Security Through Diversity 1 FUNDING OF SOCIAL SECURITY PENSIONS: POLAND Presenter: Dariusz Stańko Pension Reform Workshop Chisinau, Republic of Moldova

SecurityThroughDiversity

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FUNDING OF SOCIAL SECURITY PENSIONS: POLAND

Presenter: Dariusz Stańko

Pension Reform WorkshopChisinau, Republic of Moldova

Chisinau, 10-11 June, 2008


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1. Linking of contributions and benefits

through notional accounts


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Why (N)DC in Poland ? High pension expenditure due to:

Relatively generous pension formula • on average 80% replacement rate• little link between earnings history and pension level

Early retirement• wide-spread early retirement privileges• average retirement age: 55 for women, 59 for men• virtually no incentives to postpone retirement

Public preferences: pension should be linked to paid contributions

Long-term outlook: population ageing, thus need to prolong working lives and increase

retirement age


4Mandatory Social Security System

New systemArchitecture

NDC

PAYGmandatory,administered by thepublic institution,individual accounts

First Tier

Open Pension Funds (DC)

Fundedmandatory,administered by privateinstitutions,individual accounts

Second Tier

Savings and additional insurance (DC)

Fundedvoluntary,administered privately,individual accounts

Third Tier


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Design of the new pension system in Poland (1)

New Polish pension system is: defined contribution with two accounts: non-financial

and financial

The old-age contribution was divided into: NDC 12.22% of wage FDC 7.3% of wage

Rates of return: In the NDC are linked to the

wage fund growth In the FDC depend on the

financial market returns

Persons below 30 (in 1999) have both NDC and FDC accounts

Persons aged 30 to 50 had a choice of one (NDC) or two (NDC+FDC) accounts 53% of them chose to have

two accounts

Persons over 50 years of age stay in the old system

Source: Polish Chamber of Pension Funds


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Close link between contributions and pensions: Shorter working lives Lower wages

Result in lower pension savings

But: There are significant

differences as far as the labour market situation of men and women

Promotes: Longer working lives Higher earnings

Policies to promote gender equality on the labour market are crucial for equality in the pension system

Design of the new pension system in Poland (2)


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Notional Capital

Pension

Average Life Expectancy at the

retirement age

=

First Pillar

NDC Pensions

Employment

Self-employment

Unemployment

Maternity and child-care

Army service

unisex life tables


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For people who had worked before the introduction of reform, an initial capital is calculated according to the following rule:

Initial Capital

(NDC)

Hypothetical old-age pensioncalculated

according to the old system rules as of December

31, 1998

Average Life Expectancy

Unisex at age 62(209 months)

= *

First Tier

Initial Capital


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First pillar

Demographic Reserve Fund

Created in 2002. Year 2009 – an extension?

Funded part of the public tier (currently 0,4% of NDC pension contributions)

Accumulates surplus in order to finance upcoming deficit

Allows to adjust to demographic fluctuations

Reduces dependency on the state budget

Since recently – equity part; passive investment


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Mixed pensions

For those who did NOT join OFEs: year 2009

80% of pension from ZUS calculated according to old pension system DB formula plus 20% of pension from ZUS calculated according to new NDC formula

year 201070% - 30%

year 201155% - 45%

year 201235% - 65%

year 201320% of old pension from ZUS, 80% from new pension


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Pension system

Projections for the future - no reform

Pension expenditure would increase: from 11% of GDP in 2000 to 17.3% in 2050

By the same time, the number of pensioners would double from 7 million in 2000 to almost 15 million in 2050, of

which:

• more than 10 million old-age pensioners

Total pension deficit would exceed 7% of GDP

Based on Social Budget Model, the Gdansk Institute for Market Economics


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Transition costs in Poland1998-2006 (% GDP)

The financing of the Social Insurance Fund still requires subsidy to cover deficits

Subsidy to cover the transition costs remains relatively stable


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Misunderstandings regarding reform costs

Transfer of a portion of contribution to funded pension scheme is not a cost (but strains on liquidity) it reveals a portion of the implicit debt and it reduces future public finance obligations

Increased funding requirements can be offset by higher debt, purchased by pension funds

Pension funds assets invested into equities stimulate investment and economic growth

It is better to turn a portion of pension liabilities into savings now than to have much greater problems with redeeming such obligations in the future


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Poland –Long-term effects

Estimated value of pension liabilities as per cent of GDP until the year 2050:

Before the reform 462% After the reform 194%

Reduction of liabilities 268%


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Summary Transition costs in Poland include most importantly

the coverage of increased deficit in PAYG scheme: pensions are paid according to the old system rules part of contributions is invested by pension funds level of transition financing: 1.5 per cent of GDP

The adequacy of future benefits does not depend on the financing, rather on the type of pension system (DB vs DC)


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2. Pension system for farmers


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2.1. Farmers as a social group

• historical grounds• some basic statistics• low productivity• problems with moving to other sectors


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2.1. cont. Farmers in Poland (2006)

• 14,8 m people living in rural areas (out of total 38,12 m)• 2,387 m farm households (with 1,742 above 1ha)

o 25,3% - farming as a source of main income (>50%)o 52,5% - pensions and disability pensions

source of main income for 24,1 % of individual farmers and 14,1% of individual farmers with > 1ha

o 51,5% - salaried worko 14,2% - non-farming activityo 11,4% - other

• average area 6,7 ha, 6,2 person/farm, output 4 061 PLN, (27 208 PLN/farm 4 388 PLN/person farm), vs GDP/capita 27 742 PLN• PKB: 3,9% vs 22,1% (industry), 17,1% (trade)


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2.2 KRUS (Kasa Rolniczego Ubezpieczenia Społecznego)

The Agricultural Social Insurance Fund runs self-governed financial activity. The following funds are the base of insurance and activity of KRUS:

1. Contribution Fund of the Farmers Social Insurance,

2. Pension Fund,

3. Prevention and Rehabilitation Fund,

4. Administrative Fund,


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2.2. KRUS – cont. farmers’ insurance system

• low level of protection yet• strong redistribution towards farmers from other social groups

Basic pension and disability pension: 636,24 PLN

Average salary in economy (Dec 2007): 2 691,03 PLN

Exchange rates (June 2007): USD 2,17 PLN euro 3,39 PLN


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2.3. Pension formula

• current formula – consists of two parts:o contribution part = number of contribution years * 1% of minimal pension

(MP=minimal pension =636,29 PLN)

o supplementary part = [95% - (x-20)*0,5%] * minimal pensionwhere x = contribution period, each full year over 20 yrs decreases the supplementary part by 0,5% of MP; however supplementary part cannot be lower than 85% of MP

• proposed new formula:= capital / further unisex life expectancy @ 65


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2.4. LegislationThe basic law defining farmers' social insurance obligations and entitlements to benefits is included in the act of 20 December 1990 on farmers' social insurance (full text: Official Journal No. 7 of 1998, item 25 with later amendments).

Beside the mentioned law, farmers receive their entitlements and benefits according to parliament acts listed below:the law of 13 October 1998 on social insurance system (Official Journal No. 137, item 887 with later amendments), the law of 28 November 1994 on family benefits (Official Journal No. 228, item 2255 with later amendments), the law of 26 April 2001 on structural pensions (Official Journal No. 52 of 2001, item 539 with later amendments), the law of 23 January 2003 on general health insurance (Official Journal No. 45 of 2003, item 391 with later amendments).

The basic legal acts of the European Community are: Council Regulation (EEC) No. 1408/71 of 14 June 1971 on the application of social security schemes to employed persons, to self-employed persons and to members of their families moving within the Community, Council Regulation (EEC) No. 574/72 of 21 March 1972 laying down the procedure for implementing Regulation (EEC) No. 1408/71 on the application of social security schemes to employed persons, to self-employed persons and to members of their families moving within the Community.


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2.5. Contributors and beneficiaries

year beneficiaries insured2005 1,66 m 1,58 m

2006 1,59 m 1,62 m2007 1,51 m 1,60 m


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2.6. Financial problems – need for reform

• low real financing level• problems with •„faked farmers”• proposals to introduce

income-based contributions

Source: Own calculations based on KRUS data (www.krus.gov.pl)


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3. Disability issues


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3.1. Disability pensions

• high number of disability pensioners• recent reforms – stricter assessment procedures,

lower disability contributions• current rules• current disability formula• reform to be introduced in 2009

o new disability formula (old disability vs new pension)o elimination of 70% and 130 % income ceilings for

working early pensioners, working disability pensioners and working family pensioners


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3.1. cont. – Disability formulas

• current formula:= 24% Basis Quota + 1.3% *n1*IAB + 0,7%*n2*IAB+

0.7%*n3*IAB

n1 – no. of contributory years, n2 – no. of non-contributory yrs, ICB – individual

assessment base, n3 – no. of hypothetical contributory yrs

(n3=25-n1-n2, from moment of disability to age 60)

• new formula (for those born after Dec 1948; full formula commencing 2014, mixed formula during 2009-2013):= [initial capital + actual capital + hypothetical capital] / unisex further life expectancy @ 60 yrsfor each missing year of contributions (up to max. 30 yrs) the hypothetical value (= actual capital/actual contributing period)


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3.1. cont. – Disability formulas

Current values of disability pensions• total disability pension 636,29 PLN• partial disability pension 489,44 PLN• Basis Quota (2008) 2 275,37 PLN


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Panel 1 on Lessons Learned from Second Pillar:

• Overview of the market

• Performance

• Costs

• What might be done differently


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Second pillar in Poland (I)

Act of 28 August 1997 on organisation and operation of pension funds (Ustawa o organizacji i funkcjonowaniu funduszy emerytalnych z dnia 28 sierpnia 1997 r.) (Dz.U. 1997 nr 139 poz. 934)

OFE - open pension fund (art. 9-26), the fund's Articles of Association (art.13, changes: art. 22-23)

A depositary (art. 157-165), paid by OFEs: 2006 – 17,38 m zł (3,21% of operational costs)

PTE – a general pension society (art. 27-52): The governing bodies of the society: 1) the Management Board, 2) the Supervisory Board, 3) the General Meeting plus also: the Audit Commission.


31Source: Own calculations based on data from KNF (www.knf.gov.pl).

Polish Open Pension Funds' market (% of Net AuM)as end of May 2008

Generali OFE; 3,80%

Nordea OFE; 3,51%

Bankowy OFE; 2,98%

OFE Skarbiec-Emerytura; 2,48%

OFE Pocztylion; 2,03%

AEGON OFE; 1,98%

Pekao OFE ; 1,61%

OFE WARTA; 1,47%

AXA OFE; 4,46%

AIG OFE ; 8,20%

OFE PZU „Złota Jesień”; 13,62%

ING OFE; 23,78%

Commercial Union OFE BPH CU WBK ; 26,67%

OFE Polsat; 0,92% Allianz Polska OFE; 2,49%


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Open Pension Funds’ Market:

Basic Statistics (as of 30 May 2008)

Open pension fundNumber of members

Accounting unit's value

(in ZL)

Net assets value(in ZL)

Market share as a % of members

Market share as a % of assets

AEGON OFE 338 543 26,11 2 773 959 926 2,51% 1,98%

AIG OFE 1 096 405 25,81 11 484 760 812 8,14% 8,20%

Allianz Polska OFE 335 897 24,89 3 495 804 975 2,49% 2,49%

AXA OFE 637 164 26,41 6 248 255 870 4,73% 4,46%

Bankowy OFE 442 141 25,61 4 174 125 489 3,28% 2,98%

Commercial Union OFE BPH CU WBK

2 787 187 27,03 37 366 400 939 20,68% 26,67%

Generali OFE 576 852 27,66 5 318 689 895 4,28% 3,80%

ING OFE 2 693 196 28,71 33 326 645 224 19,98% 23,78%

Nordea OFE 742 705 27,32 4 925 080 172 5,51% 3,51%

Pekao OFE 317 480 25,68 2 252 467 955 2,36% 1,61%

OFE Pocztylion 442 364 24,96 2 848 378 818 3,28% 2,03%

OFE Polsat 321 230 28,90 1 292 602 528 2,38% 0,92%

OFE PZU „Złota Jesień” 1 983 241 26,98 19 090 213 244 14,72% 13,62%

OFE Skarbiec-Emerytura 453 337 25,27 3 472 092 919 3,36% 2,48%

OFE WARTA 309 596 27,34 2 058 432 631 2,30% 1,47%

Total 13 477 338 27,13 140 127 911 396 100,00% 100,00%

Source: KNF (www.knf.gov.pl) and own calculations.


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Performance of OFE

PeriodNominal rate of

return* (p.a.)

1999 (since June) 32,48%

2000 13,03%

2001 5,69%

2002 15,27%

2003 10,91%

2004 14,22%

2005 14,99%

2006 16,41%

2007 6,21%

2008 (until June) -9,70

* average rate of return weighted by market share

Source: Own calculations based on the data from KNF.


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Impact on adequacy?

Compared to the value of contributions paid:

Value of pension accounts in OFE are much higher than in ZUS

Relatively low wage growth

Good returns on financial markets

If the current developments are continued, expected pensions could be higher

Value of individual accounts – ZUS and OFE


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Safety mechanisms

• legal and physical separation of pension fund from managing company • legal requirements for PTE and its staff• depositary (custodian)• investment limits• supervision and control by KNF• mandatory minimum rate of return• so-called cascade of guarantees (Guarantee Fund)• minimum pension• Treasury as the last resort


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Fees for participating in OFEs

Amendment of pension law (15 October 2003) – substantial changes in commissions.

Three main sources of income for PTEs: distributional (up front) fee management fee transfer fee (for changing membership in a fund)

Gradual change of weights of first two commissions:

2002 – up front fee 79,4% of all revenue for PTEs, management fee - 19,2%2004 – 62,9% and 25,7% 2005- 68,2% and 31,8%2006 – 75,5% and 24,5% 2007 – 60,9% and 33,8%


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Costs of open pension funds 2006

Open pension funds: 1,49% of average yearly assets

Mutual funds (stable growth): 1,67% of average yearly assets

Fees in open pension funds regulated, more transparent – cheaper? Mutual funds are expensive in Poland, however.

• Total expense ratios TER in weighted average actively managed equity funds:

0,92% US vs 1,79% Europe vs 3,73% in Poland.Source: http://www.altruistfa.com/dfa.htm and Analizy on line.



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What might be done differently

Tenders for asset management mandates – a few institutional investors for each cohort?

401k-like mandatory retirement accounts – many institutional providers?

Passive management for core portfolio?

More efficient information campaign on future replacement rates and inheritance of the funds (vide annuity market)



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Panel 2 on Second Pillar Introduction:

• Readiness conditions

• Macro-fiscal conditions

• Capital market conditions

• Administrative framework conditions


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Readiness conditions

IT infrastructure

Wide political consensus

„Window of opportunity” (Polish case)

Market infrastructure (depositary banks, clearing houses, size and liquidity, instruments available vs investment limits)

Staff (managers, investment advisors)

People’s ability to understand financial markets and financial information (informed choice?, drivers for competition?)


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First pillar

ZUS - Correctness of information

70%

80%

90%

100%

September2001

March2002

September2002

March2003

September2003

March2004

Identification of employers Identification of employees

Formal control Identification of payments

Overall efficiency

Source: ZUS


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First pillar

Initial capital Initial capital calculation turned to be a difficult

administrative task Equivalent of retirement of 11 million individuals

Problems in retrieving past wage and earnings history Changes of the employers Creation and destruction of companies But: problem would have been more acute in the future

Initial capital calculation completed by the end of 2006


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Conclusions

Lessons up to date Quality of information must be assured

• All participants are equally responsible for adequate performance of the system

• Computer system is important….• …. as well as system managers• Proper identification should be ensured• Procedures should be designed to avoid errors

Implementation takes time – also as far as retrieving past wage history

Difficulties in overcoming societal believes:• Retirement age of women• Widespread early retirement widely accepted

Political opportunity needs to be seized: all reform items should be placed as soon as possible


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curbing the implicit debt, showing explicit debt – long-term financial stability

adjusting to current social and demographic situation

labour market incentives externalities (growth,

savings, capital market development, financial market stability, mgmt efficiency etc.)

Pros and cons

social problems – lack of solidarity (redistribution), low pensions for worse-off (particularly in the initial period)

funded system not that immune from political influences

political backlash (transition costs – euro criteria, annuity market, etc.)

DC – problem with investment risk, peoples’ rational choices and education


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Raising retirement ages for women Reducing the poverty risk for women Promoting more gender equality

Re-defining the role of minimum pension Current indexation mechanism is reducing the role of minimum pension guarantee Projections show its limited role in reducing the poverty risk for those with low

wages and short working careers Re-design is needed to develop adequate poverty protection mechanisms in the

future

Relatively fast economic growth may lead to increased income differences between retired and working generations

Building pension-literacy so that people react to the incentives

OFE – multifunds, investment limits, performance evaluation needs to be revised/introduced

Annuities market

Challenges for the future

Documents

Security Through Diversity 1 FUNDING OF SOCIAL SECURITY PENSIONS: POLAND Presenter: Dariusz Stańko Pension Reform Workshop Chisinau, Republic of Moldova