Estonia's economic performance has been impressive in recent years. In 2005 and 2006, GDP grew by more than 10%. In the EU-27, only Latvia has had a comparable economic growth rate. Until the country's independence in 1990, the Estonian pension system was part of the Soviet system. The most important pension reforms were initiated in the late 1990s and have since proceeded gradually. In 1998, voluntary supplementary pensions were introduced; the first pillar was modernised in 1999/2000 and the mandatory pension pillar was launched in 2002.

Demographic developments are less dramatic in Estonia than in other CEE countries and the EU as a whole. Although the dependency ratio will worsen from 24.1% to 43.1% in 2050, the figure is nine percentage points lower than the EU average forecast for the same year. Public pension expenditure is expected to decrease from 6.7% of GDP to 4.2% in 2050. The current EU-25 average is 10.6% and will increase to 12.8%.

In 2006, Estonian pension assets in the second pillar amounted to EUR 475 million. According to our estimates, they will grow by at least 25% p.a. until 2015. Third pillar assets stand at EUR 49 million, and are expected to grow by 13% per year until 2015.

The first pillar is a PAYG defined benefit scheme with universal coverage. It is composed of two different schemes: a flat rate national pension, which is meant to guarantee a minimum pension, and an earnings-related full pension scheme. The flat rate national pension amounted to EEK 1,269 (EUR 81) per month in 2005. Adjusted annually by Parliament, the flat rate is payable to everyone regardless of the number of contribution years. In contrast, the full pension is linked to the employee's length of service before 1999 and contributions paid after 1999. To qualify for a full pension, an employee must have worked in Estonia for a minimum of 15 years. The full pension is indexed annually, based on consumer price increases and social contribution revenues.

The first pillar is financed by social contributions of 20% of gross salaries, paid solely by employers. In addition to this, employers must pay 13% contributions for health insurance. The retirement age is 63 for men and 59.5 for women, though it will be raised to 63 for both by 2016. Early retirement is possible three years prior to legal retirement age, but is discouraged by a 0.4% pension reduction for every month taken. Deferred retirement, on the other hand, is encouraged with a 0.9% increase for every month worked beyond the legal retirement age.

The pension plans in the second pillar are DC schemes. Participation is mandatory for employees born in 1983 or later; workers born between 1942 and 1982 can choose whether to remain in the state-run social security system or join the mandatory pillar. Once the decision to join has been made, it is irreversible. Workers older than 60 cannot join the system.

Individual accounts are managed by specialised pension fund managing companies. These companies are private institutions with the exclusive aim of administering their members' accounts, managing pension funds as well as granting and administering benefits. The pension funds themselves have no legal personality; their assets must be held independently from the resources of the managing company. 

When Estonia implemented its second pillar mandatory accounts in 2002, it took a different approach than other CEE countries. Most other CEE countries used a carve-out method through which contributions were split between the first and second pillars. Estonia also used this method, but introduced employee contributions on top, making it the only country with higher contribution rates after pension reform. Participants in the second pillar now contribute 2% of their gross salary, whereas employers contribute 4% (out of their 20% pension contributions).

Pension fund managing companies can offer more than one fund, provided that investment policies differ significantly and that one of these funds is invested in fixed-income products only. Three types of funds with different risk/return characteristics are on offer and admissible:

- Conservative funds with no equity exposure and a 100% share of bond and money market instrument

- Balanced funds with up to 25% of equities and at least 50% bonds and money market instrument

- Progressive funds with an equities limit of up to 50% and no limit on bond and money market instruments

Members are free to choose the pension fund that best suits them regardless of their age, but can only be members of one fund at a time.

Besides investment regulations for the respective funds, there are investment limits on certain instruments. The main maximum investment limits are as follows:

- 40% in real estate or real estate funds

- 35% for securities issued and guaranteed by the Estonian government, a European Union member country or states with a similar risk profile

- 30% for investment funds of companies belonging to the same group as the pension management company

- 10% for investments in fixed assets

- 5% for securities issued by the same group; for securities issued by a single investment fund; for the pension management company's investment funds and for deposits at credit institutions of the same group

Regulations concerning international investments are distinctly liberal. There are no limits on investments in the European Economic Area, OECD countries and certain other countries.

The first benefit payments will commence in 2009. Benefits are paid out as life annuities, or – if the accrued rights amount to less than a quarter of the national flat rate pension – as programmed payments.

There are five pension fund management companies in Estonia that offer 15 funds in the mandatory pillar (six conservative, three balanced, six progressive). The two largest companies count 80% of members and 70% of the assets. By the end of 2006, 517,000 employees were enrolled in the second pillar, which corresponds to roughly 80% of the workforce. Given that it was just implemented in 2002, the new system's growth and acceptance are impressive. Assets under management amounted to EUR 475 million in 2006.

Pension plan members tend to prefer the higher-risk variant to balanced and conservative pension funds. Over 75% have chosen the progressive fund, while only 15% have opted for the balanced fund and 10% have selected the conservative fund. This preference can be considered an outcome of favourable stock market development as well as of the participants' age structure – almost 70% are under 40. Similarly, the majority of progressive fund members are younger: 80% are under 40, 16% are between 40 and 50 and only 4% are over 50.

Overall asset allocation for mandatory funds shows the impact of the preference for riskier funds. In 2006, 37% of assets were invested in equities or equity funds, 42% were allocated to bonds and 12% were placed in units of non-equity investment funds.

Estonia has an EET system in place. Contributions and investment returns are tax-exempt. Benefits from the first and second pillars are tax-exempt up to EEK 5,500 (EUR 320). Beyond this threshold, benefits are taxed at the normal income tax rate.

Voluntary pension funds were introduced in 1998 and can take two forms: pension insurance policies provided by life insurance companies or voluntary pension funds managed by asset managers. Public policy does not promote occupational pension provision. Employers can make contributions for their employees in the third pillar, but unfavourable tax treatment is an obstacle.

Employees, on the other hand, are given tax incentives to participate. Contributions can be deducted from taxable income up to 15% of the annual income. What's more, pension benefits are taxed at the reduced rate of 10%. Benefits can be paid out in a variety of forms, ranging from lump sums to life annuities. Life annuities are exempt from income tax, provided that they are paid periodically in equal or increasing amounts. Investment income is not taxed.

Investment restrictions for voluntary pension funds are not as strict as those for mandatory funds. For example, there are no maximum limits for equity investments and there are no limits for securities issued by low rating issuers. Limits for securities by a single issuer and real estate investments are also less strict. Fees for voluntary pension funds are not regulated, but there are certain information requirements.

At present, four pension fund management companies offering 15 voluntary pension funds are operating in Estonia. Employees can also choose from 11 pension insurance products. Participation in the voluntary pension funds remains low. They counted 24,000 members at the end of 2006, representing 4% of employees. In 2006, 75,000 people purchased life insurance. Voluntary pension fund assets under management currently stand at EUR 49 million. 38% of assets are invested in equity funds, 26% in equities, 15% in bonds and 12% in non-equity investment funds.

Assets can only be withdrawn after the age of 55. If members withdraw their assets before retirement, income tax advantages are lost.

Pension reform in Estonia is widely considered to be a success. The extraordinarily high participation rate in second pillar pension funds is evidence of this, as most people could choose whether or not to join. In terms of public finance, the system is also well-balanced and will remain sustainable in the decades to come. Transition costs are moderate, and according to the EU, additional subsidies are only required until 2012. Future challenges for the first pillar include preventing old-age poverty, as replacement rates are fairly low and the national pension and other benefits do not necessarily keep retirees above the poverty line.

The huge success of the second pillar has led to a rapid build-up and impressive growth rates. As the system matures, however, growth is likely to slow down. As seen, pension fund regulation in Estonia differs from other CEE countries. There are no minimum guarantees and almost no restrictions on international investment and providing funds with different risk/return profiles. Estonia is not a big market for asset managers due to the size of the country, but it is certainly a market with innovative regulatory approaches.