Pension system reforms
Lessons from Central/Eastern Europe
Vladimír Dlouhý
presentation for The Russian Presidential Academy
of National Economy and Public Administration
Moscow, May 30, 2011
Presentation Outline
• Basic terminology
• Challenges
– General
– CEE specific
• Pension reforms in Poland, Hungary
and the Czech Republic
• Appraisal of the reforms & lessons
• Implications for Russia
I. Terminology, challenges,
basic reform features
Basic terminology (1)
• Contributory basic pension. A pension paid, often
at a flat rate, to a person with a full record of
contributions, or pro rata to a person with an
incomplete contributions record.
• Funded pensions use an accumulated fund built from
contributions by or on behalf of its members.
• Pay-as-you-go (PAYG). PAYG pensions are paid out of
current revenue (usually by the state, from tax
revenue) rather than out of accumulated funds.
• Notional defined-contribution (NDC) pensions are
financed on a pay-as-you-go or partially funded basis,
with a person’s pension bearing a quasi-actuarial
relationship to his or her lifetime pension
contributions.
Basic terminology (2)
• Defined-benefit (DB) pensions. A pension in
which the benefit is determined as a function
of the worker’s history of pensionable
earnings. The funds are adjusted to meet
obligations; the risk falls on the sponsor.
• Defined-contribution (DC) pensions. A
pension in which the benefit is determined by
the amount of assets accumulated toward a
person’s pension; the individual faces the
portfolio risk.
• Parametric pension reform. Adjustment of
parameters within the existing pension
pillars.
• Systemic pension reform. Implementation of
new pension pillar.
Typical challenges for sustainability of
traditional pension schemes
• Demographic development
– Increasing life expectancy (people live
longer)
– Declining fertility rate (with less
children)
• Tendency to retire earlier relative to
the official age of retirement
Challenges specific for CEE countries (1)
•
Demographic shock exposure
Number of 65+/number of 15-65, for period 2008-2060
Challenges specific for CEE countries (2)
• Low retirement age (mostly below 60)
• High replacement ratios
• High contribution rates (weak link to
future benefits resulting to limited
incentive to comply)
 all factors combined undermine the
sustainability of public budget  call for
the systemic pension reforms
Reforms in the CEE region:
common characteristics
• Taking place on the verge of millennia,
mostly reflecting the WB (1994)
recommendation
• To create a pension system based on 3
separate pillars (PAYG, Mandatory and
Voluntary FF DC)
• Besides the necessary reforms of the 1st
PAYG pillar all major reforms involved
introduction of private mandatory FF DC pillar
– Sufficient capital contributions from fund sponsor
– Investment results become crucial: e.g. the
differential of 2 pp in annual investment returns
over 30 years period leads to the difference of
II. Poland
Major reform steps
• Major reform conducted in 1999:
• „0“ pillar – A solidarity tier guaranteeing (meanstested) minimum pension of 25% current average
wage
• 1st pillar – Mandatory Pay-As-You-Go (PAYG) tier
based on the notional defined-contribution (NDC)
principle, main element of old-age protection
(contribution rate: 12,2% of gross salary)
• 2nd pillar – Mandatory Fully-Funded DefinedContribution (FF DC) tier (7,3% of gross wage)
• 3rd pillar – voluntary FF DC scheme (individual
and/or employer contributions), in place already
since 1994
Mandatory 2nd pillar (1)
• Became a robust part of the economy
(19,4% of GDP in 2010)
• Satisfactory investment results due to procompetitive regulation:
– Convenient minimum rate of return guarantee
(the lower of the following two)
• 50% of weighted average rate of returns of all
pension funds over the last 3 years
• Weighted average rate of return over last 3 years
minus 4 pp
– Reasonable asset classes exposure limits
(average historic exposure >30%)
Mandatory 2nd pillar (2)
• Investment lock-in to domestic market (95%) lead to a
significant development of Polish capital market
• Reformed system results less volatile due to
diversification, real rate of return in 1999-2010 6.6%
• Positive public perception of 2nd pillar existence
• High projected transitional costs with identified sources
of financing (tax revenues, 1st pillar savings, debt)
2.5%
2.0%
%
1.5%
GDP
1.0%
0.5%
0.0%
2000
2005
2010
2015
2020
2025
2030
2035
2040
year
privatisation revenues
credit
public pillar savings
2045
2050
Current settings
• Constitutional debt limit 60% GDP, balanced
budget requirement when the debt/GDP ratio
exceeds 55%
• Mandatory contributions into 2nd pillar were
chosen as a means to combat growing
government deficits  “the reform of reform”
• By 2011 the contributions have been cut to
2,3%, gradually increased again, but to lower
target of 3,5% in 2017
• Remaining 5% would be managed in newly created
second-pillar individual sub-accounts by 1st pillar
NDC PAYG, with an annual return indexed to GDP
growth and inflation
III. Hungary
Major reform steps
• First country in the CEE region (1997-98)
that implemented a major pension reform
reflecting the WB (1994) proposal:
• 1st pillar – mandatory PAYG pillar (24% of
gross wage paid by an employer)
– parametric changes: increase of retirement age to 62 (unisex)
• 2nd pillar – mandatory FF DC pillar (originally
6% increased to 8%, paid by an employee)
• 3rd pillar – voluntary FF DC pillar
Mandatory private pension pillar in 19972010 (1)
• Mandatory labor market incomers, opt-out
for rest (conditioned by 25% reduction of
PAYG pillar income) with following
outcome:
– between 1998-99 around ½ of workforce joined
(mainly voluntarily)
– in the period of 1999-2010 another 25 percent
were mandated to join
• Up to 2010, mandatory 2nd pillar gathered
the assets amounting to 10% of GDP
Mandatory private pension pillar in 19972010 (2)
• Strongly regulated industry
– Return guarantee: 85 % of the official return index of longterm government bonds over the last 3 years
– Direct limit on foreign investments imposed at 20% level
• Significant 2nd Hungarian pillar underperformance:
– Over 2000-2010 the real rate of return reached 0,65%
(corresponding to minus 0,46 pp over 10Y government
bonds)
• Potential explanation
– Inconvenient choice of minimal guarantee benchmark
– Underdeveloped domestic capital market
– Negative macroeconomic conditions affecting bond yields
Hungary - reform of the reform (1)
• Unfavorable conditions in 2008-2009, IMF
rescue package
• In 2010, just one political party, Fidesz,
obtained the constitutional majority
– Constitutional law has been passed prohibiting the
Constitutional court to rule out on the financial issues
(unless public debt < 50% of GDP)
• End 2010 (besides other austerity
measures), Government decided for
nationalization of accumulated funds in
mandatory private pension sector
Hungary - reform of the reform (2)
• Up to date no formal estimation of fiscal
implications of this move has been delivered
• Government plans are to use the 2nd pillar
means to
– temporary reduction of public debt by 5% (from
current 80% of GDP)
– Allow for radical tax cut amounting to 4% of GDP
• However, this further increases the implicit
government debt in the first because of future
pension entitlements
IV. Czech Republic
Major reform steps
• Creation of voluntary subsidized FF DC pillar in
1994
• Parametric reform of PAYG pillar (2008)
– Contributions: 28% of gross wage - paid by employer
(21,5%) and employee (6,5%)
– Unisex continuous rise of retirement age to 65 by 2030
– Full pension eligibility insurance period rose to 35 years
– Conditions for disability pension redefined
– More changes are expected in 2011
• CZE (together with Slovenia) is the only postcommunistic EU country that have not
implemented mandatory FF DC pension pillar yet.
Current reform proposals
• Current government is proposing a voluntary
curve-out of 3 pp from PAYG pillar to FF DC
pillar if another 2 pp are added from employee’s
funds
• Result of the political compromise
• Transitional costs covered from VAT unification
at 17,5% (current rates of 10% resp. 20%)
• Automatic retirement age protraction to lifeexpectancy development
• Pensions valorized by inflation (100%) and by
real wage growth (1/3)
Experience with the FF DC voluntary
pension pillar (1)
• High scheme coverage:
– 70% of total workforce (4,5 mil.)
– Result of high government subsidies (monetary + tax)
• Current sector size: 6% of GDP
• Employer’s contributions to one third of
participants
• 10 pension funds in operation
Experience with the FF DC voluntary
pension pillar (2)
• Low contributions: sector’s share on the
future pension benefits at 6% (94% of future
pension paid from PAYG)
– Excessive regulation (annual nominal non-negative
minimum guarantee => maximal equity exposure <10%)
– High OPEX (decreasing in time) to run the scheme
• Strong financial underperformance
– Over 2000-2010 the real rate of return reached
0,51% (corresponding to minus 1,61 pp over 10Y
government bonds!!)
V. Assessment of the reforms
General
• 8 of 10 CEE countries implemented the
mandatory 2nd pension pillar
• Experience: a mixed success (or failure?)
• Financial crisis in 2008-09 has been
important driver behind 2nd pillar reversals
– Complete: Hungary (2nd pillar nationalization)
– Partial (lowering of contribution rate): Poland,
Latvia, Lithuania, Estonia, Romania
– Minor actions taken: Slovakia, Bulgaria
Lessons (1)
Best case 2nd pillar practices identified
• Despite recent events, Polish 2nd pillar
relatively successful
• Success attributes:
– Adequate rate of contribution (7,3% of
gross wage; 3/8 out of total)
– Satisfactory investment results (over
1999-2010 period the real rate of return
of 6,6% vs. 4% GDP growth)
Lessons (2)
Best case 2nd pillar practices identified
• Result of the proper regulation:
– Minimum rate of return guarantee reflecting 3 years
period, based on average market performance
– Reasonable investment limits (historic equity
exposure >30%)
– Reform supported by public (70% of public did not
agree with recent government action)
• Favorable 2nd pillar consequences:
– Pension system less volatile due to diversified
sources
– Significant development of the capital market
• See Polish example
Lessons (3)
Lower returns volatility due to diversification
2nd pillar
1st pillar
GDP (right
axis)
Lessons (4)
Causes of 2nd pillar weakening
• Unsatisfactory investment results due to
strict investment regulation and
inconvenient minimum return guarantees
settings + pressure on public finances
 (partial) reversal of the 2nd pillar reform
steps in the majority of CEE countries
• Learning outcome: Second pension pillar
is not immune to the political risk
Lessons
(5)
Causes of 2nd pillar weakening
• 2nd pillar implementation turns implicit
pension debt into explicit (transitional
costs)
• Transitional costs funding needs to be
identified and detached
– This key reform aspect has been neglected
in many countries
• National indebtedness worsened due to
economic crisis, search for short term
remedies
VI. Implications for Russia?
Crucial …
• … retirement age!
Same challenges, same lessons?
• Russia faces similar pension system
challenges as most of the CEE countries
• Warning from mixed experience with
mandatory/voluntary 2nd pillar
• If mandatory 2nd pension pillar then:
– the need to thoroughly analyze transitional costs
– define the sources for its funding (National
Welfare Fund?)
• If 2nd pillar voluntary then probably use
automatic enrollment for reasonable
participation rate
Regulation, openness, transparency
• The regulatory policy (minimal guarantee &
asset class exposures) should be in line
with the best case practice identified
– reflect long-term pensions investment nature
– reflect market situation rather than external
benchmark
• Market should be opened to international
players in order to enforce market
competition (lowering the scheme costs
thus increasing its sustainability)
• Prudent supervisory activities
Thank you for your attention