Sunday, 8 November 2009

Polish pension system in brief

Following the recent uproar over government’s plans to take over a fraction of the pension insurance premium, which is currently transferred to the pension funds I decided to familiarise those of you dear readers, who still know little about the structure of the new Polish pension system with its basic assumptions and principles.

Disclaimer and warning: the picture is a bit subjective as the issue is one of the author’s hobby horses. Moreover author has a rather low opinion about the solutions put into practise in Poland.

It’ll take on a form of FAQ – so here we go!

1) How is it designed?
- The new, reformed system basically consists of three parts, called pillars. The first one is run by the national insurer, called ZUS, the second are private-owned pension funds. Participation in the first and in the second pillar is obligatory. The premium is divided and currently around sixty per cent goes to ZUS, the rest to the pension funds. As the replacement rate (last salary to first benefit ratio) under the new system will range from forty to fifty per cent, the employed are encouraged to save in the voluntary third pillar, in which the participants can save under pension schemes and on individual pension accounts, run by banks, insurance companies, or at brokerage firm.

2) How does it function?
- The money which flows to the first pillar is assigned directly for payments of current benefits. ZUS just keeps an account of what has been transferred into the system. The amount of the future benefit is subject to increments according to the political decisions, based mostly on inflation rates. The real money remains in the second pillar, where the companies managing pension funds invest it. Unfortunately the way they build their portfolios is not at their discretion, but they are constrained to buy certain types of securities in order to protect the future benefits. They can invest up to five per cent abroad, have up to forty per cent of stock in their portfolios, at least sixty per cent needs to be invested in government bonds… In the third pillar an employed person can either participate in the pension scheme, set up by their employer or choose an individual form of putting aside money – a bank account, an investment fund (there’s a choice of risk profile), taking out an insurance policy or buying stocks. The amount yearly set aside in the third pillar is at the present capped to over 9500 zlotys.

3) Who this money belongs?
- Good question! Firstly – what money? In ZUS you just have a book record, just a figure in the computing system. The money in the pension fund, managed by a private company is… a public money. You can’t just withdraw this money whenever you want just like in the United States, but if you pop off before you retire, you capital is inherited by the family members, but watch out – as much as possible is transferred into their pension accounts in pension funds. Only the money in the third pillar is available for you. You can pay it out whenever you want, but it entails the obligation to pay the capital gains tax. (The savers are exempted from the tax only if they don’t pay out money until they pension off).

4) Who has a right to decide what is being done with that money?
- For sure not you, dear reader. There’s no influence on the way ZUS is run, nor on the rate of increment. In the pension fund also there’s no possibility to control the investment strategy, which is greatly determined by the precautionary regulations. So if you feel the bear market is coming don’t call the fund manager and advise them to divest of stocks and buy bonds, just keep a cool head and see your money shrinking.

5) Yes, so how about investment strategies?
- ZUS doesn’t invest your money – as it has been written above. Pension funds managers build the portfolio on the basis of rather stiff guidelines. This means the returns of funds are very similar. The most idiotic thing in the OFE business are mandatory investments in government bonds, interest on which is paid from our taxes, so we pay to the state for the return on sixty per cent of portfolio’s makeup…

6) What are the costs?
- In case of ridiculous first pillar not as high as you’d think. In spite of all scandals with marble-laid head offices and luxurious holiday resorts, costs of administering the service of benefits account for around one per cent of managed sum – quite little. In OFE, pension companies charge currently (until the end of this year) a distribution fee of seven per cent of the premium, so out of each 100 zlotys paid into the fund only 93 are invested, the rest goes into managing companies… This is one of the biggest scams, done within the letter of law, pension companies did Poles out of around twelve billion zlotys within the last ten years. The management fees are reasonable and don’t exceed one per cent.

7) What are the incentives for the pension funds to invest the money effectively and what are the punishment if they fail to do so?
As the old Polish saying goes: “czy się stoi, czy się leży, siedem procent się należy” – the old adage, referring to socialist economy is, when paraphrased still up-to-date with the private-run pension funds. People are bound to transfer premiums to the funds, so the risk that they’ll take their money away doesn’t exist. Of course they can change the fund, but there’s no real competition on the market, so even if one goes away, another one comes up. There’s no carrot in the system, as the fees for managers are not dependent on the investment results. The stick also doesn’t work properly – the Polish regulatory body gives (on the basis of calculations) a minimum rate of return setting out the profit each fund has to fetch – this year in March 3Y minimum return was below zero. If it doesn’t it must pay into the fund to make up for the insufficient returns. Such situation took place only once in the history of the Polish system. According to the rule “don’t stand out, if it doesn’t pay off” their investment portfolios are very similar, so the choice of a fund smacks of a fiction…

8) What is the government trying to do?
They want to move some of the newly coming premiums to ZUS, rather than to OFE. Currently 19,52 per cent of the salary are paid as a pension insurance premium. 12,22 per cent go to ZUS, 7,30 per cent go to OFE. Under the new regulations, 15,22 per cent would go to ZUS and only 4,30 per cent to OFE.

9) What’s the purpose and what may it result in?
The main goal of course to have a cash injection to the budget in the lean times, in the long term it means accumulating the “book record of capital” and carrying on building a financial pyramid – it’s a major downside. It’s hard to say, whether the increments in the first pillar will be higher than returns in the second, but it’s almost sure that system’s running costs will be much lower – it’s a major upside. I see another positive aspect of the planned reform – the funds won’t be allowed to collect money for which they’ll buy government bonds. Minister Rostowski goes even further and suggest that funds shouldn’t buy government bonds at all and make profit only in the private sector. This is the wisest thing about our pension system ever said! The restrictions for the fund managers should be abolished and funds shouldn’t have gilt-edged securities in their portfolios. It’s better to issue less bonds (author is in favour of balanced budget at all and in his humble opinion state should issue any securities and run up any debts) and cut the taxes…

10) What else can be done?
I’m calling for more freedom, which means most of all responsibility for the taken decisions. Let me save for my pension on my own, put the money whenever I want or spend it however I want. But if in fifty years I was looking for the food in the rubbish bin – it would be my fault. Such scenario will never be realised as most of people consider it inhuman.

So how would be my ideal pension system look…?
The first pillar would be state-run, participation would be obligatory. Benefits from it would be just tiny “subsistence allowances”. As an element of redistribution, benefits would be equal, but premium would be collected on the principle of flat rate. The second pillar would be private and discretionary. Wish to hand your money over to professionals and pay them for management – go ahead, but not under constraint. Such normal system, based on the free-market rules would work much more effectively. My idea is rather unrealistic, so I’d opt for what has been applied in Sweden – citizens there are obliged to save in the private system, but instead of 15 uncompetitive funds, they have a choice of around 500 institutions offering a wide range of products, including long-term bank deposits, investment funds, insurance policies, etc.

Thank you for getting here. If you see any factual errors or have questions, let me know.

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