Hungary
compiled by Allianz Global Investors
Pension System Design
Hungary is the pioneer in reforming its pension system in Eastern Europe. It was the first country to introduce a mandatory second pillar with individual accounts in 1998; it restructured its first pillar pay-as-you-go system substantially; and it introduced voluntary individual schemes in 1994. In doing so it followed the World Bank model of pension reform very closely and set a standard for the reforms in the other CEE countries. More recently, in 2006, it introduced a fourth pillar, which consists of voluntary individual retirement accounts, and aims at broadening investment opportunities and encouraging greater retirement savings.
The reforms were necessary not only because of the demographic developments, but also because of financial pressures on the generous pre-reform, pure pay-as-you-go system in the early and mid-1990s. The financial pressures stemmed from generous benefits and permissive eligibility rules as well as from high unemployment, early retirement policies and evasion due to one of the world’s highest contribution rates.
Due to the early introduction of mandatory pension schemes and the strong acceptance among the population Hungary is the second biggest pension market in the region with EUR 5.9 billion assets under management in the mandatory and with EUR 2.7 billion in the voluntary pillar. Mandatory pension assets will grow with 20% p.a. until 2015, the growth of voluntary pension assets will be between 15 and 18%.
Public Pensions
The public pension system is a pay-as-you-go-financed, defined benefit scheme, covering all employees as well as the self-employed. Before the reforms in the 1990s, Hungarian pensions were calculated as a percentage of a reference wage, which benefited low-wage earners and had a strong redistributive impact. Reforms in 1995 increased the retirement age from 60 for men and 55 for women to 62 for both sexes (for men by 2002, for women by 2009). From 2013 onwards the link between contributions and benefits will be made stronger by introducing linear accrual rates in the pension formula, which is supposed to enhance transparency and give incentives to work longer. When mandatory schemes were introduced in 1998, they were made compulsory for new labour market entrants under the age of 42. Existing employees were given the option to voluntarily join the mandatory tier. About 50% of labour force exercised this option; those who did not opt for participation remained enrolled only in the first pillar.
Benefits from the first pillar are based on the employee’s average net income earned after January 1, 1998. The income in the years prior to the third year before retirement is indexed according to the annual increase in average national net wages. Indexed average monthly earnings are then counted up to a ceiling to establish a pension base. A pension formula, scaled by years of employment from 10-40, is then applied to the pension base. The formula is regressive, allocating more pension benefits to the lower parts of the pension base; resulting pensions amount to around 60% of covered earnings.
The overall contribution rate to the pension system currently stands at 26.5%. Employers pay 18%, which go completely into the Pension Insurance Fund for the first pillar. Employees contribute 8.5%. For those employees participating in the mandatory second pillar, the contribution is divided and 7% go to the individual retirement accounts and 1.5% are allocated to the public pension system. For those employees who have chosen to remain within the pay-as-you-go system, the total contribution rate is 19.5% of the employee’s taxable income – 18% are paid by the employer and 1.5% by the employee.
The reforms, especially the move towards funded pensions, gradually decreased total contribution rates, from 31% of gross wages to 26.5%. Employer contributions dropped from 24% to 18%, whereas employees’ contributions rose from 6% to 8.5%. In order to qualify for a minimum pension from the first pillar, beneficiaries must have a contribution history of at least 20 years; a partial pension without a minimum is paid after 15 contribution years. The minimum pension amounted to 40% of the average old-age pension in 2004.
The reforms also softened the pressure on public finances. Public pension expenditure amounted to 10.4% of GDP in 2004, which is slightly below the EU-25 average of 10.6%. However, Hungary is expected to experience one of the steepest increases in public pension expenditure among EU-countries – projections foresee 20.3% of GDP in 2050 – mainly due to the impact of an increasing wage level on the level of new pensions.
Second Pillar – Mandatory Individual Accounts
The mandatory second tier is a defined contribution system with individual retirement accounts. All covered persons – those who have opted to join the system and new labour market entrants below the age of 42 – are obliged to participate in the mandatory private pension scheme through joining a mandatory pension fund.
Mandatory pension funds are independent legal entities owned by their members. They take the legal form of mutual foundations and may be founded by employers, chambers of trade, professional associations, employees' interest organisations or regional self-governments. A pension fund must have at least 25,000 members if it pays annuities itself and at least 2,000 members if annuities are bought from an insurance company. Membership may be open or closed. An MPF must be licensed and must have a prescribed minimum of members in order to remain in operation. Contributions are collected and managed by fund managing companies, called private pension funds. Pension funds may manage the investment of fund assets internally or may outsource it partially or entirely to an investment company, financial institution or investment fund company duly licensed by the HFSA.
Regarding the governance of pension funds, the main decision-making body of Hungarian pension funds is the general assembly of members, where all members – irrespective of the money accumulated in their account – enjoy the same voting rights. The general assembly elects a board of directors responsible for managing the fund for 5 years. The board of directors is obliged to appoint an investment adviser, an actuary, an auditor, a lawyer and a custodian. Other duties include reporting to the Financial Services Authority, disclosing information to members and setting-up internal asset management regulation and asset valuation. The general assembly of members also appoints a supervisory committee, in which the members’ representatives must form the majority, and which controls the accounting, the financing and the operations of the pension fund.
Benefits and withdrawal method
Benefits are paid out when the beneficiary reaches the legal retirement age, which is currently 62 for men and 59 for women. The withdrawal of funds before reaching retirement is not possible. Pension fund members who have contributed for less than 15 years have the option to have their assets paid as a lump sum. If the contribution period is longer than 15 years, members must buy a life annuity. There are four annuity options available:
- Individual life annuity;
- Joint life annuity for a fixed period with a set beginning;
- Joint life annuity for a fixed period with a set end;
- Joint survivorship annuity.
Annuities can be bought from an insurance company or be provided by the pension fund. If the pension fund provides the annuities itself, its membership figure must be higher than otherwise.
In the case of the death of an active fund member, the eligible survivor may choose between receiving the accumulated capital in the individual account as a lump sum or having it transferred to the publicly managed social security scheme in order to improve the survivor benefits received under this scheme. In the latter case, the eligible survivor receives a full survivor pension under the publicly managed social security scheme whereas otherwise only 75% of the full survivor pension is payable. The benefit improvement under the publicly managed scheme does not depend on the amount transferred. In the case of a retiree, the annuity contract (depending on the type) may stipulate that designated survivors continue to receive an annuity after the death of the policyholder.
Investment regulation
Hungary’s investment regulations have two main facets: the guarantee of a minimum rate of return and maximum limits for asset holdings. The Hungarian Financial Supervisory Authority determines an expected return band each year. In practice, the minimum rate of return has been 85% of the official return index of long-term government bonds. If the actual return exceeds 140% of the long-term government bond return, the excess amount must be credited to a risk-adjusted reserve (which is also continuously credited through monthly contributions). If the fund does not reach the lower limit of the band, it must use the risk-adjusted reserve to credit the amounts necessary to reach the minimum rate within the band to the individual accounts.
Portfolio regulations established 5% limits for hedge funds and private equity funds; 10% limits for unquoted equities, real estate, Hungarian corporate bonds, Hungarian and foreign municipalities bonds; a 25% limit for mortgage bonds; and a 50% limit for investment funds. Pension funds are not allowed to hold loans in their portfolio. There are no portfolio limits for quoted equities, government bonds and bank deposits.
Foreign investment is allowed up to 30% of assets, investment in non-OECD countries shall not exceed 20%. Regulation concerning equities has been loosened. Whereas until 2004 there was a 50% limit on equities, from 2005 onwards this limit has been abolished. Furthermore, the possibility to invest in fund of hedge funds was introduced in 2005 and the option to invest in private equity in 2006. Further investment regulations rule that a maximum of 10% may be invested in securities from a single issuer (except for state bonds) and no more than 20% of the overall value can be allocated to securities and deposits issued by an organisation belonging to the same banking group. Pension funds are not allowed either to have ownership in businesses in which the founders of the fund, the employers of the fund members or service providers of the fund own more than 10% of the shares.
Tax treatment of contribution and benefits
Taxation of second pillar pensions does not follow the common concepts of EET or TEE in their pure form. 25% of contributions are tax-deductible; investment income is not taxed, whereas only 50% of benefits are tax-exempt.
Third Pillar – Voluntary Pension Savings
In addition to the mandatory system, Hungarians have several options to save for retirement. They – or their employers – can voluntarily contribute to the mandatory pension funds up to a certain limit; they can contribute to a Voluntary Pension Fund (VPF) or they can join the so-called fourth pillar, launched in 2006.
Voluntary pension funds were introduced in 1994. After a slow start at the beginning, they counted 1.3 million members in 2006, roughly half as many as in the mandatory system. VPFs provide individual defined contribution accounts and are managed by the employer’s insurance companies or financial institutions. Employer-owned pension funds must appoint a trustee to manage their assets. Both the employer and the employee can contribute to the fund. Benefits can be received as a lump sum at any age after 10 years of membership or as an annuity depending on the member’s choice.
Savings in VPFs are tax-favoured. 30% of contributions are tax-deductible for employees up to a limit of HUF 100,000 per year. Employer contributions are tax-exempt up to 100% of the minimum wage. Investment income is tax-exempt, whereas benefits are only tax-exempt under certain conditions.
Investment regulation
Investment regulations of VPFs are identical to those of the mandatory funds with two exceptions: firstly, there is a maximum limit of 20% of bank deposits, whereas there is no limit for mandatory funds; secondly, VPFs can invest up to 5% of their assets in loans, whereas mandatory funds are not allowed to hold any loans.
Outlook
Hungary is one of the key pension markets in Eastern Europe. Its early moves towards structural pension reform have resulted in relatively mature pension markets, whose growth is fuelled by the mandatory nature of the second pillar and a widespread acceptance of voluntary pension savings in the third pillar. In 2007, there were 2.5 million subscribers to second pillar pension funds – i.e. 25% of the population and two-thirds of the workforce. Assets under management amount to EUR 5.9 billion in the mandatory and to EUR 2.7 billion in the voluntary pillar, making Hungary the second largest pension market in Eastern Europe behind Poland. Asset managers and pension fund members can profit from recent moves of loosening investment regulation. The lifting of caps on equities, the possibility to invest in private equity and hedge funds broadens the array of instruments and supports investment performance and risk diversification. The obligation to introduce funds with different risk profiles in the second and third pillar follows the recommendations of modern finance theory and combines security of retirement savings with the upside potential of financial markets.