World Bank-inspired pension schemes are rolled back across the region

The Visegrad region is the cradle of the most radical type of pension reform in Europe’s recent history. Hungary (1998) and Poland (1999) were the first post-communist countries to implement mandatory pension accounts with assets invested in the financial market. Slovakia joined in relatively late (2004) but went further, creating the biggest pillar of personal accounts out of not just Visegrad, but all post-communist countries. Yet it seems that the region is sobering up from the original excitement.

Foto: Creative Commons/ christine.gleason

In August, the Slovak parliament cut contributions to privately managed pension accounts from 9% to just 4% of gross wage. This marks yet another step in a steady retreat from the schemes which were once so popular. Since 1998, every new EU member state, except Slovenia and the Czech Republic, has introduced investment accounts.

Details vary. Estonia started the reform with a modest personal account contribution of 2%. In contrast, the Slovaks, the most ardent reformers, immediately went for the whopping 9%, without any phase-in period (other countries typically had a schedule of contributions gradually rising to meet some target rate). In one deviation from the norm, Lithuania did not make participation mandatory for new labor market entrants as others did – instead, there is a voluntary opt-in.

The pendulum swings

Everywhere, the reforms were accompanied by glitzy advertising. While new labor market entrants had to be enrolled automatically, older workers typically had a choice – they could stay fully in the state system or they could split off part of their mandatory contributions into private accounts. They were eager to join. Everywhere, the actual enrollment numbers were beyond initial official expectations.

But the tide has now turned. At the height of the global economic crisis in 2009, Latvia and Lithuania slashed contributions to privately managed accounts to 2% (from 8% and 5.5% respectively), and Estonia halted them altogether. The latter soon reintroduced modest contributions (2%) and plans a further increase to 4%, but the freeze remains in force in Latvia and discussions are rife on abolishing the accounts altogether in Lithuania.

In 2011, Poland reduced contributions from 7.3% to 2.3%. The most dramatic development came in Hungary where the government nationalized private accounts between 2010 and 2011. In Bulgaria, the government’s efforts to get private pensions under their full control have so far been thwarted by the constitutional court.

And now the Slovaks have cut their contributions by more than half. In a related effort to ease the pressure on public finances, the recent changes also make the system voluntary, with an opt-in for new labor market entrants (just like in Lithuania). The amendment also created an opt-out window from September to January that will allow existing participants to fully rejoin the public system. Romania remains the only country which has not seen dramatic adjustments or efforts to roll back the reforms, although it has temporarily postponed the scheduled rise in contributions.

As if to testify that the age of radical reform is over, the Czech Republic is now implementing a modest reform where the working population will be able to partly opt out of the public system. They will contribute 3% of their mandatory contributions to a private scheme and will have to top this up by a further 2%. In essence, this sensibly discourages low-paid workers from joining and at the same time deals with the problem of the financing gap arising in the public pillar.

The Czechs have also introduced strict controls on how much pension funds can spend on marketing. Licenses will be given to established financial institutions – this constitutes a further check on the costs of running the schemes. Especially in Poland or Hungary, the cost of establishing a fund and running expensive marketing campaigns contributed significantly to low returns to savers.

Ballooning deficits force governments to act

Everywhere, the primary impulse to cut contributions has been the effort to shore up public finances. In all cases, diverting part of mandatory contributions into private accounts has created a long-term gap in financing existing public pensions (which rely on current contributions).

The Baltic states were the first to act because they also faced the most dramatic fiscal crisis (in particular Latvia and Lithuania). In the case of Poland, the country had a “debt brake” introduced into its constitution in 1997 that caps total public debt at 60% of GDP. When the country got close to this limit, the government acted by cutting private contributions. Hungary’s efforts were even more frantic, since the country faced a dramatic economic crisis. The Slovaks, too, have cited the need to comply with the Stability and Growth Pact and the nascent Fiscal Stability Treaty, like other eurozone members. Their package of changes includes a provision for private contributions to start rising again in five years.

So, some governments have portrayed the retrenchment as temporary and have pledged a continued commitment to private accounts. However, the support for them now seems lukewarm. Strikingly, nobody seriously protested when Hungary’s government decided to simply dismantle the system. What had gone wrong?

The origins: The World Bank comes with a recipe

The original reforms were largely inspired by a controversial 1994 World Bank publication, Averting the Old-Age Crisis. The book criticized systems where pension rights are ‘unfunded,’ i.e., not backed by an existing pot of money and instead paid out of current contributions. This is what is called a pay-as-you-go (PAYG) system. Practically all publicly managed pension schemes in developed countries are PAYG.

One potential problem with these kinds of schemes is that governments might set the rules irresponsibly, which leads to overgenerous pensions out of line with economic fundamentals. The problem becomes more acute as societies age (people live longer and have fewer children), but governments might fail to react quickly enough by raising the retirement age, for example.

The Bank, following its earlier similar efforts in Latin America, said the risks can be controlled by developing a ‘multi-pillar pension system.’ This was meant to consist of:

  • the ‘first pillar,’ which would be a continuation of the existing public PAYG scheme;
  • the ‘second pillar,’ where money would be handled by private fund managers;
  • and the ‘third pillar,’ which would be the same as the second but voluntary and might offer a wider variety of investment and payout arrangements.

Diverting part of pension contributions to private accounts creates a shortfall in funding existing PAYG rights. But, the Bank said, countries in Central and Eastern Europe could cover this with income from the ongoing privatization of state assets.

World Bank influence varied across the region. In the case of Poland and Hungary, the bank was a cheerleader and a source of inspiration, but the actual reform was, to a large degree, in the hands of local economists and politicians. Particularly Slovakia and, to some degree, the Baltic states and Romania, saw much more direct involvement of World Bank experts, and the bank also provided financial assistance (covering logistics and the wages of local reform teams). In Bulgaria, the reform was a condition for access to financial aid.

The recipe does not seem to work

The World Bank book was criticized for using spurious arguments. Nicholas Barr of the London School of Economics and Nobel Prize-winning economists Joseph Stiglitz and Peter Diamond were among the most prominent critics. They did not appreciate that the World Bank portrayed the reform as a panacea to ‘negative demographics’ and that it did not warn against potential risks to future retirees.

The book implied that claims accumulated via a private account are somehow immune from demographic developments. This is simply not true. Pensioners’ financial claims can only be exchanged for goods and services created by a productive population and thus have to adjust to the real economy.

Things become more complicated in an open-economy model, but not much more. First, the developed world is aging. The reforms in general only allow investments into OECD countries. This is to make them safe from geopolitical turbulence  – allowing assets to be invested in potentially unstable regions was a risk that reformers did not want to run. In fact, Eastern Europe has needed heavy capital investment and had high growth rates in recent years – and thus needed more, not less, capital.

Secondly, in principle openness can help growth, and large pension funds facilitating financial openness can, under some circumstances, be beneficial. But, ironically, Eastern European economies are already among the most open in the world. Trade and capital openness are extremely high and so is labor migration. Countries like Latvia or Slovakia have seen as much as 7% of total workforce being out of the country in certain years! This has had two effects which no one seems to have anticipated: it has worsened the financing gap for current pensions, but eased strains in the future as these workers accumulate pension rights elsewhere.

Those in the migrating workforce, however, who had signed up for the funded schemes, usually shot themselves in the foot: as they move abroad, they stop contributing and their small investments are eaten away by administrative fees. Policymakers failed to warn them that for those who are going to live for longer periods of time elsewhere, it is better not to sign up for private accounts. Public pension rights are transferable within the EU, but private schemes are not.

Contested virtues of  pension reform

‘Better labor market incentives’ was another of the supposed virtues advocated by the World Bank and its proponents. In this microeconomic argument, people are supposed to understand that the more they work, the more they contribute towards their pension, unlike in some PAYG schemes, where the formula for calculating a pension can be fairly obscure. However, there is nothing preventing policymakers from making PAYG schemes closely tied to earnings. And in fact they often are. The two most popular approaches are the innovative Swedish notional defined contribution (NDC) system and the widely copied German wage-point system. Equally important, in funded systems the earnings relationship is not linear, as contributions can be wiped out through bad investments or administrative fees.

Another contested issue is whether the new schemes provide for better allocation of assets. Proponents of funded schemes have often argued that their strength lies in the fact that money gets invested in stock exchanges, and the existence of a strong stock exchange is vital to the economy. Critics have disputed this blatant assertion. Reformers often followed two contradictory arguments: that funded schemes are good because they help diversify assets away from the local economy, and that they are good because they help accumulate capital in the local economy.

Moreover, proponents of reform argued that investing in the capital market would bring higher returns than what the state can provide. To “prove” this, they would point out how much a particular stock index had risen over a certain period of time and compared that to the general growth of the economy. This is very manipulative. An index changes its composition over time, so it is a very bad proxy for returns for the average investor. Establishing actual returns on stock investment, in the meantime, requires picking a reasonably representative sample of the broader stock market and estimating dividend and capital gains income. All in all, the broader the base of investors, the more the returns will be in line with the development of the gross domestic product (GDP), which is the basis on which the government can tax, and therefore base its financing of a PAYG scheme.

Supporters of reform would often highlight supposed ‘flexible personal portfolios’ that the new scheme brings. Yet this argument does not make much sense, given the actual design of reforms in every one of these countries. Portfolios are chosen by fund managers. There is no lifecycle adjustment, and no proper mechanisms to smooth out temporary market turbulences (as we know from Dutch occupational funds, for example). Citizens are only given a highly misleading choice of two (as in Poland) or three (as in Slovakia) types of funds with various limits on holdings of equity. Ironically, in order to make sure their second pillar reforms were successful, governments were not interested in promoting voluntary, third pillar schemes, which allow more flexible mixes that make sense. In at least one country, Slovakia, third pillar schemes effectively died out after mandatory funded accounts were introduced.

Finally, an oft-cited virtue of the new scheme was expectation of the political stability of funded schemes. Elderly citizens may damage the economy by voting for irresponsible pension policies, and this can be prevented by shielding at least part of the pension system from political influence, by having it privately managed. At the end of the day, this seems to have been the main message of the World Bank. Today, it seems almost ironic, as real life events have shown the schemes are simply not insulated from politics. Governments find it very easy to manipulate them by changing investment rules but also can simply abolish the schemes altogether (as Hungary did). And why shouldn’t they? After all, if the government mandates that citizens invest in these schemes, citizens have every right to demand government take action if things go wrong.

At the same time, funded schemes pose new kinds of risks. They are very bad at dealing with common shocks, such as inflation. Another common shock, which is practically never mentioned, is demographics. Any unexpected jumps in longevity play havoc with annuities. Another risk is mismanagement and fraud. PAYG schemes are safer – simply put, no assets are accumulated that can be stolen.

In fact, robustness against common shocks and inherent safety are the two reasons why PAYG schemes became so prevalent in the Western world after inflation, market turbulences or fraud wiped out assets in many schemes in the early 20th century. Even long before the state took over, many occupational schemes were PAYG, rather than funded.

Pensions need fewer myths, more economics

The World Bank soon stopped its aggressive promotion of funded schemes, especially after it was criticized by the banks’ own Independent Evaluation Group in 2002. Also, Robert Holzmann, an Austrian, the bank’s head of social protection department in 1997-2009, was not particularly keen on promoting wholesale conversions to funded accounts. Instead, the bank issued a more cautious recommendation that  governments should generally support the diversification of the sources of old-age income.

Why, then, despite all the risks and controversies, did Eastern European governments embrace these kinds of reforms so wholeheartedly?

Some see Eastern pension reforms as a simple case of a neoliberal conspiracy to roll back the state and lock the Eastern European countries into the networks of international capital. Indeed, there should be more research into the role of not only issue networks and epistemic communities, but also of the simple collusion of think-tanks and the financial industry in shaping the reforms.

This line of investigation, however does not explain why, for example, these reforms were often underwritten by people with no particular ideological commitment or material interest. Nor does it explain why it was exactly funded pensions that became the policy of choice, while there is no equivalent single package of ‘super-reform’ offered for labor markets (where the region offers a fragmented picture) or healthcare (where the region retains pretty much a unified model of highly centralized healthcare provision, free at the point of delivery).

Perhaps this was for two reasons. First, the reforms were accompanied by attractive graphs showing savings to public finances once the funded schemes are fully phased in. Therefore, reforms were appreciated for their signaling function; they seemed to indicate governments’ commitment to long-term stability.

Secondly, even though pointing at the worsening ratio of contributors-to-pensioners is no argument for a funded scheme, as a rhetorical trick this is very effective. Most people get the simple arithmetic of the shrinking contribution base but are hard to convince that the purchasing power of assets in private accounts is ultimately subject to the same forces.

In fact, when one looks at the press in the region, it is easy to see that arguments for funded schemes still revolve dominantly around nebulous hints that “we need to reform because of demographics.” The way that this stump of an argument has become accepted wisdom, in many cases especially by the self-perceived urban elite and so almost a status signifier, would warrant more extensive sociological research, borrowing heavily from discourse studies.

Limited results in the V4

Nowhere did funded pensions provide the long-term returns promised by official projections at the time of reform. Let us look at the sub-sample of Visegrad countries. Most drastically, Hungarians simply lost money. On the one hand, long-term real returns from the funds were close to zero. On the other, the original reform asked those who joined voluntarily to forgo 25% of their pension rights accumulated in the public system (this special feature of the Hungarian reform was introduced to ease a future transition deficit in the PAYG pillar). It is not surprising then that people did not protest when the government finally decided to abolish the whole experiment.

One can probably argue that the reform was successful in Poland where the aim was to help create a strong regional stock exchange – and this did happen. This was facilitated by the legal requirement that funds invest at least 95% of their assets in Poland. This lasted until 2010, when the European Commission told Poland (and Slovakia, which had a much lower threshold of 30%), that this was in breach of the EU’s freedom of capital movement.

In contrast, the Slovak reform had confused objectives. The government did not make any provisions for the establishment of a strong domestic capital market. In the end, just like in Hungary, the government had to borrow heavily from institutional investors, including the pension funds, to cover the financing shortfall in the PAYG pillar. This was supposedly for the benefit of the pension savers, whose returns so far have been slightly below zero.

Future: Accept there is no miracle cure

In the West, banks and governments came to use the demographics argument to entice people to invest heavily in real estate. This was supposed to be the sound investment shielding the individual from turbulences in the rest of the economy. In some countries, this discourse was accompanied by very significant tax incentives (Ireland being a very good example).

In the East, this quest for an economic perpetual-motion machine translated into exaggerations and misplaced faith in funded pensions.

Of course, there is nothing inherently wrong with funded schemes. They might make sense, depending on the economic context, policy objectives and the actual setup (the devil is in the details). But they are no miracle cure for demographic or other socioeconomic developments.

In the meantime, governments should accept that population aging requires a range of policy reactions which go well beyond the pension system. In fact, investment in better health (through lifestyle campaigns and preventive medicine) and education are far more important. Only a healthy population with flexible skills will deal successfully with the turbulence coming with the retirement of the baby-boom generation between 2020 and 2050.

Juraj Draxler

Juraj Draxler

is Associate Research Fellow at the Brussels-based think-thank CEPS, and lecturer at the Anglo-American University, Prague. He has authored and co-authored several reports contracted by the European Commission on social policy and labour market regulation.