Donald Tusk, the Polish Prime Minister, announced major changes to the country’s pension system earlier this month that will drastically cut back the role of private funds and appear similar in direction to those taken by Hungary in 2010.
While the announced measures will improve the budget deficit and the public debt over the short term, this is a regrettable set-back for local capital market development and the availability of market-based investment funding.
The longer term fiscal implications are unclear as the government takes on contingent liabilities for future pension payments. Across the EBRD region, it is urgent to address some of the justified concerns of pension funds’ fee structures and the fiscal ‘transition costs’ to a mature private pension system without undermining the key investor base in local capital markets and the benefits that a multi-pillar pension system offers.
In 1999, Poland was among the pioneers in central Europe to introduce a multi-pillar pension system, in line with a widely-shared consensus at the time among emerging market policy makers and international financial institutions. Since then, mandatory pension funds (‘OFEs’) have emerged as formidable investors in the Polish bond and equity markets, with the stock of assets under management of PLN 284 bn (about 17 per cent of GDP), of which 98 per cent is invested within Poland. Their share of domestic public equity investments of over 30 per cent of total assets has been one of the highest among OECD countries. The Warsaw Stock exchange has become the most liquid in the EBRD region.
However, there have been growing misgivings about two aspects of the privately funded system in recent years. First, the government has been increasingly critical of the substantial ‘transition costs’ for the budget of establishing these funds: existing retirees continued to be paid out from the budget, while the contribution payment of workers who have opted for participation in the OFEs (in anticipation of future pension payments from there), have been ‘diverted’ into these private funds. Without matching fiscal adjustments the Polish cash deficit and public debt rose as a result. Second, the fund management industry had also repeatedly come under attack for its fee structure and low returns particularly as the 2008/9 crisis hit.
The reversal to a predominantly unfunded state system was in large measure motivated by increasing pressures on Poland’s public finances due to countercyclical policies and weakening growth. Before the announced measure, the public debt stood at 54.5 per cent of GDP, about to hit the national debt limit of 55 per cent of GDP that would require politically painful expenditure adjustments.
In our view, the announced changes imply a drastic cut-back in the role of the funds. While the short term impact on the fiscal deficit and public debt will be positive, it is a clear set-back for financial development within Poland and the attempt to develop non-bank local funding channels, an agenda that the Polish regulator has recently revived, and which has been supported by the EBRD under the Local Currency and Local Capital Markets Initiative. In a nutshell the key changes are as follows:
- A transfer by the private pension funds of 51.5 per cent of the assets to the state insurance system (ZUS), an amount roughly in line with the aggregate holdings of government bonds at end-2012, for which pension fund beneficiaries will obtain commensurate rights for future payments from the state system over the course of their retirement.
- A ban on private pension funds holding government or state-guaranteed bonds in the future, though the funds will be free to invest in equities, money market instruments, corporate and municipal bonds. The limit on foreign holdings (not binding to date) will gradually be lifted to 30 per cent.
- The about 16 million members in the 14 pension funds will have three months to exercise the right to opt to remain in their funds. Should they fail to do so, the default option will be a complete return of accumulated individual funds to ZUS, with corresponding actuarial calculation of future additional retirement payments. Similarly, future entrants to the labour market will need to explicitly opt for insurance in the funds (which previously was compulsory).
- For those who remain or newly enrol in the funds, the contribution rate will be fixed at 2.9 per cent of gross wage payments, way below initial contributions of 7.3 per cent in effect up to 2010.
- Ten years prior to the statutory retirement age, the remaining accumulated assets in individual accounts will shift into ZUS in equal annual instalments.
- Maximum fees charged by the fund management will be reduced in half.
The implications for the immediate fiscal outlook are clearly positive:
- The transfer of about PLN 120 billion, equivalent to EUR 30 billion, from the OFEs will become an asset in the consolidated government accounts, and the transferred government bonds will subsequently be cancelled. The public debt ratio is set to come down by about 8 percentage points of GDP, significantly reducing the immediate risk from breaching the legal debt limit (which would have triggered a VAT increase and automatic spending constraints).
- A substantial share of ongoing contributions from wage payments into the OFEs will be diverted back into the state’s pension manager, ZUS. Larger flows into the state pension manager will count as government revenue and, along with reduced debt servicing costs on the cancelled state debt, will provide an additional fiscal room.
At the same time, the flip side of these changes is of course that the budget will take on additional liabilities for future retirement payments. Experience from other countries suggests that the default option of a return to the state system will apply to the vast majority of the population not least because the future of those funds appears highly questionable. Whether or not the discounted value of future additional payments out of the state retirement account will exceed the costs of government debt that would have been accumulated had the present system stayed in place is not at all clear. In any case retirees that repatriate funds into the state system will forego the benefits that had motivated the initial multi-pillar system, such as more diversified and possibly superior returns in privately managed financial assets.
At the same time the damage to Poland’s capital market development will be immediate and severe:
- The principal source of long term, risk-oriented investment within Poland will be marginalised. It is unclear whether a pension fund sector will remain viable, and if so whether it can sustain flows into other private bonds. Given the pervasive investment needs within Poland and the constraints on maturities and volumes in bank funding this will present an important challenge for the real sector.
- Poland’s government bond market will shrink, possibly with diminished liquidity. Foreign participation will be more prominent, with an associated vulnerability in case of external shocks. For longer maturities, yields on Polish bonds may rise, as may costs for other term funding.
- With a much diminished participation, lower inflows, and capped fees the economics of the pension industry will deteriorate and significant consolidation is likely.
- OFE funds that remain will be constrained to equities, domestic non-state bonds and foreign securities. The implied volatility may further deter many pension savers.
- The funds will likely adopt a more passive investment style, and the participation in public equity market, IPOs, and privatisations may suffer.
The reversal in the Polish pension system clearly sends a negative signal to other countries in central and south-eastern Europe. In a low-growth environment fiscal pressures remain acute and may entice others to look at similar options. Returns on asset holdings remain disappointing and the high cost base in an immature pension industry provides little political support to multi-pillar systems.
Yet, there are positive examples as well: the three Baltic countries have brought their public finances back to health, and in the process restored the role of their funded pension systems. Slovakia, among the first to re-open the pay-as-you-go system for members of the funded pension system in 2008, has recently adopted a more resilient approach with capital guarantees based on a long investment horizon, allowing more risk-taking that may benefit infrastructure and other long term investment.
More broadly, it is increasingly urgent to address some of the justified concerns of pension funds’ fee structures and the ‘transition costs’ to a mature private without undermining the key investor base in local capital markets and the benefits that a multi-pillar pension system offers.
 Given a 'charge ratio' in the bottom half of a range of emerging markets this criticism was in fact not fully justified.