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

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 38% in the level of future pensions!

II. Poland

Major reform steps Major reform conducted in 1999: „0“ pillar – A solidarity tier guaranteeing (means- tested) minimum pension of 25% current average wage 1 st 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) 2 nd pillar – Mandatory Fully-Funded Defined- Contribution (FF DC) tier (7,3% of gross wage) 3 rd pillar – voluntary FF DC scheme (individual and/or employer contributions), in place already since 1994

Mandatory 2 nd pillar (1) Became a robust part of the economy (19,4% of GDP in 2010) Satisfactory investment results due to pro- competitive 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 2 nd 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 % Positive public perception of 2 nd pillar existence High projected transitional costs with identified sources of financing (tax revenues, 1 st pillar savings, debt)

Current settings Constitutional debt limit 60% GDP, balanced budget requirement when the debt/GDP ratio exceeds 55% Mandatory contributions into 2 nd 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 1 st pillar NDC PAYG, with an annual return indexed to GDP growth and inflation

III. Hungary

Major reform steps First country in the CEE region ( ) that implemented a major pension reform reflecting the WB (1994) proposal: 1 st pillar – mandatory PAYG pillar (24% of gross wage paid by an employer) –parametric changes: increase of retirement age to 62 (unisex) 2 nd pillar – mandatory FF DC pillar (originally 6% increased to 8%, paid by an employee) 3 rd pillar – voluntary FF DC pillar

Mandatory private pension pillar in (1) Mandatory labor market incomers, opt-out for rest (conditioned by 25% reduction of PAYG pillar income) with following outcome: –between around ½ of workforce joined (mainly voluntarily) –in the period of another 25 percent were mandated to join Up to 2010, mandatory 2 nd pillar gathered the assets amounting to 10% of GDP

Mandatory private pension pillar in (2) Strongly regulated industry –Return guarantee: 85 % of the official return index of long- term government bonds over the last 3 years –Direct limit on foreign investments imposed at 20% level Significant 2nd Hungarian pillar underperformance: –Over 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 , 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 2 nd 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 post- communistic 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 life- expectancy 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 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 2 nd pension pillar Experience: a mixed success (or failure?) Financial crisis in has been important driver behind 2 nd pillar reversals –Complete: Hungary (2 nd pillar nationalization) –Partial (lowering of contribution rate): Poland, Latvia, Lithuania, Estonia, Romania –Minor actions taken: Slovakia, Bulgaria

Lessons (1) Best case 2 nd pillar practices identified Despite recent events, Polish 2 nd pillar relatively successful Success attributes: –Adequate rate of contribution (7,3% of gross wage; 3/8 out of total) –Satisfactory investment results (over period the real rate of return of 6,6% vs. 4% GDP growth)

Lessons (2) Best case 2 nd 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 2 nd 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 2 nd pillar 1 st pillar GDP (right axis)

Lessons (4) Causes of 2 nd pillar weakening Unsatisfactory investment results due to strict investment regulation and inconvenient minimum return guarantees settings + pressure on public finances  (partial) reversal of the 2 nd 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 2 nd pillar If mandatory 2 nd pension pillar then: –the need to thoroughly analyze transitional costs –define the sources for its funding (National Welfare Fund?) If 2 nd 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