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Pension System Design
Slovakia introduced a major pension reform in 2005. The key element was the introduction of a mandatory second pillar due to the low effectiveness of the voluntary private pensions established in 1997. Additional steps included an increase of the statutory retirement age and the establishment of a stronger link between contributions and benefit payments. These reform steps were undertaken mainly because of the deficits of the public pay-as-you-go system. Today, the Slovak system consists of a reformed pay-as-you-go pillar, mandatory individual accounts and a voluntary supplementary pension saving scheme.
The demographic development in Slovakia is similar to the development in the other Eastern European countries: its dependency ratio will worsen from 16.3% today to 50.6% in 2050, which is below the 52% ratio of the EU-27 in 2050 and better than several other CEE countries.
The second pillar in Slovakia was only introduced very recently; nevertheless pension assets had grown to EUR 710 million in 2006. Assets under management in third pillar plans total EUR 635 million. Growth rates for second pillar assets will reach more than 30% per annum, for third pillar assets between 16 and 22% per annum.
The system in place before the reform in 2005, which had been passed in 2003, suffered from serious financial difficulties. These resulted from a high unemployment rate and a low motivation of employees to contribute to the system. There was a low linkage between contributions and benefits, a low retirement age and increasing migration of the labour force. The state system had been in deficit since 1997, causing a steady decline in real pensions. In 2003, the average pension amounted to around 45% of the average wage, compared to 54% in 1991. Consequently, there was widespread dissatisfaction with the standard of living of pensioners.
The main aims of the pension reforms were the restoration of long-term sustainability of public pensions, the strengthening of the merit principle and the promotion of private pension savings.
The reform established a gradual increase of the retirement age to 62 for both sexes, effective as of 2007 for men and 2015 for women. Incentives for early retirement were reversed to the same extent as bonuses for delaying retirement were widened. The merit principle was strengthened by a direct link between contributions and pension benefit; length of service and pension benefits became important parameters for calculating pensions.
The introduction of the mandatory pillar had of course repercussions on the public pension system.The substantial reform measures will help softening financial pressure in the long-term. However, in the short-term the relatively radical transformation of the system will cause considerable transformation costs. The first pillar system has to cope with considerably reduced contributions, so that additional transfers from the state budget and/or the reserve fund seem likely. The Slovak government intends to use additional revenues from privatisation to cover the coming deficit. Total transition costs are estimated, according to the EU Commission, to amount to SKK 50-70 billion (15-20% of current GDP).
In the face of the transformation costs the government rolled back and enacted legislation in November 2007 that uses second pillar assets to finance the upcoming deficit in the public pillar by enabling members to opt out and transfer accumulated capital from the second pillar.
Participants in the mandatory pillar can redirect part of their payroll tax to their individual accounts. This share is high in Slovakia and amounts to 9% of gross wages. The overall contribution rate is 28.75% of gross wages whereof employers pay 21.75% and employees 7%. The contribution rate is divided between the public pension program (19.75%) and the new mandatory pillar (9%). The former also includes disability insurance and a reserve fund to cover transition costs and possible deficits in the first and second pillar.
Employees aged 51 and younger were automatically enrolled in the new system; those aged 52 and older could decide to join the new mandatory tier or to stay in the old system. This decision had to be taken until the end of June 2006. Those who decided to join the new system cannot return to the old system, but they keep the benefits acquired under the old system.
Public pensions expenditure is projected to increase from 7.2% of GDP to 11.2% in 2050, the corresponding values of the EU average are 10.6% and 12.8%. The exact figure will depend on the number of people joining the mandatory pillar.
Second Pillar – The Occupational Pension System
The mandatory system is of the defined contribution type with 9% of gross wages directed into the individual accounts of the members. The funds are managed by single-purpose pension asset management companies (PAMCs). The PAMCs are private sector, joint stock companies with a minimum capital requirement of about SKK 300 million (EUR 7.1 million). Their exclusive business is the creation and administration of pension funds. As a further condition, they have to attain at least 50,000 members within a period of 18 months from the establishment of the pension fund.
A specialty of the Slovak mandatory pillar is the requirement that each pension fund that has to be managed by a different fund manager and cannot be outsourced to external asset managers has to offer three different funds with different risk / return profiles, ranging from low to high:
- A conservative fund with no equity exposure and a 100% allocation into bonds and money market instruments;- A balanced fund with an equity share of up to 50% and a bond / money market instrument share of at least 50;- A growth fund with an equity share of up to 80%.
In general, pension fund members are free to choose one of the mentioned options provided that they have more than 15 years until they reach retirement. Participants who are close to retirement have limited access to riskier funds, i.e. those who have only 15 years before reaching retirement are exempt from investing into growth funds and those with just 7 years until retirement have to completely shift the account balance to the conservative fund. Individuals can only be members of one fund at the same time.
PAMCs are subject to a variety of regulations. The Pension Funds Act defines the range of permissible investment instruments and sets maximum limits for portfolio allocation. Investment procedures and valuation of investments (daily at market prices) are also regulated. Since Slovak pension funds have to offer three types of portfolios, there are no overall maximum holdings as in many other CEE countries.
However, a very important regulation is that pension funds have to invest at least 30% of their assets into instruments of Slovak issuers. Initially a 50% limit was approved, but it was reduced in 2004. The regulation aims at preventing capital outflows and supporting the Slovak capital market. However, it also hinders diversification and might result in suboptimal returns. Other dangers include liquidity excesses and artificial rise in domestic assets and the emergence of a 'bubble', which would then threaten future retirees. This investment limit takes effect 12 months after the creation of the pension fund.
An equally important point is that PAMCs have to guarantee a minimum return for each of the three funds. The regulation does not require specific performance goals or the value of paid-in capital, but a relative performance guarantee. 24 months after the pension management company started operating the pension fund, the funds minimum return must be equal to the lower of the two respective values:
- Conservative: 90 % of the average yield during the past 24 months or the average yield minus 1 % point;- Balanced: 70 % of the average yield during the past 24 months or the average yield minus 3 % points;- Growth: 50 % of the average yield during the past 24 months or the average yield minus 5 % points.
In terms of disclosure, each member must be given the statutes and information prospectus of the fund when joining it. The law lays down minimum requirements on the contents of the statutes and information prospectuses. The statutes must inter alia contain the investment strategy and the eventual sectoral or geographical allocation of investments. The information prospectus must address the fund's risk profile, the investment possibilities offered, and the risks associated with those possibilities. Members are free to switch between different PAMCs up to twice a year.
The mandatory pension market is fairly concentrated. Until 2006 there were eight pension companies on the market, all linked to international financial services firms. However, due to intense competition in the market the number was reduced to six. A key factor in the consolidation was the regulation that every fund must have at least 50,000 members; otherwise, pension funds would lose their license and their members would be transferred to other providers. The PAMC with the largest market share had – in 2005 – roughly 30% of total members. The three largest PAMCs have a combined membership of 75% of all members.
Before the start of the mandatory pillar, it was expected that around 50% of employees would decide to join the new system, and indeed currently there are approximately 1.5 million workers which account for around half of the working-age population that had already joined. But unfortunately, a new law passed in November 2007 gives pension fund member until June 2008 the opportunity to opt out of the second pillar and transfer the accumulated capital back to the first pillar to strengthen the public pensions. Furthermore, the government considers changing the splitting rate between the first and the second pillar to the disadvantage of the second.
The growth fund with its high equity share is the most popular product. 65.5% of the members enrolled in late 2005 had opted for it, almost 30% chose the balanced fund and only 4.6% joined the conservative fund. This bias towards the fund with the highest return potential and the highest risk was supported by the strong growth of the Slovak stock exchange and the age structure of participants.
Despite the dominance of the growth fund, pension funds do not exploit the limits they have in their respective asset allocation at all. On average, growth funds show an equity allocation of 7% and balanced funds of 5%, which stands for a quite conservative investment behavior.
As the take up and the acceptance of the new mandatory pillar has exceeded expectations – 50% of employees participated after the first year –, its prospects for further growth are fairly rosy. One important factor is the high fixed contribution level, coupled with high wage growth.
In 2005 assets stood at EUR 239 million, and by August 2006 assets had already grown to EUR 510 million, i.e. an increase of more than 100% after only seven months. This rapid growth reflects the brief time span people were given to decide to join the system and a market in its infancy.
More recent reforms have tended to feature a backlash to previous reforms. This implies that the further success of second pillar pensions will hinge critically on the reliability of the political framework to ensure reforms are not turned back.
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