Attacking the second pillar
Written by Pádraig Floyd
Pádraig Floyd reports on central European governments’ raiding of the second pillar and the subsequent effects this has for overall pension provision
In 2011, Hungary’s policy of pension reform sent shock waves across Europe. In order to reduce its budget deficit, it collapsed the second pillar of its pensions into the state scheme and appropriated all private funds.
Since then, fears have grown that cash-strapped governments might plunder their pensions systems in order to shore up their creaking fiscal positions.
Over the same period, Poland, Slovakia and Romania have all tapped into the private elements of their – largely compulsory – second pillar structures to increase revenues to their respective treasuries.
The decision by the Hungarian government was highly controversial and justified by the need to cut the budget deficit. However, the controversy was fuelled by the government’s announcement at the eleventh hour that the suspension would be permanent and the second pillar would be removed altogether, says Daniel Gera, an associate in the employment team at French legal firm Gide Loyrette Norel’s Budapest office.
Consumers were given the option to transfer their account into the existing private sector third pillar, he says, but this was made difficult and the deadline was very short. And there was worse to come.
“If you wanted to keep a private account, there was a risk you would not receive your state pensions entitlements accrued to that date. Although this was ultimately declared unconstitutional, by then only 3 per cent remained outside the first pillar,” says Gera.
The impact of this measure was far reaching. It effectively ended the private provision of pensions in Hungary and greatly knocked public confidence. Private provision is important to investors in these countries, because it is one of the few tax-efficient means of accumu-lating wealth that may be passed on through inheritance.
So now in Hungary, not only is there no second pillar pension system, there is little trust among the average consumer in saving at all. There is certainly no interest from providers to create a financial services market.
“The government uses incentives for employers to use the third pillar but there have been no new market players in since the change,” says Gera. “Pension funds operating in the second pillar wanted to keep as many clients as possible, but simply couldn’t survive. Even the largest bank, OPT, had to dissolve its fund recently.”
The financial markets in central and eastern Europe are “hetero-geneous and fragmented” and the crisis in 2008 affected the asset management business in a negative way, says Schroders deputy head of sales, central Europe, Lydia Malakis.
“In Hungary, the institutional business is dead and it is impossible to raise assets. While in other markets, the business is very locally concentrated,” she says.
This makes it difficult for a financial services market to develop and the same is true in other countries in the region. A number have already greatly restricted the amount that can be paid into the private sector, though have held back from dismantling the three pillar system, largely based upon the World Bank’s model.
Poland, which has around €50 billion of assets, reduced the amount that could be paid into second pillar pensions from 7.3 per cent to 2.3 per cent for the next five years, though has made plans to increase it to 3.5 per cent by around 2017.
Slovakia similarly cut the maximum contribution from 9 per cent to 4 per cent, with a gradual uplift to 6 per cent by 2017/18.
Romania, one of the smaller markets with around €2 billon of assets, reduced the maximum contribution to second pillar pensions to 2.5 per cent from 6 per cent in 2010. It too put in place an annual 0.5 per cent increase which has raised the limit to 3.5 per cent in 2012.
The soft compulsion of auto-enrolment introduced into the UK’s second pillar in October 2012 has set savings considerably higher levels, and yet are dismissed as inadequate by many commentators. So it would seem reasonable that investors in these countries may be better off not saving. But nothing could be further from the truth, says Generali Slovakia CEO and chairman, Vladimir Bezdek.
Bezdek, an economist and co-author of the Czech retirement reform programme, says in countries such as Poland, Slovakia and Romania, even if the average second pillar contribution is only 3 per cent to 4 per cent, two or three decades with compound interest will have a profound effect on the lives of their citizens.
“The Czech Republic has three million retired people in a population of 10 million. By studying their spending, we see that 94 per cent of income for those people comes from the state budget either in pensions or benefits,” says Bezdek. “Almost all the income of these people depends on one source – there is no diversification.”
Bezdek points out that unlike western Europe, there is no history of occupational pension provision and therefore something is a lot better than nothing. He adds: “Even 5 per cent to 6 per cent pots make political sense in 20 years time.”
As for political risk, Bezdek is generally optimistic, dismissing fears that more countries might seek to emulate Hungary and raid private pension structures.
There is opposition in every country making changes to pension structures says Bezdek, and Slovakia offers an interesting political case study. In spring 2012, elections delivered the first strong government in Slovakia’s short history, with the social democrats securing a majority of more than 80 members in the 150 seat chamber.
“In Slovakia, there is no second chamber,” says Bezdek, “so this leftish-orientated government has the power to do what they wish.
“Even then, they did not close down private pensions completely and made provision for them to come back in five or six years time.”
The Czech Republic is also about to undergo considerable reform. The opposition party has promised to reverse the policy when it comes into power, but few believe it will be able to even if it remains a political priority. But importantly, says Bezdek, the model being implemented demonstrates an understanding of the importance of private provision.
In the Czech Republic, employer and employee contribute 28 per cent of gross wages into pensions. Those wishing to go into the second pillar must now contribute 25 per cent to the state and 3 per cent to the second pillar. In order to be allowed to contribute 3 per cent, an individual will have to invest a further 2 per cent from net income. But this condition is to make the process fiscally neutral rather than to punish investors, says Bezdek, and believes private savings will remain very popular.
“The third pillar has been very popular since it was introduced in 1994,” says Bezdek. “After 20 years history of voluntary contribution almost five million individuals participate in it. In a country with a population of only 10 million, that participation rate is extremely high.”
The only question that remains unanswered for Bezdek is where they find the money. But find it they will, he asserts.
“Will they be able to reduce their consumption and save? I certainly do not believe they will cancel old policies to find the money.”
The Czech Republic is a devel-oping and attractive market, according to Schroder’s Malakis. “It is the most mature and advanced and offers opportunities for institutional assets,” she says and agrees that private sector (third pillar) investments offer opportunities in terms of unit-linked business written by insurance companies.
“This is quite a popular area and one part of the asset management industry that has seen the highest growth of between 17 per cent and 20 per cent,” says Malakis.
Malakis sees Poland’s situation as merely a “temporary slowdown”, but what holds back all the markets from developing is that they are relatively closed and domestically orientated.
Despite having their options reduced in order to maximise contributions into state coffers, citizens of central and eastern European countries remains well-placed to continue saving into pensions funds.
Many second pillar structures are already compulsory, so there are few options for investors to seek alternative arrangements beyond unit-linked savings products – some similar to ISAs – from net income.
The commitment of the Polish, Slovakian and Romanian governments to return second pillar contributions towards former levels shows there is no long-term desire to disrupt independent – if under-developed – financial markets.
Though the Czechs have also imposed limits, they are further from Hungary’s position than any of their neighbours. Their compromise shows foresight in nurturing – even stimulating – a growing private pension sector by rewarding those who make provision from their net pay.
As the long term goal for most of these countries is to enter the eurozone, it may be tempting to follow Hungary’s lead in order to keep their deficits below the 3 per cent of GDP required to make the grade. But this would ultimately be futile, says Gera, as Hungary’s raid of private pensions has done nothing to stabilise the first pillar pension system.
“The problem with the elimination of the second pillar is it does nothing to make the system, more sustainable. Demographic changes means the population above 65 – the retirement age recently increased from 62 – has increased significantly and is forecast to grow from more than 16 per cent in 2006 to above 20 per cent by 2020.”
This is the effect of baby boomers, as much a demographic problem in the east as it is in the west.
Written by Pádraig Floyd, a freelance journalist