1 INTRODUCTION, RESULTS AND EXPERIENCES OF THE MULTIPORTFOLIO SYSTEM IN THE HUNGARIAN MANDATORY PENSION FUNDS 18 September 2009, Sofia, Bulgaria Csaba Nagy chairman Hungarian Association of Pension Funds

Association of Pension and Health Funds Contents  Background  Drawbacks in competition - Pillar 1 vs Pillar 2  Pressure to improve - Legislative changes in 2008  Implementation of multifunds  Accounting unit based approach  Post implementation experiences  Evaluation of the Hungarian multifund system  An alternative approach - „Target date (lifetime) funds” system  Conclusions 2

Association of Pension and Health Funds Background Introduction of funded Pillar 2 in 1998 Rapid growth of mandatory pension funds Participation mandatory for first-time workers Entry was open for active workers upon voluntary decision before Option to return upon retirement to social security pension scheme until 2002 Management of assets in a single fund 3

Association of Pension and Health Funds Drawbacks in competition Pillar 1 vs Pillar 2 Guaranteed growth of state social security pensions based on „Swiss indexation” (i.e. the average of the consumer price index and the wage index); Promises by politicians : pensions for 13 or even 14 months in a year Unattractive real returns of mandatory pension funds –Average real return in period from 2000 to 2007: 1.7 %  Loss of trust in the multi-pillar system 4

Association of Pension and Health Funds Reasons for underperforming returns The proportion of the government securities within pension fund’s investments in : ~ 70% Relative high government bond’s yields Frightening effects of the stock exchange crisis 1998 Short-term approach (a „wrong year” involves competition drawback at member recruiting) Publishing of only 1 year’s yield 5 There is no possibility to take yield advantage of higher risk assets

Association of Pension and Health Funds Pressure to improve - Legislative changes in 2008 Introduction of the multiportfolio’s system (from 1 January 2008 it’s an opportunity, from 1 January 2009 it’s compulsory) Introduction of the accounting unit based records system (from 1 January 2008 it’s an opportunity, from 1 January 2009 it’s compulsory) Restriction of the asset management fee : The annual fee not allowed to exceed the 0.8% of the size of assets. Restriction of the operating expenses : Maximum 5.5% (from 2009: 4.5%) of the membership fee incomes can be spent on operating expenses. Apart from 1 year’s yield indexes the last 5 years’ (from 2009: 10 years’) indexes must be published. 6

Association of Pension and Health Funds Implementation of multifunds – administrative requirements Funds must create exactly 3 portfolios Classic (law risk and yield) Balanced (middle risk and yield) Growth (high risk and yield) A member’s saving can only be in one portfolio at the same time Member’s decision can be an own choice or „auto-enrolment” which means the acceptance of enrolment based on the time remaining until retirement age (62 years) If it’s more than 15 years: Growth portfolio Between 5-15 years: Balanced portfolio Less than 5 years: Classic portfolio Funds must update the automatic enrolment based on time remaining at the end of every year Members can change portfolio any time, but not more than with 6 months’ frequency (fee: 1 ‰, max 2,000 HUF) 7

Association of Pension and Health Funds Implementation of multifunds – asset management requirements 8 The limits ensured necessary scope to create well-diversified portfolios. Determined optimal investment term Classic portfolio : short-term liquidity without losses, yield advantage will have to appear within 5 years Balanced portfolio : yield advantage will have to appear within 10 years Growth portfolio : yield advantage will have to appear long term (over 10 years)

Association of Pension and Health Funds Accounting unit based approach Earlier: Distribution of yields by average stocks of individual accounts every quarter Accounting unit based records system Account keeping in units primarily Base exchange rate at the time of starting: HUF/unit Daily calculation and publishing of exchange rates for all portfolios Every transaction is converted from HUF to units (and in the opposite direction) by daily exchange rates Account balance in HUF: account balance in unit x daily unit exchange rate The new method is exact, but labour-intensive: it requires close cooperation of fund, asset management company and custodian every day The real challenge - system development and operation - was the change to accounting unit based method (less the multiportfolio system) 9

Association of Pension and Health Funds Implementation statistics from 18 mandatory pension funds started in 2008 OTP Mandatory Pension Fund’s data (market share by membership: 30%) Almost 10% of membership chose individually Most of individual decisions reflected the proper classification by age Slight overweighting of Classic portfolio

Association of Pension and Health Funds Adverse returns geared by multifunds 2008: Unfortunate timing of implementation Due to recession and equity market trends in 2008, pension funds applying multifund system have significantly underperformed the funds with single portfolios. 11 Significant part of 2008 year’s losses (not realized) till the middle of Difficulties in communication : In the annual statement of account (which was delivered in June 2009) members were facing the losses of 2008

Association of Pension and Health Funds Post implementation experiences I. Fund members’ reactions to the crisis in regard to OTP Mandatory Fund 12 October 2008: falling of the stock market rates February 2009: publishing of the 2008’s yields of pension funds End of June 2009: Delivering of the annual statement for members 1,554 switching transactions during 20 months (number of members: 800 thousand) Members don’t show too much interest in their own pension savings.

Association of Pension and Health Funds Post implementation experiences II. Recommendations (not too much success) to members regarding the portfolio transfers: In case of lack of personal knowledge  age based classification Choose portfolio for long-term Don’t realize losses by switching to a less risky portfolio 13 Fund members’ reactions to the crisis in regard to OTP Mandatory Fund

Association of Pension and Health Funds Post implementation experiences III. Agents capitalize the crisis and „convince” the members of usefulness of switching. From the 2nd half of 2009 the rules of switching are more rigorous: Members must declare they had been informed about fund’s yields and risks of switching Raising of switching fee 14 Fund members’ reactions to the crisis in regard to switching between funds (all mandatory sector)

Association of Pension and Health Funds Evaluation of the Hungarian multifund system I. Positives Stable and useable model was born in a short time which can and must develop further. Possibility to create well-diversified investment portfolios. In this time - in spite of crisis - retiring members are fortunate with the new system (proportion of the government securities in „Classic” portfolio more than 90% - in single portfolio system it was only 70%) Negatives Funds introduce the multiportfolio system at different times: Due to crisis those funds which were faster and more client orientated  suffered higher losses in Starting dates of daily exhange rates are different at the funds  exchange rates of funds are not comparative directly. 15

Association of Pension and Health Funds Evaluation of the Hungarian multifund system II. Need improvement Duration of portfolios are not optimal for all age-groups Duration of the 3 portfolios is not designed to match short-term savings (especially within 2 years before retirement) or the needs of career-starters (over up to 45 years) Switching portfolios may lead to losses The law requires to allocate participants to the matching portfolio as of the end of the year, regardless of the costs and losses caused by this forced switching. Participants are not encouraged to take advantage of diversification Many of the participants are likely to stick to the portfolio they are allocated to. Limited opportunities for the individual to allow optimal asset-liability matching. 16

Association of Pension and Health Funds Multifunds system – an alternative approach I. „ Target date (lifetime) funds” system Intention : To avoid the double traps of taking low risk at young age and high risk at old age Creating the portfolios and classifying the members on the basis of age, also. But: If the member dosn’t choose individually, will stay in the same portfolio until retirement. Portfolios have life-cycle periods and maturity. Number of portfolios is fixed. If a portfolio runs out, another takes the place of it, and the new portfolio will be the longest maturity. In the portfolios - in their duration - proportion of high risk assets continuously decreases. 17

Association of Pension and Health Funds „ Target date (lifetime) funds” system Time turn of the asset allocation from working age (around 25 years) to retirement (65 years) 18

Association of Pension and Health Funds „Target date (lifetime) funds” system - An example from USA 19

Association of Pension and Health Funds Multifunds system - Conclusions Key issues Timing Education of membership: Financial awareness ( Risk ↔ Yield) Number of portfolios: Should be optimal for all age-groups Investment policy: Enough room for diversification 20

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