Challenges of the 2nd Pillars in CEE Countries Brussels, May 7, 2009 Heinz P. Rudolph hrudolph@worldbank.org

Agenda The financial crisis and pension funds Are negative returns a pure market problem? Are there regulatory issues? Conclusions

The financial crisis has affected the returns of pension funds…

Returns since inception, the situation looks less dramatic

Vulnerable groups seem relatively protected People close to retirement age are the most vulnerable There are only a few thousand across the CEE region With few exceptions, 2nd pillar is a small part of their retirement income All CEE countries offer 1st pillar protection Problem is some pension systems do not offer enough alternatives

Labor force participation in 2nd Pillar is relatively young in CEE countries

Challenge is to offer proper portfolios according to participants’ ages

Are negative returns a pure market problem? Pension portfolios seem overweight in exposure to CEE countries While interest rates in developed countries have decreased, they increased in CEE countries Equity prices in CEE countries have underperformed the S&P500 Are fund managers realizing the losses? Mixed evidence

Long term interest rates in CEE countries have moved in opposite direction to developed countries Emerging Europe Germany, UK, USA

Equity exposure to CEE countries has exacerbated the losses

Mixed evidence about realizing losses…

Lithuania: timing the market?

Short-term or Long-term investments?

Can regulatory issues explain the performance of pension funds? Available Alternatives Single, lifestyle or lifecycle pension funds? Performance Measures Fair value accounting Return Guarantees (MRG) Investment Regulation Limits to equity & UCITs Derivatives Capital Market Development

Single portfolios? Single Portfolios Fixed income % Poland, Bulgaria, Croatia, Macedonia, and Romania Herding behavior One size does not fit all 100 50 25 age

Lifestyle portfolios ?…. Slovakia, Estonia, Lithuania, and Chile Lifestyle portfolios ?…. Lifestyle Portfolios Slovakia, Estonia, Lithuania, and Chile Fixed income % Assume that people are rational Assume financial literacy Assume that individuals know the portfolio composition that accommodate their age Assume that individuals move out of riskier portfolios as they age 100 Conservative 50 Balanced 25 Growth age

or Lifecycle portfolios? Fixed income % 100 Conservative Balanced Growth age

Lifecycle portfolios TSP (USA), Chile and Mexico (default options) Provide default options for pension funds Market does not solve the optimal portfolio allocation Benchmarks that optimize the accumulation pattern of individuals are exogenously provided Pension funds compete on beating the benchmark PFMC move asset allocation as individuals age Open the possibility of guaranteeing the value of contributions.

Fair value accounting Mark-to-market (MM) works in liquid markets Prices may not reflect the real value of assets in illiquid markets When illiquidity, MM introduces volatility in asset valuation Allow for mark-to-model Centralized system works better than decentralized: Chile, Colombia. CEE countries have decentralized systems Risk of pricing the same instrument differently Challenge: to develop homogeneous criteria for modeling Come back to MM as soon as markets become more liquid & avoid book value accounting

MRG is some countries creates less distortions than others

Absolute guarantees on contributions a reasonable alternative to explore? Guarantees on the value of contributions (Slovakia, Romania) work ONLY if applied on retirement. Otherwise incentives to invest in safe but unprofitable instruments If guaranteeing real value of contributions, governments need to provide instruments to hedge inflation risk Lifecycle pension funds provide the right design to deal with absolute guarantees at low cost. Challenge: pricing and funding guarantees (research agenda).

Should pension funds resume investments in equity? Evidence of equity premium and mean reversion Not any equity but worldwide diversified portfolios Pension funds should avoid timing the market and follow more strategic investments Long term investments do not necessarily show good results in the short term

Investments in equity: active or passive management? Both have advantages Some CEE countries discourage UCITS Argument : regulators do not see value added However UCITS are good vehicles for global diversification Investment limits should not be lower than equity limits Who should pay UCITS fees? The pension fund manager has few incentives to invest through these funds, unless fees are paid by the fund. Obscure mechanism of rebates (caps in Chile) These fees should be reported with fees charged by the PFMC

Fixed income: finding the risk free rate Short-termism is one of the main criticisms of pension fund portfolios Due to volatility of long term bonds, pension funds typically invest in T-bills Reinvestment risk and inflation risk Long-term “sovereign” inflation index bonds close to the relevant risk free rate for funds Role of the government in developing this market Consider a minimum duration requirement & developing inflation index bond market Conservative portfolio achieves its objective when immunizes the value of an annuity

Conclusions Pension funds are for the long term Pension funds’ negative returns in 2008 do not justify cutting contributions rates to 2nd pillar As a temporary measure, it is understandable in countries pursuing a superior good (i.e. Eurozone access) in the short term, but inconvenient in most of the CEE countries Government short term financing needs should be preferably financed by government debt Use government bond issuance to build the capital market Governments should upgrade pension regulation to align the interest of fund managers with pension funds

May 7, 2008 Heinz P. Rudolph hrudolph@worldbank.org Thanks! May 7, 2008 Heinz P. Rudolph hrudolph@worldbank.org