Hungary
Gabor Borza, ING Insurance PTE Co. Ltd Budapest
Background
By the end of the 1980’s the Hungarian pension system fully covered the Hungarian active
and passive population by providing a relatively high replacement ratio to pensioners. The
retirement age was relatively low (60/55 years), but given the full employment at the time the
financing did not generate a deficit. It should be noted that the situation was not sustainable as
the full employment was largely dependent on at that time still rapid capital inflows. At the
onset of economic transition from the centrally planned economy to market economy
Hungary (along with Poland) had the highest foreign debt.
The country – compared to the Western-European standards, but similarly to the regional
peers – had a very low financial culture and poor financial infrastructure.
The beginning of the 1990’s brought high unemployment and therefore the balance of the
social security drastically worsened and contribution rates had to be raised so that the role of
the grey economy increased further, causing a further debt in the system. The unsustainability of the system became clear.
We should also mention the material limitation of the insurance principle. The system was
characterized by many levelling features, such as degression in the number of service years as
well in the income level calculation or the fix dollar amount indexation. Other distortions
included the service years without contribution payments or taking into account the best 3 of
the last 5 years as a kind of final pay formula.
Many of these elements were already being limited in the years of 1991-1993.
From 1994 it became possible to start so-called Voluntary Pension Funds and from 1995
individual life insurance premiums were supported by personal income tax deductions, so the
role of the self provisioning was recognised and these steps showed the way of the direction
of the pay-as-you-go system.
Third Pillar / Voluntary Pension Fund (1994)
First of all the Voluntary Pension Fund (VPF) is not a pension product or benefit in WesternEuropean terms, but rather a tax-incentivised long term saving product without material
annuity feature in practice.
The tax incentive from the extremely favourable levels of the introductory years has slowly
decreased to the current rather modest – but still motivating – level.
The product is provided by non-profit funds, but as from 2007 – due to EU intervention – it
became possible to set up Occupational Pension Funds (OPF). The industry still had to wait
for the first foundation until 2011.
Characteristics
2
Contributions arrive from employer as well as employees.
Employer payments (contributions) are almost fully tax deductible and despite the restrictions
in this respect contribution payments have still a very strong advantage compared to salary
payments.
The employer however should treat all the employees equal on a way that either provide the
same percentage of pay or the same dollar amount to all of them. There is however a tax
efficient cap of payments.
Employees may pay contributions regularly or irregularly, there is however a tax efficient cap
of payments from personal income tax point of view, but there is no limit with respect to the
exemption under from yield tax, so employees close to retirement may transfer higher
amounts to the fund account, especially before other special accounts with similar features
have not been available.
The product in the accumulation phase is a defined contribution individual account and most
of the providers offer different subfunds with special investment policies, mostly with
different risk profiles (equity exposure) but without automatic switching based on age. Capital
and yields are available before retirement age, (after 10 years of accumulation), so this is why
this is not a real pension product as many clients withdraw the cash as soon as possible even
without waiting for the tax benefits fully vested.
Life annuity is therefore not demanded, but the non-profit VPF would not have been able to
provide it as they do not have any solvency capital. Temporary or financial annuities are
provided in case of special tax situation.
There are regulatory limits both on administration fees and asset management fees introduced
as from 2008. Prior to this only certain fees (entry, exit, switching, etc) were regulated.
The product is therefore very cheap compared to other retail products (life insurance, unit
linked, even mutual funds), but due to the very low margins the distributors can not be
incentivised properly so the product and therefore the tax advantages do not reach the target
audience. Mostly those members use the tax advantage to the maximum who are anyway
conscious financial planner, so this is an example of the client protective regulation where the
secondary impact in underestimated.
The 2008 crisis and the decreasing tax incentives started to reduce the contributions and
increase the withdrawal rates.
However almost one third of the working population is covered by the voluntary pension
funds, the active membership is significantly lower (ca. 80%). The reason for that is the
employers pay two third of the contribution and when it is suspended the individuals may not
contribute anymore. This phenomenon had been strengthened by the current financial crises.
The graph below shows the number of members (left axis) and the assets under management
(AuM, on the right axis in HUF bn). Despite favourable nominal yields both in 2009 and 2010
the AuM started to decline due to lower contribution levels and higher withdrawals.
3
Voluntary Pension Funds
1 000,0
1 600 000
900,0
1 400 000
800,0
1 200 000
700,0
1 000 000
600,0
800 000
500,0
400,0
600 000
300,0
400 000
200,0
200 000
100,0
0
0,0
1998
1999
2000
2001
2002
2003
2004
Membership
2005
2006
2007
2008
2009
2010
Assets (Mrd Ft)
Due to recent developments in the second pillar (and the government’s intentions) it is
expected that the role of self provisioning -- and therefore of the VPF – revitalizes. However
VPFs will need to communicate to clients that second pillar developments will not impact the
third pillar.
Second Pillar / Mandatory Pension Fund (1998)
First of all there are many pillar models (OECD, Worldbank, EU) and in the region these
funds are classified under second pillar, but since they are mandatory by law some call them
first pillar bis. Hungary was the first country introducing such reform mostly based on
Worldbank advice.
The proponents of that model – which originated in South America – have listed many
arguments why funded pension systems are superior to pay-as-you-go systems, but most of
them have not passed the test of times in professional discussions. The funded system globally
can provide solution to the demographic challenges and will not have material impact on
capital markets.
The most important reason that still validate the existence of these reform is the option for
international diversification. This is especially a strong argument in case of small and open
economies with worsening demographic developments and inefficient immigration
capabilities.
Introduction of the system only has a limited direct impact on the national economy as at the
beginning most of the assets were invested into government bonds and only later benefitted
from the international diversification – though we now see a heavy bias in local equities.
Arguably, local investment has not boosted the local economy. It is however difficult to state
that how many foreign investment inflows e.g. by pension funds and other institutional
investors have been generated by the fact that the economy became more open and the
financial infrastructure have been developed along with the local professionals.
4
The system was introduced in a way that 25 per cent of the individual pension contributions
were privatized.
For career starters the formula was straightforward. Approximately 25% of the total
(employee and employer) PAYG contributions have been removed from the PAYG system
and directed into the funded system. This resulted in 25 lower PAYG benefits. Members
expect that the funded system will compensate for the loses or even overperform.
For employees with vested rights entering the system meant that 25% of their vested rights in
the PAYG are lost. This meant that employees with only limited number of service years were
advised to switch but those close to retirement age (giving up high number of service years)
were advised against such a step. Consensus in 1998 was that at least 15 years before
retirement would have been needed before a switch.
Parallel to the paradigmatic reform a parametric reform was introduced by restricting the
benefits by several means.
o Increase the retirement age limit to 62/62
o Swiss indexation (50% price + 50 wage index)
Along with the above mentioned gains in the PAYG system the Hungarian pension system
became sustainable. We have to note that the number of switchers have far exceeded all the
expectations and this success was also a reason to further problems.
The product is an identical product to the third pillar DC individual account with the
exception that life annuity is defined in the law, but its supply is not solved as the providing
entity is the same/similar non-profit organisation without solvency capital. (To fix this issue
proposal was accepted by the Parliament in 2009, but it was rejected by the President at that
time, and the current government did not have that law on the agenda as the whole pillar
structure is now undergoing redesign).
The market is dominated by those funds (sponsored by financial institutions) which had
strong retail financial distribution channels behind them.
Sponsored funds used captive asset management belonging to the sponsoring financial
institutions and despite the funds were not owned by them they let the fund use their brand
and therefore running strong reputational risk. Sponsoring entities were interested in the
growth of the funds as their asset based could grow subsequently.
After 2002 the PAYG system started to become unsustainable again as several populist steps
were introduced, e.g. the 13th months pension and expanding the benefits of the
widows/widowers.
In 2009 the system was corrected back again by eliminating the 13th month benefit, gradual
increasing of the age limit to 65/65 and lower indexation, so the PAYG system became
sustainable again (thanks to the crisis).
Modification in 2008
5
Without formal agreement and without written yield guarantees the investment policy of the
funds were harmonised. The reason is the herding effect, that is, funds with different
investment policies may materially under- or overperform peers, but underperformance is
always punished more heavily compared to the reward due to overperformance. Unfortunately
this harmonised investment policy came out at a more or less stable level of 15-20% equity.
This means that the set up of the whole system (including all transaction costs, administration
cost) on national level became meaningless as the system could hardly benefit from the
international diversification. This was explained and analysed in detail by National Bank
studies in 2005 and 2006. As a result of these trends as from 2008 some steps were made.
Most importantly the mandatory single fund approach was stopped and 3 funds had to be
offered on a way that the minimum equity level was set up for those who have at least 15
years until retirement. 80-85% of the assets fell into this group.
Other measures applied to asset management and administration caps as well as mandatory
introduction of the unitized system. Furthermore, originally the premium and contribution
collection was decentralised -- each pension fund had direct contact with each employer.
Subsequently, a centralized system was established and a government agency now collects
premium and transfers this to the pension funds. This latter step (after the usual introductory
problems) implied a gain on macroeconomic level. The unitized system however caused huge
IT investment with only immaterial client benefit.
Macroeconomic impact
Reducing the PAYG contributions increases the deficit and the national debt of the country
introducing such reform. This increase is in place until first career starter generation starts to
retire, so the transition period is 40 year long. If this investment is not recognised in the
measurement of the deficit and debt (stability and growth pact) then a very strong financial
incentive is built into the EU legislation to cancel any similar reform and definitely not to start
if a country would ever consider.
Even before the crisis the level of the deficit was a problem as Hungary has been under the
EU’s Excessive Deficit Procedure since the mid 2000s but - along with the higher and higher
amounts in the mandatory fund (10%-11% of GDP in 2010 see graph below) – the crisis
really made the accrued funds a convenient tool to fix short time budgetary problems.
6
Total Assets of Pillar2/GDP
0,14
11%
0,12
10%
0,1
8%
0,08
7%
7%
6%
0,06
4%
0,04
0,02
0%
1%
1%
2%
2%
3%
0
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
This is why the new Hungarian government started a quasi nationalisation of the system
targeting a 2-pillar system, that is a PAYG system supported by VPF and other long term
savings.
Directing people from the 2nd pillar to fully to the PAYG is not an easy exercise. Most people
would insist to “their own” account, so the chosen solution was to make the members confirm
their stay in the pension fund, so those who did not confirm were automatically switched
back, so from the original 3 million members only 3.2% remained with the 8-9% of the assets.
A very strong financial incentive was also built into the system, that is, those who stay in the
pension fund will not accrue future pension rights in the PAYS system. This latter is
challenged however based on non-discrimination principles.
Change of member number due to the government's action
3 500 000
3 118 200
3 000 000
2 500 000
2 000 000
-96,9%
1 500 000
1 000 000
500 000
97 422
0
members (before)
members (after)
7
Mem ber num ber before governm ent' action
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700 000
600 000
500 000
400 000
300 000
200 000
100 000
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As a summary until the EU level recognition of these payment/funds demotivate the existence
of these funds the higher the accumulated amount in the fund the higher the incentive is to
direct back them to the state budget. We see similar steps in Poland and Bulgaria.