Key Differences in Public Pension
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early 1990s the number of pensioners living in the eastern European coun-tries has grown dramatically, the result not only of demographic change but also of economic transformation in these countries. Over the same period the number of contributors to pension funds has fallen, producing for many countries in the region a significant increase in the system dependency ratio. This situation, as you know, is repeated all over the world. In some countries the problem will become critical within 10 years; in others, within 50 years.
In the case of Ireland, there currently are five people active for every pensioner. In Poland there are only 2.1 contributors for every retiree. It is this situation that provided the main impetus for the significant and deep reform of Poland’s pension system, as clearly there was much work to do to ensure the long-term sustainability of the system. The reforms thus far have required an increase in public spending on the pension system to around 1.5 percent of GDP, to cover the transition costs. It will be a number of years before we can reduce this figure.
Funds’ Main Objectives and Funding
Both countries have created reserve funds. The main purpose of Ireland’s National Pension Reserve Fund, established by act in 2000 and made opera-tional in 2001, is to meet part of the escalating cost of future pensions. In Poland the main purpose of the fund is to accumulate financial surplus in the system to support the pension part of the social security system through demographic change.
There was a significant delay in instituting Poland’s fund. Despite being enshrined in law at the end of 1998 as part of the total legislation for reform, the fund started operation only in 2002. This delay was caused in part by political problems, but also by a failure to accurately anticipate the cost of the reform. Costing of the change was complicated by the fact that about 20 cohorts of the population had the option of remaining in the pay-as-you-go system, modified according to the concept of a defined contribution scheme, or of moving part of their contribution to the funded part of the system.
In the case of Ireland, every year 1 percent of GDP is transferred to the scheme. With the additional payments that also may be made to the fund, there is potential for the accumulation of a huge amount of money. In Poland, in contrast, the initial plan was to pay into the fund the equivalent
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of around 0.2 percent of GDP.1 Because of the huge cost of the pension reform, however, in 2002 and 2003 the equivalent of just 0.02 percent of GDP was accumulated. We are aiming to increase this sum by 0.01 percent of GDP every year.
This raises the question of why we should be trying to save money in a reserve fund when we are at the same time transferring 1.5 percent of GDP into a social security scheme. There are a few reasons, I think, to do so. First, we are looking to the long term, with the goal of achieving at the minimum a pension component of the social security system that is fully financed and fully stable. Second, the reserve fund gives us the possibility to test the public management or combined private–public management of a public fund. And third, it serves as an example through which to demonstrate to politicians and citizens the importance of saving money for the long term, for the old age pension. By putting aside money for pensions the state provides a practical demonstration of its conviction that voluntary savings schemes, for example, are justified and necessary.
Ireland plans not to make any payments from its reserve fund until at the earliest 2025. In the case of Poland, which created its fund specifically to reduce the impact of demographic fluctuations on the social insurance system, all assets are likely to be withdrawn in 2009 and 2010. This estimate is based on calculations that take into account only demographic factors, and which show that, applying the current law, the need to cover spending on old age pensions will deplete the fund to zero by 2010. Accumulation to a new reserve fund will begin again a few years later.
Governance
The assets management practiced by the two countries is strikingly different.
Where Ireland employs an external, independent commission to manage its reserve fund assets, Poland retains all management in-house. In Ireland, the independent commission determines the investment strategy and appoints investment managers; in Poland, responsibility for the investment strategy and basic asset allocation—along with diverse other responsibilities, ranging from the collection of contributions to the daily operation of the pay-as-you-go social insurance system—rests with the management board of the Social Security Institution. The rationale for these different practices lies with the
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sizes of the funds managed: the Irish fund has accumulated assets of about US$8 billion, compared to the Polish assets of about US$100 million.
The President of the Social Security Institution is nominated by the Prime Minister on the joint application of the Minister of Finance and the Minister of Social Security. The presidency is not bound by time limits.
Members of the Supervisory Board of the Social Security Institution are nominated by a supervisory council, such that employee unions, employer associations, and the government are equally represented on the board. The Supervisory Board in turn nominates members to the Management Board, on the application of the President of the Social Security Institution.
Investment Policy
The Social Security Institution has the right in law to decide the investment policy of the reserve fund, but only where that investment is to be made in treasury bills or securities issued by the State Treasury. (This in fact occurred in 2002 during the institution’s first year of operation, when all assets were invested in treasury bills and state securities.) The institution is now consid-ering converting some portion of the assets to mutual funds, which accord-ing to law may be handled by external managers. It is also tenderaccord-ing for the appointment of external managers for other fund’s assets. Again, there are some limitations in law, most notably that no single external manager can be responsible for more than 15 percent of the assets.
The structure of the Irish fund portfolio is planned for the long term at a combination of 20 percent bonds and 80 percent equities (although it appears from recent announcements that additional classes of assets may also be permitted). The structure of the Polish portfolio also is constrained by law, but to a different degree. Poland does not have a tradition of fiduciary standards nor the concept of prudent manner, for example; rather, every-thing must be described by law. Other constraints arise in the reluctance of politicians to give too much freedom to the fund managers. At present, the proportion of fund assets invested in equities is limited at 30 percent, in company securities is limited at a cumulative total of 40 percent, and in securities as bonds guaranteed by the state treasury at 80 percent. There is no limit on the proportion of assets that is invested in treasury bills.
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Public Awareness
Reaction to the reserve funds appears in Ireland and Poland to have been similar. In Poland, it seems few politicians understand our objectives for the fund. Many question why we have such a fund when the country is beset by budgetary problems. Payments to the fund are made out of public money and effectively are increasing the public deficit; one of the most popular schools of thought therefore is that we should cancel the fund and instead reduce the deficit. Economists—including those working as advisors to poli-ticians—also on occasion fail to understand our objectives.
There evidently is much hard work that needs to be done to improve the level of public understanding. That said, I believe from my own observations that there is a growing need worldwide, in more and more countries, for the creation of reserve funds. These funds must be managed independently of the government, but not entirely without government involvement. For example, government should create the rules of operation or otherwise approve those rules, including those guiding the apportion-ing of assets to securities, equities, treasury bills, and so on. (It is essential that equities assume a significant share of the fund’s portfolio, although defining the appropriate share is always problematic.) Government also has an important role to play in the nomination of the people who will be responsible for the fund.
Many politicians, as I have said, seem still not to understand the reason for regular payments to a reserve fund. The education process therefore is very important, and as such it is well to create the fund even if initially the value of its assets may be small, as in Poland’s case. (A small fund car-ries small risk, and thus has the advantage of permitting its operators to create, implement, and test procedures without the fear of catastrophic failure should something go wrong.) A fund of any size assists in persuad-ing politicians and society alike of the necessity of a long-term approach to social security, and specifically of the need for the state to set aside assets for long-term spending and of the need for people to save money themselves, for their future and to provide an income in old age.
The political climate in many countries means that it would be well to start the operation of such a fund step by step. By starting as Poland did with low-risk investments, in our case in the form of securities issued by the State Treasury, a country can keep at a minimum the negative sentiment directed against the fund while at the same time encouraging positive
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port. Starting in this manner also minimizes the risk that within the first two or three years of the fund the value of accumulated assets will fall below the total value of payments. Once the fund has been established for a few years it may then be appropriate to increase the investment risk, again step by step.
In many countries, including Poland, the issue of foreign investments also raises some problems. These tend to be of a psychological nature but they are important, and it is because of them that we have for the moment decided not to invest overseas. We may change our stance in the future, as Poland becomes a member of the European Union and a participant in the euro zone, but I think that during the early existence of the reserve fund it is better not to take the political risk of proposing foreign investments. For many countries, the prevailing social and political climate in fact simply would not permit outside investments.
Concluding Remarks
The step-by-step approach may in the long term be the best way to increase the value of assets collected in the fund. The evidence of the Polish case would seem to confirm this. I am sure that we would not have been able to maintain our fund if we had tried to keep to the initial decision to allo-cate 0.2 percent of GDP to the fund each year. In a situation in which the additional cost of our pension reform is around 1.5 percent of GDP, it is the decision to reduce investment in the fund to 0.02 percent of GDP, and to build gradually from there, that has kept the fund alive.
Thank you for your attention.
Notes
1. The basis for the calculation of this contribution is in practice the aggre-gate of salaries on which the social insurance contribution is assessed, but I have recalculated this to enable a direct comparison in terms of GDP.