to save moreAnother popular saving instrument are for old age provision to compensate forinvestment funds. Together with stocks, they falling pension benefit levels.make up the second largest portion ofhousehold portfolios, a result of the With 24,000 members, participation in theprivatisation process in the 1990s. Insurance voluntary private pillar is modest. As there isand pension products make up roughly 8.5 % barely any information about the assetof the portfolio, a relatively small portion that volumes of these plans, we calculated a roughreflects the limited importance of second starting value by using the per capita assetspillar pension products. of second pillar pensions. This resulted in an estimate of EUR 45 million in assets underSlovenia saw life premiums grow by 26 % management within the third pillar by the Outlookfrom 2004 to 2005, which is weak compared end of 2005. As income levels increase, moreto growth in other CEE countries. people may start saving money voluntarily,Nevertheless, Slovenia is further ahead in but this will be a slow process.terms of life insurance penetration. Lifepremiums amount to 1.7 % of GDP, the For our projection, we assumed that peoplehighest ratio in CEE and 30 % of the EU-15 still contribute only a small portion of theiraverage. income and that mainly high income people in the prime of their working lives will setFuture pension assets additional funds aside for their retirement.427,000 participants, or almost 50 % of Increasing participation rates and wageemployed people, are enrolled in the increases will help the third pillar pensionvoluntary occupational system. The growth market grow in the future, albeit at very lowin membership was 6 % in 2005, which was volumes. In the minimum scenario, assetslower than the previous year when public under management will reach EUR 264sector employees entered the system. Assets million by 2015 (+22 % p.a), while thein the voluntary occupational system optimistic scenario foresees EUR 404 millionamounted to EUR 813 million in 2006. (+27 % p.a.). 95
    • Slovenia The lack of a mandatory second Despite some foreseeable challenges, pillar makes Slovenia an exception Slovenia’s second occupational pillar hasamong other countries in the region. The achieved high coverage and life insuranceSlovenian government limited itself to penetration is the highest in the region. Inparametric reforms that focused on this sense there are significant fundedsecuring state provision of old-age income. elements in Slovenia’s pension system thatSlovenia’s system resembles Continental contribute to diversifying retirementEuropean pension systems with a generous income. Even if the country’s market isand redistributive first pillar that is small, Slovenia is the wealthiest CEE statefinanced by social contributions. However, and therefore attractive for asset managers.reforms can be expected to continue asSlovenia experiences one of the biggestdemographic shifts in Europe.Slovenia: Pension assets under managementEURm7,000 6,3896,0005,000 4,2414,0003,000 2,852 2,0302,0001,000 858 0 2006 2010e min. 2010e opt. 2015e min. 2015e opt. Second pillar assets Third pillar assets Source: Bank of Slovenia, own calculations96
    • Appendix
    • 98 Pension assets under management projections [EUR million] Appendix 2006 2015 * 2nd pillar 3rd pillar Total 2nd pillar 3rd pillar Total net increase CAGR p.a. 2006–2015 Bulgaria 523 253 776 3,615 1,274 4,889 4,113 36.8 % Croatia 2,158 54 2,212 10,164 363 10,527 8,315 18.9 % Czech Republic 0 5,263 5,263 – 24,774 24,774 19,511 18.9 % Estonia 475 49 524 3,443 146 3,589 3,065 27.1 % Hungary 5,934 2,733 8,667 30,485 12,273 42,758 34,091 19.1 % Latvia 183 74 257 5,434 385 5,819 5,562 42.3 % Lithuania 305 15 320 4,623 203 4,826 4,506 43.7 % Poland 30,016 571 30,587 127,021 3,635 130,656 100,069 19.1 % Romania** 0 0 0 2,024 869 2,893 2,764 41.2 % Slovakia 710 635 1,345 7,568 2,363 9,931 8,586 28.9 % Slovenia 813 45 858 3,977 264 4,241 3,383 21.1 % Total 41,117 9,692 50,809 198,354 46,549 244,903 194,094*** 19.1 % * Most likely scenario ** We assumed an asset volume of EUR 129m in 2008 for our projection and the growth rate *** Due to the calculation method for Romania and to roundings, the sum of the net increases of all countries is lower than the difference between total assets 2015 and 2006.
    • ImprintPublisher:Allianz Global Investors AGNymphenburgerstr. 112 –116D-80636 Munichhttp://www.allianzglobalinvestors.comResponsible:Dr. Alexander Börsch,Senior Pensions AnalystAllianz Global Investors AGE-mail: alexander.boersch@allianzgi.comPhone: +49 (0) 89 1220 7472Contributors:Dr. Alexander Börsch,Allianz Global Investors AGKai Fachinger,risklab germany GmbHDr. Renate Finke,Allianz Dresdner Economic ResearchDr. Wolfgang Mader,risklab germany GmbHDr. Jürgen Stanowsky,Allianz Dresdner Economic Research The entire content of this publication isLayout: protected by copyright with all rights reserved toUdo Zerbes, Allianz Global Investors AG. Any copying,Graphics modifying, distributing or other use of theAllianz Global Investors KAG content for any purpose without the prior written consent of Allianz Global Investors AG isClosing date: prohibited. The information contained in thisJune 8, 2007 publication has been carefully verified by the time of relase, however Allianz Global Investors AG does not warrant the accuracy, reliability orThis study was conducted in cooperation completeness of any information contained inwith Allianz Dresdner Economic Research. this publication. Neither Allianz Global InvestorsThe OECD provided information on the AG nor its employees and deputies will take legalsecond and third pillar. responsibility for any errors or omissions therein. This publication is intended for general information purposes only. None of the information should be interpreted as a solicitation, offer or recommendation of any kind. Certain of the statements contained herein may be statements of future expectations and involve known and unknown risks and uncertainties which may cause actual results, performance or events to differ materially from those expressed or implied in such statements. 99
    • Allianz Global Investors AG –the partner of OECD in the GlobalPension Statistics ProjectAllianz Global Investors AGNymphenburger Straße 112–116D-80636 Munich