In the 1990s, the Croatian pension system underwent similar types of reforms to those of most other CEE states. The country reformed its first pillar and introduced mandatory and voluntary pillars. In the case of Croatia, these reforms took place in the midst of even more dramatic social and economic changes than elsewhere in the region.

Croatia and its pension system not only had to cope with the deep structural transformation that came with the transition from communism to capitalism in the early and mid-1990s, but also with the disastrous consequences of the war in the former Yugoslavia. Apart from human and material losses, the war also led to a dramatic increase in the number of pensioners and a drop in the size of the active workforce.

The PAYG system in place until 1998 was not able to deal with these shocks due to low retirement age, a weak link between contributions and benefits, and generous benefits. This is why major pension reforms were initiated in a gradual, step-by-step manner. The Croatian government implemented parametric reforms of the PAYG system in 1999 and introduced mandatory and voluntary pension funds in 2002.

Demographic development in Croatia is comparable to that in the rest of the region. The old-age dependency ratio is projected to rise from 25.6% today to 49.6% in 2050. This means that Croatia will be doing only slightly better than the forecasted EU-25 average of 52%. According to a study from the Institute of Economics in Zagreb, public pension expenditure will fall (in the baseline scenario) from currently 13.1% of GDP to 6.3% in 2050. The EU-25 average will increase from 10.6% of GDP to 12.8% over the same period.

Pension assets in Croatia currently add up to EUR 2.2 billion in the second and EUR 54 million in the third pillar. Until 2015, we expect to see annual growth of 19% for second pillar and 24% for third pillar pension assets.

The pre-1998 system was purely PAYG. It was organised in three different funds for workers, the self-employed and farmers; benefits differed for each group. What's more, certain groups, among them World War II veterans, former political prisoners, academics, police and military personnel, enjoyed a privileged status; their benefits were determined by a special law. In the late 1990s, almost 200,000 people belonged to these privileged groups. Retirement age was low at 60 for men and 55 for women. Early retirement was fairly easy and there were various supplements for years without contribution.

The 1999 reform was the first step towards introducing a three-pillar system. That year, Croatia reformed the public pillar and aimed at financial sustainability and cost containment. By 2009, retirement age will have gradually been increased, reaching 65 for men and 60 for women. The minimum early retirement age has also been raised, as have benefit deductions for early retirement.

The current contribution rate is 20% of gross salary, paid by employees alone. Minimum earnings for contributions are HRK 2,270 (EUR 309), maximum HRK 37,194 (5,066). For people who joined the mandatory pillar, 5% of contributions are directed into their individual accounts. For those who had to or chose to stay in the old system, the full contribution is used for first pillar pensions. Initially, 10% of contributions were to be re-directed into the mandatory pillar, but the amount was reduced to 5% due to fiscal problems.

"Pensioners' debt" represents a special burden that arises from the first pillar. In 1998, the Constitutional Court ruled that the state was liable for unpaid pension indexation entitlements for the period of 1993 to 1998. During that time, pensions were legally indexed to nominal wages, but governments capped indexation payments at lower levels. The Court decided that pensioners are entitled to nominal wage indexation through mid-1998. The state is liable for up to HRK 13.8 billion (EUR 1.9 billion or 5.75% of 2006 GDP). In 2005, a decision was made on how to repay this debt. Each entitled pensioner will be offered a choice between payments of half the amount in 2006-2007, or full repayment from 2008 to 2013. The debt is to be paid from privatisation receipts. The IMF estimates that approximately 70-75% of eligible pensioners would choose the first option. If this assumption proves to be accurate, repayment could amount to HRK 2-2.5 billion (EUR 273-342 million, or about one percentage point of GDP) in 2006 and 2007.

The mandatory second pillar system with individual accounts started operating in 2002 with defined contribution schemes. All people under 40 at the time of the reform had to participate. People between the ages of 40 and 50 could choose between staying in the old PAYG system and joining the new second tier, while people over 50 had to remain in the old system.

Savings in this pillar are created and administered by mandatory pension fund management companies that must be licensed joint stock or limited liability companies. Managing the pension fund is their exclusive business, and each pension fund management company may only set up one fund, the assets of which must be kept by a custodian. The fund itself is not an independent legal entity, but a vehicle to invest members' assets.

Just like in most other CEE countries, Croatia applies investment limits and a minimum rate of return to the mandatory pension funds. A special characteristic of Croatian regulation is that a minimum of 50% of assets has to be invested in Croatian government bonds. Maximum investment limits include the following:

- 30% for Croatian shares; for shares of domestic open investment funds; for Croatian municipal bonds, for Croatian corporate bonds    traded on organised exchanges in Croatia 15% for foreign securities issued in OECD countries and for bonds issued by OECD countries

- 10% for corporate bonds and shares issued in OECD countries

- 5% for shares of open domestic investment funds or foreign investment funds that are primarily invested in bonds issued by governments  of OECD countries, and for cash and bank deposits

Investing in real estate and derivatives, self-investment (investing in the pension fund management company) and investing in related companies of the pension fund management company is prohibited. Croatia has a limit for international investments: 15% of pension fund assets can be invested abroad.

Pension fund management companies must credit a minimum rate of return to the individual accounts. The reference rate of return is defined as a weighted arithmetic mean of all mandatory pension fund average rates of return in the previous three years, reduced by two percentage points. Each mandatory pension fund member is guaranteed the rate of return that equals one third of the reference rate of return, if the reference rate is positive. If the reference rate of return is negative, each pension fund member is guaranteed a rate of return that equals a triple reference rate of return for the last three years. To offset losses if the pension fund falls below the minimum rate of return, it must have a guarantee fund, which is funded with part of the "success" fee.

If the fund's actual rate of return falls below the minimum rate, the shortfall must be covered with assets from the guarantee fund. If these assets are insufficient, up to 20% of the pension fund management company's own capital must be used. If both sources are insufficient to compensate for the low rate of return, the state guarantees the remainder.

At retirement, the accumulated capital in a member's individual account must be used to buy a life annuity from an authorised pension insurance company of the member's choice. If married at the time of retirement, retirees must opt for joint survivor annuities (unless spouses have accumulated their own rights under a mandatory private pension scheme). Annuities must be indexed to prices.

The initial take-up rate of the mandatory scheme was very high. Between November 2001 and the end of 2002, nearly one million people joined the mandatory system. By the end of 2006, the system had 1.3 million participants and assets worth EUR 2.2 billion. The mandatory pillar now covers 83% of persons in employment.

Four mandatory pension funds are operating on the Croatian market, and all of them are linked to international financial institutions. In terms of members, the two biggest funds share 71% of all members between them.

Assets are allocated in a fairly conservative way, even considering the restrictive investment limits. 91% of assets are invested domestically. Of these, over 70% are invested in domestic government bonds, 7% in open-end investment funds, 5% in domestic shares and 3% in corporate bonds. Foreign shares amount only to 1.4% of assets. Croatian pension funds do not exploit the 15% limit on foreign assets; only 9% are invested outside Croatia.

Taxation of the mandatory pension scheme is of the EET type. Contributions and investment income are tax-exempt, whereas benefits are taxed. The tax allowance for pensioners is 1.7 times higher than for employees, meaning that pensions are only modestly taxed.

Voluntary pension funds were also introduced in 2002 and complete the three-pillar system. These schemes are DC plans based on voluntary pension savings. Voluntary pension schemes are either offered by voluntary pension funds, or can be set up by trade unions and employers, making open and closed funds possible. Voluntary pension funds need to have at least 2,000 members two years after being established.

Participants in voluntary schemes benefit greatly from tax incentives. The state provides an annual subsidy of up to HRK 1,250 (EUR 171) and allows a tax deduction of up to HRK 1,050 (EUR 151) per month. Employer contributions are not subject to tax breaks; they are treated like salary payments. Benefits are paid as annuities or as periodic payments. Contrary to the mandatory pillar, voluntary pension fund companies can offer more than one fund.

There are currently six open pension funds on the market, provided by four pension companies. Voluntary pension companies overlap strongly with the mandatory pillar; three of the four pension companies offering mandatory funds also provide voluntary funds. 65,300 members participate in voluntary pension funds, which have assets of EUR 54 million under management. The two biggest voluntary funds have a market share of 80%; the biggest fund alone has a share of 53%. Investment regulation of voluntary pension funds is very similar to that of mandatory funds, but slightly more liberal. For example, the limit for international investments is 20% rather than 15%.

In geographical terms, voluntary pension fund asset allocation is slightly more conservative than that of mandatory funds: 94.5% of assets are invested domestically. Investments in domestic bonds are lower (51% of assets) than in the mandatory pillar, corporate bonds and open-end funds account for 12%, deposits for 6%. Foreign assets (5.5%) are almost exclusively invested in open-end funds.

Closed voluntary funds are offered by three companies, which are also active in the mandatory and/or open voluntary pension fund market. There are currently 10 closed pension funds with 10,700 members and HRK 60.3 million (EUR 8.2 million) in net assets.

With its three-pillar pension system, Croatia has followed the CEE pension reform trend. Repaying pensioners' debt is an ongoing burden that will continue in years to come. Participation in the second pillar – some population groups were given the choice of joining – is remarkably high. The numbers for the third pillar are less impressive, but this might change with growing wealth. Regarding investment regulations, the requirement that at least half of the assets must be invested in Croatian government bonds could lead to suboptimal geographical diversification and a concentration of risks according to capital market theory.

In terms of market attractiveness, Croatia has the biggest pension market among the smaller CEE markets, and the fourth largest pension market in the region. It will therefore remain an attractive market with considerable growth potential.