Pension Policy: Reversals of Funded Schemes

Public Disclosure Authorized Public Disclosure Authorized Pension Policy: Reversals of Funded Schemes Public Disclosure Authorized Agnieszka Chłoń-Domińczak, Ph. D. Warsaw School of Economics Washington DC - Warsaw, May 5th, 2016 Pension Core Course d

Outline Pension reforms and reversals in CEE countries in two decades: from late 1990s until 2013 Socio-economic context of pension systems: demography, labor market and pension system Post-reform experiences Performance of funded schemes Transition costs: plans and reality Fiscal situation Reversals of funded schemes and their impact on individual pension wealth Conclusions

Pension reforms in CEE countries Economic and social transition: Reduced employment and rising unemployment in early 1990s Rising costs of pension systems, widespread early retirement Demographic change: sharp drop in fertility rates causing fast population ageing in the future Pension reforms: Changes in the PAYG pillar: from parametric reforms (rising retirement age, lower indexation or accrual rates) to paradigmatic reforms: introducing NDC schemes Changes in pension financing: introducing multi-pillar schemes

Selected features of pension systems in 8 CEE countries Public pension scheme Retirement age Mandatory funded contributions Enactment date Bulgaria DB 60/55 63/60 2% 5% 2002 Who participates Mandatory for all workers <42 Estonia DB 60/55 63/63 6% (4% +2%) 2002 Mandatory for new entrants Latvia Notional accounts 60/55 62/62 2% 8% 2001 Lithuania DB 60/55 62.5/60 2.5% 5.5% 2004 Mandatory for new and workers < 30, voluntary for 30-50 Voluntary for current and new workers Hungary DB 60/55 62/62 6% 8% 1998 Mandatory for new entrants Poland Notional accounts 65/60 (60/55) 67/67 7.3% 1999 Romania DB 62/57 65/60 2% 3% 2008 Slovak Republic Points 60/53-57 62/62 9% 2005 Source: A.Schwartz and O.Arias, The Inverting Pyramid (2014) Mandatory for new and workers < 30, voluntary for 30-50 Mandatory for new and workers < 35, voluntary for 36-45 Mandatory for born after 1983

Demography dependency rate 80 70 60 50 40 30 20 10 0 BG EE LT LV HU PL RO SK 2010 2035 2060 Source: EUROSTAT Population Projection

Demography All CEE countries will face significant increase in demographic dependency rate It will be particularly acute in those countries that currently have low fertility levels, after 2035 Retirement ages remain lower than in old EU countries, which is partially explained by shorter lives. but changes in retirement age are slower than the actual increase of life expectancy

Employment changes Divergent labor market developments: Initial decline and later increase in PL and SK Increase and decline in HU Cyclical changes in Baltic countries Loss in contribution revenues after the crisis caused by declining employment

1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Pension expenditure 16 14 12 10 8 6 4 2 0 European Union (27 countries) Bulgaria Estonia Latvia Lithuania Hungary Poland Romania Slovakia Source: EUROSTAT Espross database

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Trends in pension fund assets (% GDP) 20 20 20 18 18 18 16 16 16 14 14 14 12 12 12 10 8 6 4 2 0 10 8 6 4 2 0 10 8 6 4 2 0 Hungary (1) Poland (4) Croatia Czech Republic Slovakia (2) Macedonia Estonia Bulgaria Slovenia Romania (3) Latvia Serbia 1. As a result of a pension reform, the assets of mandatory pension funds decreased in 2011, while voluntary pension fund assets did not change significantly. 2. The break in series in 2006 is due to the inclusion of voluntary pension plans, not included in the previous years 3. The increase of pension funds assets between 2011 and 2012 is due to the increase of pension funds' members, contributions and positive returns. 4. Due to the shift of assets in 2015, there is a drop in total assets of pension funds in Poland due to the transfer and redeeming of government bonds in pension funds' portfolio Source: OECD Pension Markets in Focus 2014

Country Type of fund Starting date of calculations Average annual rate of return (%) Investment returns in CEE funded pension pillars Source: Bielawska, Chłoń-Domińczak, Stańko (2016) Bulgaria mandatory 1.07.2004-2.06 Estonia Latvia Lithuania Hungary all -0.10 conservative -0.91 balanced 2.07.2002-0.96 progressive 0.33 aggressive 1.01.2010 1.61 balanced -1.22 aggressive 7.01.2003-1.65 conservative -1.75 conservative -0.84 stable 0.00 balanced 15.06.2004-0.21 aggressive -0.85 classic 1.01.1998 until end of 2007 conservative 3.39 2.05 balanced 22.03.2005 1.70 growth 0.75 Poland mandatory 1.09.1999 5.74 Romania mandatory 21.05.2008 5.97 Slovakia conservative -0.42 balanced 22.03.2005-1.40 aggressive -1.63 indexed 2.04.2012 1.75

Accumulated real returns (investment) in CEE funded pension pillars Generally not satisfactory either minus or low positive values Problem with asset allocation (investment limits, return guarantees, local market capacities) Only three funded pension systems with satisfactory results Hungary, Poland and Romania Actual investment performance cannot serve as a justification for pension reversals done in first two countries

Pre-crisis pension reform implementation challenges Despite initial plans in most of the CEE countries pension reforms were financed by increasing public debt As a result it meant that the part of the implicit pension liabilities were turned into explicit one Governments were not persistent in pursuing the initial reform agenda related to financing transition Privatization used for other purposes Pension savings were not generated (higher indexation of pensions, postponing increase of retirement age) EU accession and necessity to follow Stability and Growth Pact requirements, combined with rising deficit and public debt led to the reversals decisions

The concept of financing the transition costs Three sources of covering the transition costs: financing from taxes and other budgetary revenues (burden for working generation), financing from savings in the existing PAYG system (burden for retired generation), through an increase of the general government debt (burden for future generations). The choice of the source for financing the transition costs is a crucial decision in terms of the reform success or failure.

Expected and actual sources of financing transition costs Country Increase of government sector revenues (taxes, social security contributions) Savings in existing PAYG pillar Privatisation revenues Bulgaria x x Estonia x x Latvia x x Lithuania x x Hungary x Poland x x Romania x x Slovakia x x Sources: Authors compilation based on Pension Reform in Central and Eastern Europe (E. Fultz, ed., 2002), ILO 2002 and Convergence Programmes of CEE countries. Source: Bielawska, Chłoń-Domińczak and Stańko (2016)

Transition costs Country Period covered in the assessment Bulgaria 2001-2012 Estonia 2001-2012 Latvia 2005-2012 Lithuania 2005-2012 Hungary 2003-2012 Poland 2004-2012 Romania 2001-2012 Slovakia 2008-2012 Transition cost (% GDP) 16,0 9,9 8,9 8,0 6,2 5,0 4,9 1,6 Source: Bielawska, Chłoń-Domińczak and Stańko (2016)

Decomposition of financing transition costs by country (% of GDP) Source: Bielawska, Chłoń-Domińczak and Stańko (2016)

Decomposition of financing transition costs by country (% of GDP) Source: Bielawska, Chłoń-Domińczak and Stańko (2016)

Total transition costs by source of financing Pension system savings LV RO LT BG EE PL Taxes SK HU Public debt Source: Bielawska, Chłoń-Domińczak and Stańko (2016)

Financial and fiscal crisis Rising public deficit and debt levels Falling capacity to finance transition costs For the EU countries: excessive deficit procedures Negative or low returns and high administrative costs Low levels of trust towards pension funds Short-term assessment perspective

Economic and fiscal situation of CEE countries after reform implementation Specification Economic slowdown or recession in years following reform implementation Country Poland (2000 2001) Romania (2009 2010) GGS deficit above 3% GDP Poland, Hungary GGS deficit close to 3% GDP Slovakia GGS deficit below 3% GDP or GGS surplus Latvia, Bulgaria, Estonia, Lithuania, Romania

Fiscal situation general government deficit and debt 0.0 10.0 20.0 30.0 40.0 50.0 60.0 70.0 80.0 90.0-10.0-9.0-8.0-7.0-6.0-5.0-4.0-3.0-2.0-1.0 0.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 HU GG deficit GG debt 0.0 10.0 20.0 30.0 40.0 50.0 60.0-8.0-7.0-6.0-5.0-4.0-3.0-2.0-1.0 0.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 PL GG deficit GG debt 0.0 10.0 20.0 30.0 40.0 50.0 60.0-14.0-12.0-10.0-8.0-6.0-4.0-2.0 0.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 SK GG deficit GG debt 0 10 20 30 40 50 60-10.0-9.0-8.0-7.0-6.0-5.0-4.0-3.0-2.0-1.0 0.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 RO GG deficit GG debt

Fiscal situation general government deficit and debt 0.0 10.0 20.0 30.0 40.0 50.0 60.0-10.0-9.0-8.0-7.0-6.0-5.0-4.0-3.0-2.0-1.0 0.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 LT GG deficit GG debt 0.0 10.0 20.0 30.0 40.0 50.0 60.0-10.0-9.0-8.0-7.0-6.0-5.0-4.0-3.0-2.0-1.0 0.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 LV GG deficit GG debt 0.0 10.0 20.0 30.0 40.0 50.0 60.0-3.0-2.0-1.0 0.0 1.0 2.0 3.0 4.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 EE GG deficit GG debt 0.0 10.0 20.0 30.0 40.0 50.0 60.0 70.0 80.0-6.0-5.0-4.0-3.0-2.0-1.0 0.0 1.0 2.0 3.0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 BG GG deficit GG debt

Expectations and facts about financing transition costs In all countries transition costs were higher then expected but were not the main drivers of GGS excessive deficits Expected privatization revenues were used also for other purposes Only few countries successfully implemented changes in existing PAYG part of pension system in line with reform projections (Estonia, Bulgaria, Latvia) Reasonable fiscal policy was run by countries with tight national fiscal rules

Changes in funded DC schemes after 2008 Bulgaria Estonia Latvia Lithuania Hungary Poland Romania Slovakia Reversals No change. Temporary reduction with off-set. 6% contribution rate cut to 0% between June 2009 and January 2011 and shifted to PAYG. Gradual increase from 2011. Rate set at 3% in January 2011 and 6% in January 2012. In 2014-2017 at 8% to offset missed contributions Partial reduction. 8% contribution rate reduced to 2% in May 2009. Rates increased to 4% from 2013 Partial reduction. 5.5% contribution rate reduced to 2% in July 2009. Rates further lowered to 1.5% in January 2012 and 2.5% in 2013. Change to 3% (2%+ 1%) January 2014, voluntary participation. Additional contribution at 2% in 2016-2019. Permanent reversal. Contribution rate reduced to 0% in January 2011 assets transferred to the mandatory PAYG system. Permanent reduction and partial reversal. Contribution rate reduced to 2.3% in May 2011. From February 2014 contribution at 2.92%, in February 2014 assets invested in government bonds transferred to PAYG scheme and redeemed. In 2014 system made opt-out and opt-in in specified time slots. Assets from FF transferred gradually to PAYG 10 years prior to retirement. Temporary reduction. Reduction in planned growth path of contribution rate from 2% to 6%. Rate froze at 2%, started to increase from 2011 at annual rate of 0,5pp. Permanent reduction. 9% contribution reduced to 4% in 2013. Funded scheme opt-out and opt-in system. Source: A.Schwartz and O.Arias, The Inverting Pyramid (2014) updated by authors

Contribution changes Estonia Latvia Difference in initial contribution levels Lituania Poland But also difference in the reduction of contribution rates Permanent change in Latvia, Poland and Slovakia Romania Slovakia

Assessing the impact of reversals on individual pension wealth: assumptions Based on the Ageing Working Group (AWG) assumptions: GDP growth: 1.2-1.6 per cent annually Wage growth: 2.0 2.4. per cent annually Financial market rate of return: 3.0 Life expectancy at 65: based on Eurostat population projection There is a significant amount of uncertainty due to possible deviations from the assumptions!

Calculating pension wealth change Pension wealth change: The difference between future value of accumulated contributions paid to the FF tier after change and before the change plus The difference between future value of accrued pension rights in the PAYG tier after change and before the change

% of average annual wage Change in pension wealth for average wage earner 60 50 40 30 20 10 0-10 -20-30 PL LV EE RO LT SK 50 year old 40 year old 30 year old

Summary context of reform reversals Fertility Dependency rate Employment Pension expenditure Pensioners Performance of funded Pension fund returns Government deficit Government debt Pension system changes after crisis Bulgaria - - + + + - - + No change Estonia - - + + + - + + Temporary reduction with offset Latvia -- -- - - - - -- - Partial reduction Lithuania - - -- + + - -- - Partial reduction Hungary -- - - -- - + - -- Poland -- -- ++ -- - + -- -- Slovakia -- -- ++ - - - -- -- Permanent reversal Permanent reduction and partial reversal Permanent reduction

Conclusions Each of the analyzed countries is characterized by different combination of socio-economic factors taken into account Reversals of pension reforms were caused by a set of socioeconomic factors, including most importantly poor fiscal situation rising pressure from current pension system expenditure Countries that introduced permanent changes also faced pressures from rising expenditure and number of beneficiaries in the pension system Performance of pension funds had little impact on reversal decisions Permanent reversals and reductions were made in countries with highest demographic pressures foreseen in next decades

Conclusions Reversals of the multi-pillar scheme have different outcomes on expected pension levels, which depends mainly on the design of the PAYG scheme In the case of higher pension expectations, the change leads also to higher level of implicit liabilities, which means that the change increases total public liabilities (Slovakia) In the case of lower pension expectations, the change leads to similar level of public liabilities, but there is an efficiency loss

Conclusions The design of the matching part of the pay-as-you-go system affects the potential pension wealth, which may have influenced some of the individual decisions (in those countries which left a choice to pension system participants) Recent modifications in funded systems increased the reliance of future pension income on wage-based financing, which will be more difficult to achieve given projected labour supply shortages due to the population ageing in the future

Lessons learnt These findings should be seen only as one of the outcomes of the recent wave of pension systems changes. One should not forget that the change in the proportion of contributions affects the risk diversification of financing future pensions. The changes also could have resulted in a loss of society trust towards state-organised pension system and reliability of accumulated pension savings.

Lessons learnt Explicit and implicit debt are not treated equally in financial/political world transition costs generate new debt, explicit/implicit debt priced very differently by financial markets Implicit debt theoretical: depends on future policy, not to be actually paid (implicit financing) Explicit debt real: current and real liability, often against foreign investors More realistic assessment of privatization benefits Higher returns expectation were optimistic (and defeated by bond financing), transaction costs of individual accounts high No evidence of pulling workers from shadow economy

Lessons learnt Diversification: reducing risks by investing in a variety of uncorrelated assets (micro-level) but pension system exposed to macro-level shocks (not about uncorrelated risks) Private pillars not immune to regulatory risks/shocks inflation tax, tax on interest, other regulatory tools, default on bonds, a possibility of nationalization The future of pension financing remains a challenge: demographically old but not yet economically rich

Thank you Research included in this presentation was financed from research grant number UMO-2012/05/B/HS4/04206 from National Science Centre in Poland Retreat from mandatory pension funds in countries of the Eastern and Central Europe in result of financial and fiscal crisis: Causes, effects and recommendations for fiscal rules (Bielawska, Chłoń-Domińczak, Stańko, 2016)