Czech Republic
compiled by Allianz Global Investors
Pension System Design
The Czech Republic is, alongside Slovenia, the only Eastern European country that has not established a mandatory second pillar. It runs a two-pillar system with a public pay-as-you-go system in the first pillar and voluntary supplementary pensions, comparable to the third pillar in the other CEE countries. Currently, third pillar pension assets total EUR 5.3bn. We expect yearly growth rates of between 14 and 19% until 2015.
The Czech Republic very quickly reformed its pension system after the fall of the iron curtain. A few months after the collapse of the communist regime it started to reform its pay-as-you-go system. The basis of the current regime was established in 1989; a major reform took place in 1995, which was the beginning of an ongoing process of parametric reforms in the first pillar. Voluntary supplementary pensions were introduced in 1994 and cover 45% of the workforce.
The Czech Republic faces one of the most severe demographic challenges among OECD and EU-countries; its dependency ratio will rise to almost 55% by 2050. At the same time, its contribution rates to the public pension system belong to the highest in the OECD. To cope with the challenges for the pension system, the main political parties developed their proposals for a pension reform in 2005. These proposals differ substantially and cover the whole range of reform patterns found in other OECD countries, from parametric reforms to the introduction of notional accounts. However, due to political deadlock substantial changes are not expected in the short-run.
Public Pensions
The first pillar, i.e. the basic pension insurance, is a defined benefit pay-as-you go system covering the employees and the self-employed. The scheme is administered by the Czech Social Security Administration (CSSZ). The system in its current form was introduced by the Pension Insurance Act, which entered into force on January 1, 1996. Among other things, it is gradually extending the periods used to determine the pensionable earnings – from a five-year period in 1996 to 30 years in 2016.
There were further reforms in the following years. In 1997, the government cut eligible periods for non-contributory pensions and cut incentives for early retirement, which were further decreased in a 2001 reform. In 2002, indexation was changed towards a combination of inflation and one-third of wage increase of the previous year. In a 2003 reform the retirement age was gradually raised to 63 years for men and women without children, to be reached in 2016 and 2019 respectively. Currently the retirement age is 61 years and 8 months for men; for women it oscillates between 56 years and 4 months and 60 years and four months, depending on the number of children raised.
The contribution rate for the public pension system is 28%, which was increased from 26% in 2004. This increase was offset by a decrease in the contributions to funds dedicated to active labour market policy. Employers pay 21.5% of payroll, employees 6.5% of earnings. The self-employed pay the whole 28% of their earnings. There is no contribution assessment limit; therefore, contributions are calculated from the full wage. Among the OECD countries, only Hungary, Italy and Slovakia have higher pension contributions. The public scheme has two components: a flat-rate basic pension and an earnings-related part. The flat-rate part provides all entitled citizens with a basic pension. The earnings-related component has a strong redistributive character. The base on which pensions are assessed is 100% up to CZK 8,400 per month, 30% between CZK 8,400 and CZK 20,500, and 10% above this sum.
Furthermore, the net replacement rate is high since pensions are not taxed up to a sum that is four times higher than the normal tax-free allowance of workers. In 2005, the minimum of old-age pension was CZK 2,170 (EUR 75) a month, around 12% of average earnings in the Czech Republic, which is composed of CZK 1,400 from the basic component and CZK 770 from the minimum earnings-related component. More than 99% of Czech pensioners receive more than the minimum pension.
This generous and strongly redistributive system has managed to keep old-age poverty at a very low level; the relative risk-of-poverty-rate of people aged 65 or more is 22% of the EU-25 average. The focus of the system is on adequacy of old-age income. Nevertheless, the coming fiscal pressures from the demographic development led to the development of pension reform proposals from all major parties. The main points of the proposals included the introduction of a system of notional accounts, the introduction of a defined contribution system similar to the other CEE countries, parametric reform of the existing system, flat-rate pensions, and an “add-on” defined contribution system. All parties suggested a further rise of the retirement age, although at very different rates. The proposals have been under examination since 2005, but the political deadlock after the general elections in mid-2006 resulted in a cumbersome formation of government. It took more than 7 months to build a coalition; thus, fundamental pension reforms are not expected in the short term. Currently, the new government proposes a further increase in retirement age; other disputatious issues are excluded from the bill.
Public pension expenditure as a share of GDP in the Czech Republic was lower than the EU-25 average in 2004 – 8.5% versus 10.6% – however, it is projected that it will reach 14.0% in 2050 versus 12.8% for the EU-25.
3rd Pillar – Voluntary Private Pensions
Following the World Bank’s model for a multi-pillar pension system 2nd pillar pension provision should be mandatory, non-redistributory and fully funded, with decentralized control over the accumulated pension and savings reserves. Due to political resistance for mandatory complementary pension provision in addition to the basic pension insurance the Czech Republic decided to run a voluntary pension system classified as 3rd pillar pensions.
The third pillar in the Czech Republic, introduced in 1994, had a slow start. In order to push voluntary pension savings, the government enhanced tax incentives and state subsidies in 1999. The voluntary supplementary pension scheme is run by pension companies, which offer exclusively defined contribution plans. The pension companies are joint stock companies, incorporated in the Czech Republic under the provisions of the Commercial Code. The purpose of pension companies is limited to the provision of supplementary pension insurance. Pension companies must be licensed by the Ministry of Finance, in agreement with the Ministry of Labour and Social Affairs and the Securities Commission. Since January 2003, members have been allowed to choose between the state asset manager and private administrators.
Pension companies are not authorized to offer more than one pension plan. In contrast to most other countries with defined contribution schemes with individual accounts the Czech Republic does not require to segregate pension company shareholders assets from pension holder contributions from either a financial or legal perspective. In the Czech Republic there is a single legal entity combining member contributions and pension companies’ assets.
The minimum monthly contribution to a pension fund is CZK 100. If participants have joined the system, they can switch pension funds as often as they like; there are no switching fees either. The fund has to publish its financial performance, asset allocation, contributions and its balance on a regular basis.
The minimum age at which payments can be received from a pension fund is 60, provided a minimum number of contributory years, which is regulated by each pension fund. If money is withdrawn from the account before this age, the state matching contributions have to be repaid and there is additional taxation. Generally, money can be withdrawn as a lump sum or in the form of regular instalments.
The state matches employees’ contributions depending on their level of contributions. For member contributions between CZK 100-199, the state adds CZK 50 plus 40% of the member contribution above CZK 100. If the pension plan member contributes between 200 and 299, the allowance is CZK 90 plus 30% of the sum above CZK 200. The allowance gradually increases with the highest allowance (CZK 150) for members contributing more than CZK 500.
Tax treatment of contributions and benefits
Tax breaks were introduced in 2000 in order to encourage retirement savings. Employers can deduct their contributions from their tax base up to 3 per cent of an employee’s assessment base. Employer contributions of up to 5 per cent of wages are exempt from income tax for the employee. This contribution is not considered part of the member’s income, both for income tax purposes and the calculation of social security contributions. Other recent measures relieve both employees and employers from paying social security and general health insurance contributions as well as from a state employment policy contribution.
Participants’ contributions are paid from net wages. If a participant contributes more than CZK 6,000 a year, he can deduct the contributions paid in excess of CZK 6,000 from his tax base up to a limit of CZK 12,000 a year. Pensions are taxed at a rate of 15%.
Investment regulation
Investment regulation in the Czech Republic has two main facets: regulation of portfolio allocation and the requirement for positive returns every year.
There are quantitative restrictions on investments in real estate, bank deposits and securities from single issuer of 10% each. Investment in loans is not permitted. There is no limit on investment in bonds and the 25% limit on equity investments was completely lifted in 2004. Other regulations include a maximum limit of 10% for investment in a single property or one movable asset.
Regarding international investments, Czech regulations do not foresee legal restrictions. However, foreign investment is permitted only for securities traded in the OECD markets. There is no limit placed on investment in Euro-denominated products, as long as the fund complies with the general restrictions defined in the law. Nevertheless, at least 70% of total assets must be invested in assets denominated in the currency in which the liabilities to participants are stated. Furthermore, a maximum of 70% of assets can be invested in bonds from a single OECD state, from a single OECD central bank, or from international organisations, such as the European Investment Bank, of which the Czech Republic is a member.
Besides the quantitative restrictions, Czech regulations foresee that pension funds have to generate a positive return every year. If they miss this target, the losses must be covered by the Reserve Fund – formed with 5% of the pension company’s profit. Hence, members are sheltered from losses, at least as long as the pension fund does not become insolvent. The downside of this regulation is that asset allocation is necessarily very conservative with low returns; for example between 2001 and 2005 the average investment return of pension funds was 3.7%. Long-term strategies that take short-term losses in the interest of a better long-term performance are very hard to implement under this regulation.
Outlook
The take-up of the voluntary system exceeded original expectations. Almost one in three Czech citizens – 45% of the workforce – currently has a private pension plan, 3.3 million in total. Assets under management amounted to EUR 5.3bn at the end of 2006.
The Czech Republic – as one of the largest and richest CEE countries – remains an attractive market for asset managers. However, without the introduction of a mandatory system the growth rates in assets will not keep pace with the ones of other CEE countries.
Plans to establish a mandatory second pillar already exist, but implementation is not expected for the near future. So far, the only thing, which has been communicated, is that this scheme will be mandatory, privately funded and privately management. However, the details of the second pillar design remain unclear.
As a first stage the government intends to increase the retirement age to 65 by 2030 and increase the number of necessary contributory years in order to qualify for a full pension from 25 to 30 years.
Reforms steps are much needed to improve the sustainability of public finances. Unfortunately, realisation strongly depends on pluralities in the parliament. The pace of implementation remains to be seen.