Bad Prospects of Private Pensions

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Funded pension schemes in CEE countries, sometimes called II. pillars, experienced significant changes in last few years. It was almost eliminated in Hungary, heavily cut in Poland, torpedoed in Bulgaria and the Czech Parliament is just voting on its closure. Other countries, not listed in previous sentence, mostly decreased the portion of contributions. II. pillar is not doing well also in Slovakia.

The pension reform was introduced ten years ago, yet the anniversary was not celebrated. This is the first year of payout phase. First pensioners met the condition of being enrolled in the funded scheme for 10 years and now they are allowed to claim their savings. Well, actually, they are not allowed to ask for their savings, they can only ask for a contract with the life insurance company. At the very last moment last summer, Slovak parliament adopted changes in the law that specify the conditions of the payout phase. It cannot be surprising that there is not much freedom of choice. Basically everyone must buy an annuity and free access to residual savings is allowed only to those savers, whose sum of PAYG pension and annuity payment is larger than if this person had only been in PAYG scheme. This may not sound too restrictive, but we should note, that calculation of PAYG pension is disadvantageous for savers in II. pillar.

PAYG fund is in huge deficit and official contributions cover only about a half of the costs. Social insurance agency transfers unused sources from other funds (sickness fund, accidents/injury fund, reserve fund) to cover the pensions expenditures, but these contributions are not included in calculation of PAYG pension of saver – decreasing it by almost 10 %. It is clear that this condition significantly restricts any access to savings. 90 % of savers will have no other option to withdraw their savings than to sell them to life insurance companies. It is estimated, that less than 10% of savers will be able to collect a part of their savings as one-off payment.

This policy of restricted access was based on two assumptions. First, savers are irresponsible and would waste their money perhaps on hazard the day after withdrawal. Second, II. pillar is a part of public pension scheme which was meant to secure regular monthly payments during the whole retirement.

These arguments are clearly paternalistic. They say the state is here to decide what a proper way of allocation of savings is. But the existence of savings in funded scheme had one great advantage. The saver could use it to cover costly expenditures. This is not possible in PAYG system, where naturally only monthly payments are allowed. Imagine a saver, who needs extensive surgery (e.g. substitution of hip joint). Usually, higher quality materials and better service require out of pocket payment. Pensioner with full access to his savings could use it to finance these kinds of one-off expenditures. With limited access, he only could borrow money (if he can get a loan) and repay it from monthly annuity payment together with interest. There are many other examples (full repayment of mortgage, financing grandsons studies etc.), where access to savings represents important advantage. 2. pillar in Slovakia was ripped of it. The government did not listen to arguments that annuity pension will not represent more than 10% of pension income and therefore even wasting the savings would not produce beggars. It just does not like the freedom of choice. Another reason for preference of limited access may be attributed to active role of life insurance companies during the preparation of these rules.

Reality check

Launch of the payout phase on January 1, 2015 was a kind of cold douche surprise for the government. First, only 3 insurance companies asked for the license to participate at the market of annuities (all 3 were approved). Second, the annuity rates offered were lower than expected (less than 5 %). So low, that at generally accepted 17 years life expectancy it would be more profitable to move savings to fixed-term deposit in a bank with zero interest rate than sign a contract with life insurance company. The proponents of the limited access to savings caught savers into a trap. Take it or leave it. Fortunately, also thanks to INESS, which also commented on the law in Parliament, there is a sort of exit option for savers, who don’t like the offered annuities but need some money from their savings. They can keep their savings account and withdraw at least annual yield. But why are the annuities so low?

There are regulatory and market reasons for it. The government decided, that life insurance companies must provide some heritability of savings also during the payout phase. A feature that is contradicting the nature of lifelong annuity payment. So, first 84 monthly payments are heritable which is not for free and decreases the monthly payment by 2-3 %. According to new law, insurance companies have to offer several kinds of annuities, also including optional widows/widowers pensions, or indexed pensions. Imposed variety of pensions increases administrative costs. But market conditions played more important role. First, this model has been operating for only 10 years, therefore average savings reached only EUR 3,000 – 5,000. The regulation has been changed plenty times, and this uncertainty limited potential yield of pension funds. During the period of 10 years of the funded pension scheme existence the savers “experienced” financial crisis and the great economic recession. No surprise that accounts were not flourishing. Furthermore only several thousands of savers will ask for pension (out of a million savers) this year. From insurance companies’ point of view – that is a small hardly predictable market. Insurance companies are cautious, expecting educated healthy savers with longer life expectancy. At the same time, interest rates of low risk bonds are close to zero – it is much harder to profit on reserves now. The effect of zero interest rate is pushing annuities down all around the world and it was one of the reasons why UK government will allow savers to withdraw full amount of savings. The last factor influencing annuity rates was the mere fact that savers have no other choice than to buy annuity at the market with limited competition. But quite surprisingly, offered annuities did not converge and the variability was quite high (4.2 – 4.9 annuity rate).

At the end of the day a representative of Ministry of Finance publicly recommended savers to wait with their annuity purchase. It was the very same person that actively promoted no access to savings and creation of annuity market. Government was trying to negotiate with insurance companies to get more competitive bids, though unsuccessfully.

Let’s find the culprit

This situation appeared like a gift from skies for a government struggling with deficit of 3 % of GDP. Savers have not saved enough money. Life insurance companies are not offering competitive annuities. Therefore the private pension scheme has been labeled as a total fiasco by the Prime minister. Based on experience from neighboring countries, we could have expected at least confiscation of savings. From this point of view, the planned simple opening of II. pillar (one must sign a letter to leave) must be considered as a huge victory of private pensions. For the fourth time already, all savers will be allowed to transfer their savings to PAYG system in an exchange for PAYG pension. From Slovak perspective, this is very soft tool. Two years ago, when government decided that too many savers have their money in riskier equity funds, it sent a letter to all savers asking for confirmation to stay with equities. Less than 10 % responded, majority did not pay attention and allowed government to move their savings to guaranteed bond funds with limited yield. If this approach was used in current opening, the outflow of savings would be massive. Current estimates based on previous openings calculate with 10 % drop in number of savers and 5-10 % drop in the amount of savings. The chance to return to safe heaven of PAYG will last for 3 months, and it will be definitely an interesting option especially for those who reached retirement age and now face non-attractive bids from insurance companies. The size of outflow will depend on quality and form of communication of the government.

Lessons learned

Ten years is way too short time to get the idea of private pension savings under the skin of Slovaks. Despite relatively massive coverage, where more than half of the working age population is enrolled, the self-identification with the savings is still relatively small. People do not trust the scheme and see the saving scheme as a bet. They are ready to accept a loss, and sole existence of savings (without yield) would mean victory. The level of trust is low and so is the public demand regarding improvements, or changes in II. pillar. This is a fertile ground for populist paternalistic politicians, who don’t like people taking care of themselves and who see the funded scheme as a theft, an unjust transfer of public money to private accounts. It is highly probable, that the 4th opening is not the last, and that future governments will try to reduce the size of this scheme so that only high income earners will be enrolled. Where future costs of aging are too far (several election periods), current political costs of financing the private scheme exceed benefits of future savings. One of the greatest obstacles for better positioning of II. pillar is a lack of interest of general public. Generous payout phase with unlimited access to savings could improve the perception of II. pillar. Unfortunately, the government eliminated this opportunity.

Radovan Durana