The Rise and Fall of Private Pensions in Central and East Europe

1. The Rise and Fall of Private Pensions in Central and East Europe IGOR GUARDIANCICH Center for the Study of Europe and the World in collaboration with The Colorado European Union Center of Excellence at the University of Colorado Boulder Monday, February 13

2. Structure of the presentation • The ‘new pension orthodoxy’ • Averting the Old-Age Crisis • Criticism and reassessment • Pension privatization in Central and East Europe • The socialist system • The transformational recession • Refinancing, retrenchment and restructuring • Diffusion and variation • The financial crisis as dual exogenous shock • Impact of the crisis • Impact of the Stability and Growth Pact • Reform reversals

3. Part I - The ‘new pension orthodoxy' The World Bank’s three pillars

4. Criticism: Economics • First-order impact is nil ‘privatization without prefunding would not increase returns at all, net of the new taxes needed to pay for unfunded liabilities.’ (Geanakoplos et al., 1998) ‘Funded pensions face similar problems as PAYG schemes, and for exactly the same reason – a shortage of output. The only difference is that with funding the process is less direct and hence less transparent.’ (Barr, 2002) • Second-order impact is doubtful • More saving, more investment, more growth • Increased labor supply and improved reporting of earnings • Lower cost through competition between funds • Internationalization of risk: exporting capital vis-à-vis importing labor

5. Criticism: Politics • The backlash of losers ‘too often the Bank has not addressed sufficiently the primary goal of a pension system to reduce poverty and provide adequate retirement income within a fiscal constraint. It has also focused insufficient attention on the income of the aged.’ (World Bank, IEG, 2006) • Persistence of moral hazard • private funds are tempting for politicians, as they accumulate many years of contributions(as opposed to less than one year in PAYG plans) • renationalization as quick budget fix (Argentina, Hungary)

6. Criticism: Transition costs • Transition costs • during transition government pays public pensions while workers accumulate their own funds • Four views Adapted from Casey and Simonovits(2012)

7. Part II - Pension privatization in CEE

8. Socialist pension systems • Three layers • Bismarckian core • employment as legal basis of retirement • universalism through the extension of the constitutionally guaranteed right to work • post-war socialist social solidarity • PAYG system • increased coverage (small entrepreneurs and farmers) • reinforced stratification (jobs • imported Stalinist centralization • monolithic public administration

9. The transformational crises • Crisis under socialism • financial strains • low retirement age and long assimilated periods (e.g. maternity leave) • benefits calculated according to best- or last-years formulae • cross-subsidization of other budget expenditures (e.g. social assistance) • poverty in old age • the ‘old portfolio’ problem, due to insufficient indexation • Crisis during the transformation • demographic emergency • ‘great abnormal pensioner booms’ • multiplication of contributors, output decline and tax evasion • political exploitation of losers and pampering of core constituencies

10. Cumulative GDP growth (1990=100)

11. Unemployment rates

12. Informal economy: Household electricity approach

13. Great abnormal pensioner booms

14. Three reform phases • Refinancing • rapid increase in social security contributions (PL 25% in 1981; 38% in 1987-9; 45% in 1990) • discontinued due to declining international competitiveness • Retrenchment • arbitrary freezing of indexation of all but minimum benefits • struck down by Constitutional Courts (lack of exceptional circumstances) • Restructuring • politically superior, allows for quid-pro-quos • resonates with the public (equity as individualization) • obfuscates cuts in public pillar

15. Diffusion and variation • Different types of privatization • Substitutive (KO) • Parallel (LT) • Mixed (BG, HR, EE – not only carved out, HU – reversed, LV, MC, PL, RO – stalled, SK – partly reversed) • Voluntary (AL, CZ, SI – quasi-mandatory, SR) • Coverage • Mandatory for young workers (HU only new workers) • Voluntary for intermediate cohorts (PL 30-50; HR 40-50) • Not available to older employees (HU rare exception, active errors) • Size • Substantial (HU68/33.5; LV 210/20; PL 7.3/19.52; SK 9/18) • Medium (BG 25/23; HR 5/20; EE 4+2/20; LT 2.55.5/18.5; RO 2.56/28) • Small (SW 2.5/18.5)

16. Impact of privatization on deficit/revenues

17. Part III - The financial crisis • Shrinking demand • Most of CEE are small and open economies (<1M – 10M people). • Banks became illiquid in late 2008. • Fall in international orders triggered an economic collapse. • Asset bubbles • Hungary and Baltic states had excessive exposure to foreign-denominated mortgages.

18. Stability and Growth Pact • Maastricht criteria for EMU membership: • inflation max 1.5 pp higher than the average of 3 lowest-inflation Member States • budget deficit <3% of GDP • government debt <60% of GDP • long-term interest rate max 2.0 pp higher than in 3 lowest-inflation Member States • ERM II joined for 2 years prior to accession, no devaluation • Stability and Growth Pact (SGP) • Enhanced monitoring procedures • Sanctions through Excessive Deficit Procedures (EDPs) • Renegotiation and increased flexibility in 2005

19. SGP and Pensions I • SGP should not encourage or discourage any particular economic structure (pension system). • Reform of SGP (2005), special treatment in EDPs: • granting time for the adaptation of fiscal policy to the front-loading of deficits; • excluding the compensation for systemic pension reforms (assets of funds not offsetting government debt); • introducing a transitory period of 5 years (2005-9) • application of a degressive scale, if • deficit is close to 3% and excess reflects the costs of the reform.

20. SGP and Pensions II • Criticism: • triggered by expiry of the transition period, soaring budget deficits; • 2ndpillars mature in 40-50 years, 5 years are insufficient; • reformers should not be penalized with regards to the Maastricht criteria. • Demand for SGP revision • letter of 8 CEE countries plus Sweden • change the statistical treatment of private pension funds; • deduct fully the costs of implementing systemic pension reforms from the budget deficit in the context of the EDP; • refusal of interim relief (deviations from accounting rules must be limited, comparability with similar measures, statistical certainty); • new draft rules allowing for flexibility for virtuous countries.

21. Reforms and reversals • Temporary measures • many CEE countries froze the indexation of pensions (wages of public employees, social transfers) during 2010-12 • Parametric reforms • various CEE countries introduced a number of ‘overdue’ parametric reforms: • higher retirement age • fewer early retirement venues • lower regular indexation • Reversal of privatization • governments prefer to spend for Keynesian measures than for transition costs

22. Reversals of privatization