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Monday, August 20, 2012

Retrenchment of Privately Managed Individual Accounts in Central Europe

Elaine Fultz, Former director of the International Labor Organization office for Russia, Eastern Europe, and Central Asia

The partial privatization of Central European pension systems is now a well-known phenomenon.  Beginning in the late 1990s, with support from the World Bank, many Central European governments scaled down their public, pay-as-you-go pensions and established mandatory, privately managed individual investment accounts.  Hungary and Poland led this process, launching new second tier accounts in 1998 and 1999, respectively.  They were soon followed by Latvia (2001), Bulgaria, Croatia and Estonia (2002), Lithuania (2004), Slovakia (2005), the Republic of Macedonia (2006), and Romania (2008). Since capitalized accounts require three to four decades to accumulate sufficient funds to pay full benefits, this major pension restructuring is still at an early stage.

However, after the global economic crisis, a number of these same countries retrenched their new second pension tiers. Hungary and Poland were again in the lead.  In 2010, Hungary ceased funding its second tier all together and recouped most workers’ account balances. In 2011, Poland enacted a permanent cut of more than half in its second tier funding. In this same period, several other countries -- Estonia, Latvia, Lithuania, Romania, and Slovakia -- also retrenched their individual accounts in some manner.

In the latest International Social Security Review (ISSR), I provide a close look at the forces that led the Hungarian and Polish governments to enact these retrenchments.[1]  While the media often portrays these retrenchments as a consequence of the global economic crisis, my analysis shows that the crisis was a catalyst but not a root cause.  Rather, when the crisis occurred, both the Hungarian and Polish second tiers were underperforming due to design specifications omitted from the original privatization laws.  The main omissions were three-fold:

  • In both countries, second-tier accounts were funded by diverting contributions from the public pension systems. This created large and sustained “holes” in public pension finance.  Neither privatization law specified how these holes would be filled.  To compensate for the missing revenues, both governments resorted to annual borrowing.  By the fall of 2008, this borrowing was inflating their annual deficits by about 1.5 percent of GDP per year, each. Since the public pension shortfalls due to privatization would continue for three to four decades, there was no end in sight for this burden.
  • Both laws were missing key parameters concerning payment of second-tier benefits.  The most important of these related to cost-of-living increases and to the possible role of gender-related differences in life expectancy in benefit computation. In both countries, proposals to deal with these issues in the post enactment period were caught in a conflict between what most policy-makers favored – inflation indexed annuities and gender neutral benefit calculation – and what private funds normally provide – unindexed benefits, calculated using gender specific life expectancies for women and men.  As the deadline for beginning to pay benefits drew closer (2009 in Poland; 2013 in Hungary), these issues continued to resist resolution.
  • Limited regulation of private management fees gave pension management companies latitude to subtract large sums from worker savings.  In the years following enactment, high fees became political issues in both countries.  The governments responded to stakeholder dissatisfaction with proposals to limit fees (Hungary) or lower existing limits (Poland).  However, the proposals met with opposition from the private funds, and the final legislation imposed only modest limits, leaving space for the funds to continue to levy substantial fees.  The global economic crisis caused the value of individual accounts to drop sharply, but the funds continued to earn profits due to high fees.  This further fueled public resentment.

Over the first decade of implementation, the governments’ inability or unwillingness to address these issues gradually weakened the support of key stakeholders.  The global economic crisis brought these problems to a head.

It is clear that the expansion and retrenchment of second-tier investments was a difficult experience for these two Central European states, which created individual accounts with hopes of higher pensions, only to have to rapidly scale them down.  With the benefit of hindsight, it is also clear that the omitted private pension design features were no easier to fill in later, and may have become more difficult due to the opposition of newly created private funds. 

From the United States perspective, these developments underscore the high transitional costs of pension privatization, as well as the mismatch between the benefit features that workers desire – i.e., regular COLAs, low administrative charges, and gender equality in benefit computation – and those normally provided in private pension markets.  These difficulties are especially relevant today, as the coming elections again bring social security privatization into political discourse.

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[1] Fultz, Elaine. 2012.  “The retrenchment of second-tier pensions in Hungary and Poland: A precautionary tale.”  International Social Security Review, Volume 65, Number 2, July-September 2012, p. 1-26.

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