2. Content
Preface 3
Introduction 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 29
Country reports 31
Bulgaria 32
Croatia 38
Czech Republic 44
Estonia 50
Hungary 55
Latvia 62
Lithuania 68
Poland 73
Romania 80
Slovakia 86
Slovenia 92
Appendix 97
2
3. Preface
The provision of retirement
income is currently a hot topic
all over the world, particularly
in countries where the popula-
tion is quickly getting older.
Ageing populations are a major challenge
for countries that rely mainly on state-run,
pay-as-you-go pension systems. This is
because contributions either rise to unac-
ceptable levels, or benefits decrease to the
point that retirees are no longer guaranteed
a decent standard of living.
The present study is Allianz Global Inve- This study aims to analyse CEE pension
stors’ second on pension market develop- systems and their market potential. In the
ment 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 in
across the region faced economic upheaval CEE. This is followed by an overview of the
and unfavourable demographic develop- main pension, regulatory and market trends
ment, both of which had a crippling effect in the region. We discuss all CEE states that
on 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. To
European 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 contribution
reform has made its way to the top of the plans by analysing lifecycle models.
political agenda, with structural reforms
being 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 detailed
radical and courageous than in Western information on each country’s pension mar-
Europe, with Eastern European countries ket. We investigate the design of pension
introducing mandatory funded pension pil-
lars of the defined contribution type. In
addition, some countries have drastically
reduced 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.
Preface
In light of longer life expectancy, diver- We hope that that this study will contribute
sifying 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 market
poverty. With its reliance on funded pillars, development in CEE, and we look forward to
CEE countries have set an inspiring example a fruitful debate.
for their Western neighbours. Indeed, CEE
has become a promising market for the
asset management and insurance industry, Brigitte Miksa,
as asset management solutions are vital for Head of International Pensions
accumulating pension assets. Allianz Global Investors AG
3
6. Introduction
Demographic and Macroeconomic
Developments in CEE Countries
The fundamental things apply – as time markets are the subject of this study. After
goes by. One of these fundamental things is some introductory remarks, we will look at
the ageing of populations. In many parts of CEE countries’ economies in detail. More
the world, people are living longer lifes as particularly, we will address the close
fertility rates drop. Central and Eastern interaction between demographic and
Europe (CEE) is no exception. The economic development and the new EU
population structures of the 10 new EU members’ prospects with regard to
member states from CEE in particular will membership in the European Monetary
face a major transformation in the coming Union (EMU), which will be of great
years. In some cases, changes will be even importance for investors.
more pronounced than in the EU-15 and the
rest of the world. Fertility rates have
declined sharply since the collapse of
The economy and the pension
communism, while longevity has reached
levels almost comparable to Western system
Europe.
Pension systems are always closely related
Together, 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 most
dependency ratio, the ratio of the population common case, employees pay contributions
aged 65 and over to that aged 15 to 64. This directly out of their salaries. Returns depend
figure tells us how many pensioners (over on the number of employees, the wage level
65) there are for every 100 people of working and the contribution rate. Whenever the
age (15-64). At the moment, the ratio in CEE number of contributors decreases, be it for
is around 20, which means that there are 20 demographic reasons or because of an
retirees for every 100 people of working age. economic downturn and rising
That number is expected to grow to 33 in 20 unemployment, the pension system suffers
years time and to 50 in 2050. This means the consequences. Short-term remedies
that two rather than five people of working include contribution rate hikes or tax
age will have to support one retired person. subsidies to the pension system. In the long
term, however, pension benefits usually end
Demographic change is only one of many up being trimmed. Tax-financed pension
reasons why CEE countries have redesigned schemes operate along the same lines.
their pension systems over the past 15 years. Ultimately, the development of the national
Above all, the necessity to adapt the social tax base, which is closely related to
security system to the new economic economic performance, determines the
environment was far more pressing than generosity of the pension system.
demographic considerations. To ensure that
the market economy could thrive, the Funded systems operate differently. In
socialist-style social system had to be principle, the pension is determined by the
reformed. For example, many CEE countries funds invested and the return earned on
once had pension systems that allowed these investments, as is the case with
retirement at age 55 and offered generous defined contribution systems in the
benefits. Today the CEE countries, their countries under consideration. Whereas a
economies and pension systems look very PAYG system operates domestically, funded
different compared to 15 years ago. The pensions can be invested abroad, thus
prospects for this region and its pension decoupling returns from domestic
6
7. Introduction
economic performance. Nevertheless, relatively small economic weight of the new
contribu 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 current
pension systems are similar. Domestic prices. However, the population of the EU
economic performance and income increased by about 20 %. The accession of
development determine the amount that Romania and Bulgaria has had similar
can be set aside for old age, either for the effects, but on a much smaller scale.
individual’s future in a funded system or the
current pensioners in a PAYG system. In order to compare income levels across
countries in a meaningful manner, varying
It should be noted that pension funds are price levels have to be considered, which can
frequently subject to constraints when it be done by measuring GDP in purchasing
comes to investment decisions. If they are power parities. This approach adjusts the
limited to domestic investments, the exchange rate of currencies to equalize the
difference between funded and pay-as-you- price of a given basket of goods in different
go systems gets smaller, and ceases to exist countries. The comparison of standards of
entirely if pension funds are required to living is usually closer to the truth than a
invest their money into national comparison using market exchange rates.
government debt. Under such However, purchasing power parities are not
circumstances, implicit government debt is flawless and in order to assess a country’s
changed into explicit government debt that economic weight, market exchange rates
still has to be serviced by taxes. Domestic are more suitable. A glance at GDP per capita
investment, for instance financing figures shows that the new CEE members
infrastructure 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 the
returns can be earned at home. This is Czech Republic show purchasing power
particularly true for the new EU member standards above that of Portugal, the
states 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 the
management. In CEE countries, return budget period spanning from 2007 to 2013
potential is high thanks to sound economic shows, net transfers into the countries range
prospects. New EU members and between 1.5 % and 3.5 % of their respective
neighbours such as Croatia have gained GDP, depending on the economic situation
good economic growth opportunities. EU of the country in question. For Croatia the
membership – or in the case of Croatia EU situation is different, since it has still to
neighbourship – fosters economic growth become a EU member. For the others,
through trade and members benefit from
generous subsidies. GDP per capita 2005 purchasing power parities [% of EU-15 average],
EU-15 = 100
100
Catching up
80
On January 1, 2007, Romania and Bulgaria
joined the European Union, boosting the 60
number of member states from CEE to 10.
Poland, the Czech Republic, Slovakia, 40
Slovenia, Hungary and the three Baltic
states have already been members of the EU 20
for three years, joining on May 1, 2004. For
the EU as a whole, the impact of the 2004 0
Slovakia
Bulgaria
Estonia
Romania
Croatia
Lithuania
Slovenia
EU-15
Hungary
Latvia
Poland
Republic
enlargement (Malta and Cyprus were also in
Czech
this round) on key macroeconomic
aggregates was relatively modest due to the
Source: Eurostat
7
8. Introduction
substantial 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 constantly
Brussels, coupled with free access to the EU at 4.5 %, compared to 2.25 % for the EU-15.
market. These funds will help accelerate the
catching-up process that is well on its way in These simple projections show that the EU
CEE. However, the discrepancies within the member states from CEE will remain
EU are enormous, and it will certainly take relatively poor compared to the EU-15 for
time for the CEE member states to close the quite some time. However, this goes hand
Hypothetical development of per capita GDP in Portugal and Bulgaria
18,000
16,000
14,000
12,000
10,000
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 2069
Source: Allianz Dresdner Economic Research
gap to the EU-15. The graph above shows the in hand with a lower cost of living and
development of per capita GDP in Bulgaria lower wages, which have attracted
(the poorest of the accession countries) and investment: many manufacturing
Portugal (the poorest of the EU-15 countries) companies have moved production to CEE
based on the hypothetical, but realistic to take advantage of a cheap, highly
assumption that Bulgaria’s real per capita educated workforce. This, in turn, has
growth rate will be 5 % and twice as high as helped to boost growth. The following table
Portugal’s. In this scenario, it would take 60 shows average gross monthly earnings in
years for Bulgaria to reach the same level as CEE countries compared to the EU-15
Portugal. 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 means
take decades for the accession countries to that the cost advantages that CEE countries
reach the average level. Even Poland, the offer will dwindle over time, as the gap
biggest economy of the CEE countries between old and new member states
considered here, will need more than four narrows.
Average monthly gross income 2005 [EUR]
2,500 2,256
2,000
1,500
1,192
882 810
1,000
635 602
515 452 492
500 370 344
192
0
Bulgaria
Croatia
Czech
Republic
Estonia
Latvia
Lithuania
Poland
Romania
Slovenia
Slovakia
EU-15
Hungary
Source: Eurostat, Allianz Dresdner Economic Research
8
9. Introduction
GDP 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
* Forecast
Sources: European Commission, Allianz Dresdner Economic Research
Member states with lower initial per capita were employed compared to the total
income have grown faster, especially the number of people in this age group. Only
Baltic countries and Hungary. At the same Slovenia showed a higher employment rate
time real wages increased by around 3.5 % in in 2005 than the EU-15 average, whereas
the new member states compared to 1 % per unemployment was lower than the EU-15
year 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 force
favourable supply-side performance. This is participation overall, but there are
also reflected in the growth forecasts significant differences between them.
depicted in the table above.
Employment and unemployment rates [%]
90
Labour markets 80
70
Structural unemployment is one of the
60
major problems that CEE countries face. 50
From 2001 to 2005, the labour market 40
participation rate was around 65 %, 30
compared with an average of 73 % in the EU- 20
15. Poor employment performance has a 10
disproportionate effect on specific age 0
Croatia
Czech Republic
Lithuania
cohorts and groups. The employment rates
Hungary
Bulgaria
Romania
Slovenia
Poland
Slovakia
Estonia
Latvia
EU-15
of young, older and female workers in
particular are relatively low. The following
graph shows the unemployment rate in
2006 and the employment rate for 2005. The unemployment rate 2006 employment rate 2005
latter shows how many people aged 15 to 64 Source: Eurostat; 2006, 2005
9
10. Introduction
While the Baltic states, the Czech Republic already very limited, interest rate policy is
and 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, the
participation rates in the other countries European monetary policy – which caters to
are considerably lower, most notably in EMU as a whole – may be too loose to keep
Poland, Hungary and Romania. Higher local inflation under control. The extra
participation rates could offset a small part degree of economic policy freedom that is
of the demographically induced labour retained by not being part of EMU could be
force 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 for
The road to EMU
joining will be stronger.
EU membership eventually means
Apart from the above-mentioned reasons for
membership in the EMU. However, only
not joining, there are other obstacles that
Slovenia has been admitted so far. As
should be considered. With the signing of
recently as 2005, it seemed as though most
the Maastricht treaty in 1992, the
of the countries that had joined the EU in
foundations of European monetary policy
2004 would become EMU members by 2008
were laid, and strict membership criteria
or 2010 at the latest. But things have
established. These are:
changed dramatically since then. In the CEE
countries considered in this publication,
· Exchange rate stability, meaning 2 years
EMU membership is no longer as high on the
within the exchange rate mechanism
agenda as it used to be. The reasons are
without realignment;
manifold, among them national politics and
the perceived consequences of EMU · Inflation of no more than 1.5 percentage
membership. 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 2
systems, too. While it has no direct effect on percentage points above the average of the
the 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 that
which is becoming increasingly important in
government debt should not exceed 60 % of
the CEE countries. Under EMU membership,
GDP, and the budget deficit should be lower
exchange rate risk, which is manageable but
than 3 % of GDP.
costly to hedge, would disappear for
investments in other EMU countries. Pension
funds could find a broader set of assets to Exchange rate stability would not be a major
invest in without having to consider currency obstacle to the countries under review. A
movements. Furthermore, EMU could make notable exception, however, is Hungary. The
CEE capital markets even more attractive for Euro – Forint exchange rate was rather
foreign investors, increasing liquidity and – volatile in 2006, with a fair bit of speculation
hopefully – supporting asset prices, a in the market. Currencies participating in
welcome effect for local pension investment the European Exchange Rate Mechanism II
managers. (ERM II) stayed within their corridors. The
next table shows the exchange rate systems
For current EMU members, the common of the CEE countries.
monetary policy is largely considered
Inflation is another area that could cause
beneficial. However, the economic
problems if the countries joined immediately.
discrepancies between current members
At the moment, most CEE EU countries would
and CEE countries are considerable. At this
fail the Maastricht test. If the three EU
stage, it is not entirely clear whether
countries with the lowest inflation in 2006
relinquishing control over monetary policy
(namely Finland, Poland and Sweden) are
would be beneficial. Even though exchange
considered together, the average inflation
rate movements against the Euro are
rate amounted to 1.4 %. This means that the
10
11. Introduction
Exchange 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 of
Source: Allianz Dresdner Economic Research problems. While last year’s budget deficit
turned out to be substantially lower than
inflation 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 that
Czech Republic would pass the test. Inflation
corrections to budget deficits are
could be a problem for some time to come, as
insufficient; in fact, last year’s positive
strong economic growth tends to keep
outcome could largely be attributed to high
inflationary 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 of
relatively close to the EMU benchmark. The
pension reform into its budget, which it has
average spreads on 10-year government
not yet done. For this reason, this year’s
bonds 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 expect
and Hungary are outside this corridor.
for the Czech Republic in 2007.
Obviously, capital markets are not
convinced that these countries will join
Except for Slovenia, none of the CEE countries
EMU 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 EMU
interest rate criterion. In 2006, the 10-year
membership should not be an aim in itself. A
government bond benchmark yield for the
country must be ready for membership, both
EU was 3.8 % – with 7.3 % and 7.9 %, Hungary
economically and politically. The larger CEE
and Romania were substantially above it.
countries such as the Czech Republic,
Hungary, and Poland are certainly not there
The public finance criterion has not been a
yet, nor are new members Romania and
major hurdle yet. In practice, general
Inflation 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 Inflation
Source: Eurostat
11
12. Introduction
Bulgaria. It is in all of these countries’ best Public finances
interest to postpone EMU membership. Bulgaria
Allianz Dresdner Economic Research government debt criterion 60 %
Czech Republic
forecasts that Slovakia will be the next
country to join the EMU in 2009. The Estonia
following table provides the forecasts for Hungary
EMU accession as of spring 2007.
Latvia
Expected 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 Hungary
Source: Allianz Dresdner Economic Research Much like in the rest of the world, the decline
in fertility coincided with increasing
Demographic development longevity. Men in the Czech Republic and
Slovenia benefited more than their
The demographic situation in the CEE counterparts in other CEE countries as their
countries is marked by a steep decline in life expectancy at birth increased by 5.3 and
fertility, which began in the 1970s and 4.6 years between 1990 and 2005 in each
accelerated in the early 1990s after the country, respectively. In the major EU-15
collapse of the Soviet Union. This is not countries – Germany, France, Italy and
surprising, given that times of increased Spain –, the increase was between 4 and 4.2
economic insecurity frequently lead to years in that period.
sudden changes in birth rates. Between 1990
and 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 the
more sharply than in the rest of Europe. highest increases for CEE countries between
Currently, 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 countries
woman; to keep the population constant, a range between 2.9 and 3.6 years. Longevity
fertility 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 was
particularly dramatic in Latvia, Estonia and generally well below four years. To see the
the Czech Republic. Croatia, Slovenia and big picture, it is helpful to look not only at
Hungary were less affected, as these changes in longevity but also at overall life
countries were less economically dependent expectancy, and here it is clear that CEE
on the former Soviet Union. countries are well below the EU average.
Fertility [children per woman]
3.0
2.5
2.0
1.5
1.0
1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 2000 2003
Bulgaria Czech Republic Estonia Latvia Lithuania Slovakia
Source: Eurostat
12
13. Introduction
In the absence of any sizeable immigration, will be much higher still. In Bulgaria, there
fertility decline is leading to shrinking will be 60 pensioners for every 100 people of
populations, while increasing life expectancy working age. The figure will be lowest in
is boosting the average age. The age group Croatia and the Baltics, with about 42 to 45
comprising people over 65 is the only one pensioners, while the EU-15 average will be
expected to grow in the future. Overall, the around 53. The following chart illustrates
population of these 11 countries is forecast to these developments. It must be taken into
shrink by about 15 %, or roughly 16 million account that the EU-15 average is pushed
people, by 2050. In absolute terms, Poland higher by Italy and Spain, which have the two
and Romania are among the worst hit, as fastest-ageing populations. The more
they will each lose about 4.5 million populous CEE countries are also ageing fast,
inhabitants by 2050, representing 10 % and making their demographic situation even
20 % of their respective populations. The worse than the EU-15 average.
situation is even worse in Bulgaria. According
to Eurostat, the country will lose roughly a Given the rapid increase in old-age
third of its current population within the dependency ratios, CEE countries will find it
next 40 to 45 years. almost impossible to run sustainable pay-
as-you-go pension systems. All of the
The old-age dependency ratio provides a good countries have reacted to the demographic
indication of a country’s demographic threat in various ways and many introduced
situation 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 on
dependency ratios in the CEE countries under 11 different pension systems that rely on
consideration range between 16 and 26. With funded pensions to varying degrees.
a ratio of about 16, Slovakia has the lowest
old-age dependency, while Croatia has the Dr. Jürgen Stanowsky,
highest with a ratio of 26. In 2050, these ratios Allianz Dresdner Economic Research
Life expectancy [years]
90
85
80
75
70
65
60
Croatia
Czech
Republic
Estonia
Latvia
Lithuania
Hungary
Poland
Romania
Slovakia
Slovenia
France
Germany
Italy
Spain
Bulgaria
men women
Source: Eurostat
Old-age dependency ratios*
70
60
50
40
30
20
10
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
14. Introduction
Pensions in Central and Eastern Europe:
Reforms, Regulation and Markets
Reforming 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 and
After the fall of the Iron Curtain, Eastern
benefits.
European states faced the daunting task of
reforming their outdated pension systems. At
In eight of the eleven CEE countries included
the time, the systems in place were not
in this study, reforms went further than that
compatible with demographic developments
and introduced mandatory second pillar
or the new economic environment. Under the
schemes with fully funded individual
old regime, pensions were the exclusive
accounts of the defined contribution (DC)
responsibility of the state. Retirement
type. Hungary was the first country to
benefits 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, Slovakia
contributions and benefits was more or less
introduced a second pillar and Romania is
non-existent. Retirement age was low, and
in the process of doing so. This is a radical
certain occupational groups enjoyed
reform step and has been inspired by the
privileges. Early retirement was widespread
World Bank model of pension reform, in
and was extensively used as a means of
hopes that a fully funded second pillar will
reducing the workforce during the transition
help diversify retirement income and allow
period.
more people to participate in capital
markets. This, in turn, will likely push
Faced with this situation, all CEE countries
domestic capital market development.
initiated similar reform strategies in the
1990s that applied to the first pillar of their
The only countries that have not introduced
pension systems. Parametric reform of the
funded second pillar systems are the Czech
pay-as-you-go (PAYG) system was essential
Republic, Slovenia and Lithuania. However,
to cope with enormous financial pressure
Lithuania has implemented a funded
and secure the solvency of public pensions.
second pillar, which works in the same way
Sooner or later, every country increased the
retirement age, reduced incentives for early
retirement, changed the benefit formula to
Overview of the pension systems after the reforms.
establish a stronger link between
contributions and benefits, scaled back NDC system Reformed PAYG system
privileges for certain occupational groups
Mandatory
and increased the required contribution Poland Bulgaria
second pillar
periods. First-pillar reforms in Poland and
Latvia were the most far-reaching. These Latvia Croatia
two countries introduced a notional defined Estonia
contribution (NDC) system in the first pillar.
Hungary
NDC systems impose the logic of funded
systems on public pension schemes by Slovakia
giving participants a hypothetical account Romania
containing all contributions made
Voluntary second or Lithuania
throughout their working lives, credited at a
voluntary third pillar Czech Republic
certain rate of return. At the time of
only Slovenia
retirement, pension benefits are calculated
14
15. Introduction
as the second pillar in the other countries, before, but a certain share was redirected to
except that participation is voluntary. The the funded second pillar. An exception to this
Czech Republic relies on first pillar public rule is Estonia, where contributions were
pensions and voluntary savings in the third increased to achieve higher contributions to
pillar, while Slovenia runs voluntary second pillar schemes. Some countries, such
occupational schemes in the second pillar, as Latvia and Lithuania, have allowed the
similarly to Western European countries. proportion of the second pillar share to
Except for the latter two countries, the third gradually increase; also Romania will do so in
pillar of voluntary pension savings remains the future.
fairly underdeveloped in Eastern Europe.
In most cases, participation in the second
After the reforms, most CEE countries now pillar was made mandatory for new labour
have a three-pillar system with a reformed market entrants, while existing employees
first pillar, a mandatory second pillar made up to a certain age could choose whether to
up of funded individual accounts and a join or not. Employees near retirement
third pillar comprising voluntary pension usually could not join, since the capital they
savings. The pillar terminology applied in could still accumulate was not sufficient to
CEE is different from the common OECD cover appropriate retirement benefits.
classification, which defines the first pillar Redirecting contributions to the second
as the state pension system, the second as pillar implies financing problems for the
occupational pensions based on first pillar, which previously received the
employment contracts and the third as full share of contributions. The losses in
personal pension plans. While this revenue for the first pillar mainly depend on
classification is suitable for Western the number of contributors to the second
European and other industrialised pillar and the share of contribution
countries, it is hard to apply it to CEE redirected. World Bank estimates for 2004
pension systems. suggest that revenue losses in the public
pillar ranged between 0.3 % and 1.3 % of GDP
As 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 and
World Bank model, which is why we have Slovakia established a demographic reserve
chosen to follow the World Bank fund to be filled with privatisation revenues.
classification in this study. The main
difference lies in the second pillar, which Overall, social security contributions are
comprises individual DC accounts in CEE, sizeable in Central and Eastern Europe, and
but (mainly) voluntary occupational
pensions in Western Europe. In CEE,
voluntary employer contributions to
employee pension arrangements are part of Pension pillar classification in CEE and Western Europe
the third pillar, but contributions are made
to individual accounts, not pension funds
established by a firm or industry. Some CEE
countries recently established a fourth
pillar that aims to generate more employer Occupational
Mandatory pensions/
involvement in pension provision, or simply State Private additional
allow people to set more money aside for CEE funded
pension pensions private
retirement. The topic will be discussed in pensions pension
greater detail later on in this study. The savings
adjoining graph illustrates the differences
between CEE pension systems and those Occupa-
State Private
prevalent in Western Europe. EU-15 tional
pension pensions
pensions
The funded second pillar systems in Eastern
Europe were introduced by way of the carve- First Second Third Fourth
out method, meaning that social security pillar pillar pillar pillar
contributions stayed at the same level as
15
16. Introduction
employers often pay the bulk of these. Reform Pressure Gauge*
Contribution rates to the second pillar vary As of April 2007
significantly, ranging from 4 % in Latvia to Greece
9 % in Slovakia. Total net replacement rates Spain
in CEE are relatively high. Net replacement Italy
Belgium
rates are the ratio of pension entitlements –
Portugal
net of taxes – to earnings, net of taxes and Slovenia
contributions. Net replacement rates are Austria
nearly always higher than gross France
Czech Republic
replacement rates, mainly because retirees
Poland
have lower personal income taxes than Hungary
before and typically pay low social security Slovakia
contributions, if any at all. In the present Germany
context, net replacement rates refer to an Lithuania
Finland
employee with average earnings. The net Bulgaria
replacement rates were calculated by the Sweden
European Commission and refer to the Romania
retirement income in the first year of Denmark
Norway
retirement, divided by income during the
Netherlands
last year of employment. Since the pay-out Croatia
phase of the funded second pillar has not yet Estonia
started, the rates refer to the first pillar. Over Switzerland
Latvia
time, the replacement rate of the first pillar
UK
will decline and the funded pillar will Ireland
account for a sizeable amount of retirement
income.1 0 2 4 6 8
* Scale from 1–10: 1 low reform pressure, 10 high reform pressure
Pension 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 increasing
1
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
17. 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 diversifying
lessened 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 that
Pressure Gauge, which calculates the pension funds can invest in as well as the
sustainability of pension systems and the maximum limits of certain asset classes in
resulting reform pressure, shows that most the portfolio.
CEE countries are ranked in the mid-range
in 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 equity
Regulating pension funds
holdings and other financial instruments,
as well as for the share of foreign assets in
Pension funds, especially those in the
the portfolio. From the viewpoint of capital
mandatory pillar, are heavily regulated in
market theory, these limits are not without
CEE. Fees, disclosure, number of funds
problems. It is argued that restrictive
offered and investment are the main
maximum limits for certain financial
regulated areas. Investment regulation is the
instruments, especially equity, render
area with the biggest impact on pension
pension funds inflexible by constraining
funds and asset managers, as it has a direct
asset allocation and thus the upside
impact on asset allocation and, consequently,
potential of pension funds. If equity limits
on the performance of pension fund assets.
are overly restrictive, they may result in
suboptimal asset performance, because
Generally, there are two main principles of
pension funds cannot sufficiently take
investment regulation, the prudent person
advantage of the higher-yielding equity
principle and quantitative restrictions. The
markets. Over the last 100 years, equities
prudent person principle is applied in
performed four percentage points better
Anglo-Saxon countries and increasingly in
than bonds on average.
Western Europe; it is the most liberal form of
investment regulation. It is based on the
Caps on international investment can
premise that pension funds or asset
hinder effective asset allocation by
managers are obliged to invest in the same
impeding an appropriate diversification
way as a prudent investor would for himself,
across countries. In the case of restrictive
17
18. Introduction
regulations, asset performance is very lead to distortions in asset pricing. Hence,
dependent on domestic markets and the trade-off between the desire to develop
economic cycles, making investment risk local capital markets and efficient pension
higher than it needs to be. fund investing is a delicate matter and
policy-makers need to strike a balance.
However, policy-makers have been faced
with a trade-off between the objective of Minimum return guarantees are another
local capital market development and regulatory instrument that is often applied
optimal asset allocation of pension funds. It in Eastern Europe and elsewhere. Minimum
was hoped that the funded pension system return guarantees can take the form of
would lead to quantitative and qualitative absolute guarantees. This has been the case
capital market development. Qualitative in the Czech Republic, where pension funds
improvements 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 of
legal and regulatory frameworks and more relative performance goals, where a
professional investment management, more benchmark must be met that is based on the
transparency and better governance performance of all pension funds. For
structures. To achieve these goals, pension pension fund members, minimum return
assets should, at least to a certain degree, guarantees have the advantage that
flow into national financial markets. retirement savings are predictable in the
However, substantial inflows of pension case of absolute return guarantees. And in
assets may result in imbalances between the case of relative return guarantees, the
supply and demand, particularly when local risk of choosing a poorly performing fund is
capital 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 2008
18
19. Introduction
In some regards, therefore, retirement their disposal, while Slovenians, the richest
planning 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 levels
argues that the necessity to secure short- explain why voluntary private pension
term profitability may lead to homogeneous savings in the third pillar are
investment strategies in the pension fund underdeveloped in CEE. Indeed, possibilities
market. This „herding“ effect may result in for additional pension savings in general are
similar performances of pension funds, limited. However, this may change if the
thereby reducing the number of real choices catch-up process proceeds and incomes
for potential and existing pension fund continue to increase.
members. A second related problem is that
effective longer-term investment strategies In CEE, investments in financial assets
cannot be pursued if the guarantee applies compete strongly with housing investments
to annual minimum returns. In this case, and consumption. The economic
pension funds must sacrifice long-term turbulences of the transition period in the
returns for short-term profitability. In brief, 1990s resulted in plummeting income
quantitative restrictions and annual levels, which in turn led to pent-up demand.
minimum guarantees are somewhat Rising income and a more favourable
problematic, as both limit the holdings of economic environment have now made it
volatile 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 in
negative 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, Slovakia
their investment regulations, especially has a saving rate of 2.4 %, the Czech Republic
with regard to equity investments. This has 0.2 % and Lithuania –2.7 %. The negative
been the case in Hungary, for instance, saving rates can be attributed to the fact
which had a 50 % limit on equities until that people prefer to spend their savings on
2004, and in the Czech Republic’s third buying houses rather than investing in
pillar, where a 25 % equity limit was in place financial products.
until the same year. While it is too early to
speak of a trend, these two examples In CEE, the bulk of household financial
indicate that the increasing maturity of assets is often held in bank deposits. In
pension systems and capital markets might Slovakia, for example, bank deposits
lead to a loosening of regulatory account for two-thirds of all financial
restrictions. 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 %. In
Financial assets and their
Hungary, they account for roughly 40 % of
allocation in CEE countries assets. In many countries, however, there
are sizeable holdings of shares and mutual
Not only is there a considerable gap between funds – 22 % of total household assets in the
per capita GDP among old and new EU Czech Republic, 29 % in Poland, 36 % in
member states, there are also major Hungary and 55 % in Estonia. In general, this
discrepancies in terms of financial assets. 2 is often a consequence of the privatisation
While 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 and
of GDP in Latvia and 100 % of GDP in Estonia. pension assets in household portfolios
This means in per capita terms that each varies considerably in the different
citizen 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, but
2
Comparable data for financial assets were not available for Bulgaria, Croatia and Romania.
19
20. Introduction
are of minor importance in the Baltic states. pensions may gain a foothold in some
This indicates that there is considerable countries. Romania has also just established
untapped 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 a
Europe, life penetration, defined as the ratio dimension to its pension system. While
of life premiums to GDP, stands at 5.6 % on employers in most CEE countries can
average. In contrast, it amounts to 1.1 % in voluntarily contribute to their employees’
the CEE countries. The CEE country with the private pension schemes, occupational
highest life penetration is Slovenia with schemes would give them an additional
1.7 %, followed by the Czech Republic (1.5 %), employee retention tool, particularly if
Hungary (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 multinational
are 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’s
The predominant position of bank deposits Institutions for Occupational Retirement
in household financial assets is a pattern Provision (IORP) directive. This directive has
quite typical for countries at the beginning generally been problematic for CEE
of an accumulation process. The preference countries, as it mirrors Western European
for consumption and the limited experience practices and is hardly compatible with the
and availability of more sophisticated systems in place. Following years of
financial products result in holdings of discussion, the directive was approved in
liquid assets. However, over time and as 2003. Its aim is to enable a pan-European
higher-yielding financial instruments are market for occupational pensions by
introduced, 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 the
Moving 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 to
establish a fourth pillar of pension provision
to complement the existing system. Fourth The IORP directive
pillars of various shapes have been
introduced in Bulgaria, Hungary, Lithuania EU member states were obliged to
and Poland. They are based on very different implement European Union directive
objectives. In Bulgaria, the fourth pillar is 2003/41/EC on the activities and
intended to enable voluntary occupational supervision of IORPs by September 23,
schemes similar to those in operation in 2005. The main goal of the directive is
Western Europe. The Hungarian fourth to enable cross-border occupational
pillar has been established primarily to pension schemes. IORPs are defined as
push the development of the domestic fully funded, separate legal entities
equity market. Lithuania established the that provide retirement benefits. They
legal framework for occupational pension must be authorised and registered only
schemes, whereas in Poland its introduction by home country supervisors; host
was 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 prescribe
While most of these schemes have just been additional investment regulations.
established or are still in the process of
being introduced, it is remarkable that
Eastern European pension systems are In this sense, the directive is not tailored to
broadening in scope, and occupational Eastern European systems, which generally
20
21. Introduction
have individual DC accounts without Hungary, this requirement will be
employer involvement in the second pillar. mandatory from 2009 onwards. In the other
In Bulgaria, the establishment of the fourth CEE countries, pension funds are only
pillar was directly related to the directive. allowed to offer a single fund. Slovakia, for
Romania has also adapted to the demands instance, follows the lifecycle concept quite
of the directive with its newly established closely. Pension fund members are free to
third pillar of occupational pensions. Other choose which of the three funds on offer
countries, however, are lagging behind. In they would like to join. When they are less
mid-2006, Slovenia was referred to the than 15 years away from retirement, they
European Court of Justice for not having can no longer be enrolled in the fund with
written the IORP directive into its national the highest equity share. Seven years before
law. In October 2006, the European retirement, they are obliged to switch to the
Commission announced that it would start conservative fund with no equity exposure.
proceedings against the Czech Republic, The trend towards pension funds with
Hungary and Poland due to incomplete different risk/return profiles and automatic
implementation and sent reasoned opinions assignment to less risky funds as people get
to these countries. In March 2007 it again older increases the security of pension
sent reasoned opinions to the Czech savings in CEE by minimising the
Republic and Hungary. At the moment, the investment risk of funded pensions.
topic of how cross-border pension funds will
work in Eastern Europe remains a sensitive
and currently unfinished matter.
The future development of
Increasing choice in pension funds pension assets
Retirement savings in defined contribution
plans have some characteristics that set Since most CEE countries introduced
them 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 began
coincides with bear markets. To prevent this sponsoring voluntary systems, a substantial
from happening, the concept of lifecycle build-up of capital has started, which makes
investing has been developed. One variant of CEE an attractive market for asset managers
lifecycle investing advocates automatically and insurance companies. Although it is
adjusting asset allocation to the age of the still in the early stages of development, the
future retiree. This set-up reduces the market has shown annual growth of 37 % in
proportion of high-risk assets as the the last few years, up from a volume of EUR
beneficiary ages, making it less likely that 13.5 billion in 2002 to EUR 47.4 billion in
financial market fluctuations will have a 2006 (excluding Bulgaria, Romania and
negative effect on pension benefits. This Croatia). And there is still considerable
approach therefore presents a argument growth potential.
against a „one-size-fits-all“ approach in
pension savings. This study includes the newest EU members,
Bulgaria and Romania, as well as Croatia. In
Some Eastern European countries have this broader group of countries, pension
taken first steps in this direction and now assets amounted to EUR 50.8 billion at the
require providers to offer funds with end of 2006. With EUR 30.1 billion, Poland
different types of asset allocation, also holds the biggest piece of the pie, followed by
known as lifestyle or balanced funds. Hungary and the Czech Republic. Not
Lifestyle funds have different combinations surprisingly, the countries with smaller
of equities, bonds and money market populations show much lower levels of
instruments and usually come in three pension assets. Croatia is the exception to
forms: conservative (only bonds and money this rule: with assets amounting to EUR 2
market instruments), balanced (modest billion, the country has surpassed the larger
equity share) and progressive (high equity Slovakia, which has accumulated EUR 1.3
share). In Estonia, Latvia, Lithuania, Poland billion. And the most recent additions to the
and Slovakia, pension funds can or must EU are still in the process of reforming their
offer funds with different risk profiles. In pension systems. With its 7.7 million people,
21
