Since leaving public service seven years ago, Leszek Balcerowicz, architect of Poland’s shock therapy after the fall of Communism, has frequently criticized the government for failing to deepen the market-oriented policies he advocated. The former Finance minister thinks the state still controls too much of the economy and can’t get its spending under control. But nothing has aroused his ire more than the government’s recent decision to partly dismantle the compulsory private pension system he helped launch 15 years ago.
In February the centrist government of Prime Minister Donald Tusk seized 153 billion zloty ($50.4 billion) in Polish Treasury bonds from 13 private pension funds, an amount equal to slightly more than half of their investment portfolios. The move gave a significant boost to public finances in the short term, but it threatens to undermine the key goals of pension reform: boosting national savings and easing the long-term burden of retirement costs on the state budget. In addition, other restraints adopted by the government imperil the ability of private pension funds to survive even in a shrunken state.
“I have been criticizing this policy not because of any personal reasons but because it is destroying one of the most important reforms in Poland,” Balcerowicz, who now heads his own economic think tank, said in a Polish broadcast interview on March 31. He spoke on the eve of a crucial four-month period. Between April 1 and July 31, more than 16 million Polish pension fund contributors must choose whether to remain in those funds or have their holdings transferred back into the state social security system. Most of them are expected to bail out of the private system thanks to rules that critics believe are stacked against the private funds: The government has prohibited the private funds from advertising during the selection period.
At stake is one of the critical reforms of the transition to capitalism. Following the collapse of Communism a quarter century ago, most governments in Central and Eastern Europe created private pension funds, known as the Pillar II system, to share the mounting costs of retirement with their state social security systems. These funds were supposed to strengthen the region’s economies by creating pools of long-term domestic capital that would help finance private enterprises and public infrastructure projects. But the dream appears near collapse now that Poland, by far the largest regional player, has joined a growing list of CEE countries that have scuttled or scaled back their private pension fund systems (see, “Pillars of Eastern Europe’s Private Pension System Are Crumbling”).
“In the longer term we are talking about the liquidation of the pension fund system,” says Malgorzata Rusewicz, president of the Polish Chamber of Pension Funds, the industry’s lobbying group. Although the chamber is fighting the bond seizure in a case before Poland’s Constitutional Tribunal, the court is widely expected to endorse the government’s move when it rules later this spring. “The government has covered its legal bases and consulted with constitutional experts before passing the pension reform in Parliament,” says Tsveta Petrova, an analyst who has followed the pension controversy for Eurasia Group, a New York–based political risk consulting firm.
The government contends that it transferred the Treasury bonds to private funds only so they could manage them — and that it always maintained the right to withdraw them. Critics including Balcerowicz and Lewiatan, a private employers’ federation, assert that the government action amounts to an expropriation of private assets. “The pension system needed reforms, but the government went too far,” says Lewiatan president Henryka Bochniarz, whose powerful business group has joined the appeal of the seizure.
The move could have wider consequences for the Polish economy, the Organization for Economic Cooperation and Development warned in a recent report: The government measures “might well damage social trust in the pension system and harm the credibility of future structural reforms more broadly.” The Paris-based agency noted that the move required an “increased role of the public pay-as-you-go system in a context of rapid population aging.”
Legal arguments aside, the main reason for the Tusk government’s bond grab was to cover growing public debts that threatened a budding economic recovery. After recalling the bonds, the government canceled them. At a stroke, a budget deficit turned into a surplus and the public debt was reduced.
The timing of the bond grab was no coincidence. With Tusk’s centrist Civic Platform party facing a tough challenge from the right-wing, nationalist Law and Justice Party in parliamentary elections next year, the government wants to avoid austerity measures and have the freedom to spend money to woo voters.
“There are more productive ways to spend this money,” Finance Minister Mateusz Szczurek tells Institutional Investor, referring to the bonds taken by the government. “For instance, infrastructure projects like transportation, which Poland is co-financing with the European Union.”
For some outside observers such moves indicate that governments across Central and Eastern Europe are shying away from much-needed economic reforms because of short-term political considerations. “Can the region ever catch up with the living standards of the world’s most advanced market economies?” the European Bank for Reconstruction and Development asks pessimistically in its latest Transition Report on the region, published in November.
Nothing demonstrates this concern more clearly than the abandonment or scaling back of private pension systems. As CEE populations age, they will demand ever-larger portions of state spending. Meanwhile, economic growth in these countries will be vulnerable to a lack of local capital, particularly in times of global financial crisis and recession. “The Polish government’s decision undermines a lot of very good work that was done over the past ten years to develop a long-term domestic capital market,” says Jim Turnbull, London-based capital market adviser for the EBRD.
As the largest country in Central and Eastern Europe, Poland is the poster child for an emerging Europe striving to reach the ranks of developed nations. In fact, because Poland’s economic prospects are bright, the government is counting on investors to accept the bond seizure as an exceptional act of state intervention in an otherwise thriving market economy. “The government prepared public opinion and let the investor community know that this was not a harbinger of more antimarket policies,” says Eurasia Group’s Petrova.
Even some investors who harshly denounced the government’s plan for the bond seizure back in June 2013, when it was first revealed, have muted their criticism — and increased their Polish holdings. Last year Mark Mobius, one of the most prominent emerging-markets investors, likened the Tusk government’s plan to Argentina’s seizure of its entire private pension sector in 2008. But in his February 28, 2014, letter to investors in his Templeton Eastern Europe Fund, Mobius hailed the strong performance of the Polish holdings in the €334 million ($458 million) fund. With a 15.43 percent share in the fund, Poland trails only Russia (30.71 percent) and has moved ahead of Turkey (14.53 percent).
Mobius is not alone. In September, when the details of the bond seizure became known, the Warsaw Stock Exchange plunged and the yield on Polish ten-year bonds hit a 12-month high of 5.04 percent. Within weeks the ten-year yield moved back down to 4.40 percent; on April 14 it stood at 4.06 percent, benefiting from a broad-based decline in European rates. Meanwhile, the WIG20, Warsaw’s blue-chip stock index, has risen 9.8 percent since a September 5 low.
Finance Minister Szczurek says he isn’t surprised by the rebound considering that most economists predict that Poland’s economy will expand by more than 3 percent this year. “True, one participant in the bond market — the private pension funds — disappeared,” he says. “But the share of foreign ownership in local currency government bonds is going up. As for the equity markets, the reaction was positive because total debt and debt service are going down.” By March foreign investors had increased their share of government bonds, to 41 percent from 32 percent at the beginning of the year.
Critics, however, warn that retirement payments will become increasingly onerous for the government and that the pool of domestic savings will remain shallow. Moreover, if the private pension fund system doesn’t work in Poland, what hope is there for its success in the rest of the region?
“It is difficult to say at this point how the system will evolve in these countries,” concedes Mamta Murthi, Brussels-based country director for Central Europe and the Baltics at the World Bank, which along with the EBRD has promoted compulsory private pension funds in the region.
EBRD officials see little economic justification for nations like Poland and Hungary to attack their private pension funds. “They weren’t hit as hard as other countries in the region during the transition to market economies in the 1990s, and they had more-advanced markets going into the recent global financial crisis,” says the EBRD’s chief economist, Erik Berglof.
The compulsory private pension fund concept was born halfway across the world, in Chile. The military dictatorship of then-president Augusto Pinochet introduced the funds in 1981 to supplement a virtually bankrupt state social security system. Since then these funds have yielded a remarkable 8.7 percent annual return on assets for Chileans and created a domestic capital pool worth $190 billion.
Poland launched similar pension reform in 1999 with hopes of matching Chile’s success. The government saw reform not only as a way to foster savings but a response to mounting demographic pressures. The wrenching transition to market economies in the CEE region after the fall of Communism drove unemployment sharply higher and discouraged the creation and growth of families. Employment and income levels recovered, but fertility rates didn’t: Polish women have an average of 1.4 children, below the fertility rates of many Western European countries and well below the level that would stabilize Poland’s population. That means fewer workers to finance the pensions of a growing population of retirees.
The government jump-started the compulsory private pension fund system by transferring sums that were converted into Treasury bonds. The funds also receive a cut of the country’s social security payroll tax, a 19.5 percent levy split equally between employers and employees. The thinking was that private pension funds would be more efficient than the state social security system as savings and investment vehicles. In the first years after the new millennium, global stock markets were booming and high investment returns seemed within the reach of blue-collar and newly middle-class Poles.
“But over time these assumptions did not hold up,” says Eurasia Group’s Petrova. “In the end, the private pension funds proved expensive and inefficient for the government and contributors.”
To be sure, the global financial crisis diminished investment returns for the pension funds. But tight government supervision also was to blame. Private pension funds had to operate under regulations that discouraged risk-taking. They had to keep more than half of their portfolios in domestic fixed-income securities, mainly government bonds; they could not hold bonds from other sovereign issuers. Equity portfolios were restricted to investment in blue-chip companies, mainly Polish ones.
Besides griping about low returns, the government had other complaints about pension funds: Devoting a portion of social security contributions to private pensions was adding to the budget deficit by creating a financing gap equivalent to about 2 percent of gross domestic product in the state-run system. The government eventually would have to close that gap, either by raising the retirement age or by increasing the contribution rate.
Moreover, both the government and pension fund participants began to sour on the costs of the private system. In the first few years, private pension funds claimed a whopping 10 percent of contributions in overall fees. According to a government report, the total fees accrued by the pension funds amounted to Zl17.4 billion out of a total of Zl185 billion of contributions between 1999 and 2012. Most of those costs were incurred in the early years of the system, when the newly created funds spent lavishly to enroll members and receive a commensurate share of government bonds. “Don’t forget, we had so little time to recruit millions of contributors,” says the head of one pension fund, who spoke on condition of anonymity because of the government gag rule against statements that might be considered as advertising.
In those early years the pension funds took to the airwaves and billboards to proclaim their merits. An army of salespeople descended on offices, factories and farms to extol their pension funds’ superiority, cajole employees into signing up — and woo contributors signed up by rival funds. Because commissions were earned on each recruit, switching from one fund to another often occurred several times a year.
Politicians and future retirees grew increasingly resentful of the aggressiveness and expense of those campaigns. Only deep-pocketed fund management companies — like the local subsidiaries of Allianz, Assicurazioni Generali, Aviva and AXA, as well as funds run by the leading Polish insurer, PZU, and the country’s top bank, PKO Bank Polski — survived the competition. Out of 21 private pension funds in 1999, only 13 remain today.
Pension fund managers say the days of high expenditures to build their funds, finance marketing campaigns and poach clients are over. Fees have declined to the equivalent of 1.75 percent of contributions. In addition, the pension funds charge a management fee of 0.5 to 0.6 percent.
Notwithstanding the high fees, government regulations and impact of the global financial crisis, the pension funds insist they have delivered decent returns for their members. According to the government’s own analysis in June 2013, the real net return on a contribution made in 1999 and held until 2012 averaged 6.6 percent annually. The Polish Chamber of Pension Funds asserts that the average annual return was 8 percent. The pension funds themselves posted net profits of Zl5.1 billion during that period.
Still, citing complaints about high costs and low returns, the government mandated a cut in employer and employee contributions to private funds in 2011, from 7.3 percent of salaries to 2.3 percent. That portion has since been allowed to rise to 2.92 percent.
Some pension funds saw the 2011 contribution cutback as a harbinger of worse to come. The Polish subsidiary of U.K. insurer Aviva stopped recruiting new members that year. It remains the second-largest pension fund, with more than 2.6 million contributors; the market leader, a subsidiary of Dutch financial services company ING, has more than 3 million members. But Aviva decided to focus its Polish operations on life insurance, in which it ranks fourth in the country.
That decision seems astute now, in the wake of the government’s attack on private pension plans. The seizure of the private funds’ bond holdings left the organizations with roughly 75 percent of their investment portfolios in equities (municipal and corporate bonds make up the remainder), rendering them riskier in the eyes of many observers. “I would be reluctant to put my pension savings into an equity-only fund,” notes the EBRD’s Turnbull.
Besides seizing government bonds, the government is squeezing pension funds in other ways. The pension overhaul included a measure that requires contributors to transfer their holdings into the state social security system, starting ten years ahead of retirement. This will provide additional funds to cover the social security deficit and, according to critics, further dissuade contributors from remaining in the private pension system.
Of more immediate concern, in the four months leading up to July 31, all 16.4 million contributors must decide whether to continue with their private pension funds. Those who don’t voice an opinion will automatically have their past and future contributions transferred to the state social security system. The widespread assumption is that this stacks the odds against the private funds. “During those four months most people won’t make a decision, and their contributions will revert to the pay-as-you-go state system,” predicts Ryszard Petru, president of the Association of Polish Economists.
“Holding on to enough contributors will be the key to whether Pillar II can survive,” says the Polish Chamber of Pension Funds’ Rusewicz. She estimates that the strongest pension funds — perhaps after acquiring weaker ones — will stay in business if at least 30 percent of contributors opt to remain in the private system.
But the government is making even that figure difficult to achieve by forbidding private pension funds from advertising their cause to their members before the July 31 deadline. This gag rule has particularly angered critics. “We are upset by the government’s prohibition on any attempts by the pension funds to disseminate information to their members,” says Lewiatan’s Bochniarz. “We know from opinion polls that most members just don’t have any idea what is going on or what they should do — so they will be moved into the state system.”
The gag rule has intimidated the pension funds. A spokesperson for ING’s Polish subsidiary declined a request for interviews with senior executives, asserting they might violate the prohibition against advertising.
Consider the situation at Allianz’s Polish subsidiary, the tenth-largest pension fund. Following the bond seizure in February, it lost half of its Zl9.1 billion investment portfolio, reducing its assets to the same total as in 2008. The pension fund had net income of Zl32.4 million last year, mostly from its 0.54 percent management fee, up from Zl24.5 million in 2012. But the firm expects a sharp drop in profits this year because of the halving of its investment portfolio and an expected outflow of members.
Executives at Allianz’s Polish subsidiary, who spoke on condition of anonymity, say they intend to rebalance the fund’s portfolio with other fixed-income securities; they contend that it makes sense for members to keep at least a small portion of their retirement savings outside the state social security system. But on the advice of its lawyers, Allianz’s Polish unit is not communicating these views to plan contributors because that might be construed as an illegal advertisement. “When all this is taken into consideration, any private pension fund has to wonder whether the business and legal frameworks exist to carry on,” Rusewicz says.
Many contributors assume the private pension system is moribund, but they don’t seem appalled by the prospect. Polls conducted in September, when the government announced the outlines of its pension cutbacks, showed that 75 percent of respondents had no strong preference for either private funds or social security.
At an ice-skating rink set up in cobblestoned Old Town Market Square, in Warsaw’s medieval quarter, Jósef Bednarz, a 32-year-old bank employee, watched his wife and infant daughter glide by. He and his wife intend to move their private pension fund assets into the state social security system. “At this point, the pension fund has become an equity fund, so it’s too risky for our retirement savings,” Bednarz says. “And if we have extra savings, we would rather put them in a mutual fund because it charges lower fees.”
Across the Vistula River, in the gritty old factory neighborhood of Praga, Elzbieta Waleski, 58, dropped off her granddaughter for catechism class at St. Florian’s Cathedral, a towering, red-brick, neo-gothic structure that was destroyed by the Nazis and rebuilt in the 1950s as a spiritual bulwark against the Communist regime. Waleski distrusts the private pension fund system and wants all her retirement assets back in state social security. But she gives no credit to the centrist government for pension reform and intends to vote for the more conservative opposition Law and Justice Party in next year’s elections. “They probably would have carried out the same reform,” Waleski says. “And they are better Catholics, for my taste.”
The Law and Justice Party voted against the bond seizure bill in a 232-to-216 vote in Parliament on December 6, but the party has focused its efforts over the past two years on opposing government plans to raise the retirement age to 67 for both men and women by 2040. Currently, men retire at 65 and women at 60.
Government officials evince little sympathy for private pension fund managers. “Life was too easy for them,” says Finance Minister Szczurek. “Now they will have to be more creative and imaginative.” He suggests that the funds replace government bonds with municipal and corporate bonds. But he concedes that there isn’t yet enough of a capital market for those securities. “Most corporate debt financing in Poland is still done through bank loans,” Szczurek says.
Budget considerations drove the government’s decision to eviscerate the pension funds. For years Poland argued that European Union accounting rules for budget deficits penalized countries with compulsory private pensions because those systems require subsidies in the form of transfers of government bonds and social security contributions. The Ministry of Labor and Social Policy estimates that pension subsidies increased the public debt by 17.5 percent of GDP between 1999 and 2012. “The EU forced the Polish government’s hand,” says Eurasia Group’s Petrova.
The Polish constitution stipulates that the public debt cannot exceed 60 percent of GDP, and it mandates automatic spending cuts if the ratio hits 55 percent. With debt brushing up against that threshold last year, the Tusk government was determined to avoid austerity measures ahead of the 2015 parliamentary elections.
By appropriating the $50 billion in Treasury bonds from the private pension funds, the government turned a yawning 4.8 percent budget deficit in 2013 — well above the 3 percent limit for EU members — into a projected 4.5 percent surplus in 2014. The budget is expected to swing back to a 3 percent deficit in 2015, but in the meantime the government will have considerable spending leeway before the elections.
The government’s makeover of the private pension system has divided the business community. Employers’ association Lewiatan joined the private pension funds in March to argue before the Constitutional Tribunal that the reform legislation was an unlawful expropriation of private assets. “The pension system needed reforms, but the government went too far,” Bochniarz says. The employers’ federation’s chief objection is that pension reform was rammed through Parliament in just four days.
Lewiatan also worried that pension reform heralded other antimarket measures, similar to the antibusiness policies carried out in Hungary, where private pension fund assets were entirely nationalized and banks are coming under more state control. “So far, we don’t see any evidence that the government is moving further in the direction taken by Hungary,” notes Bochniarz. “But politics is unpredictable.”
The major credit rating agencies raised no alarms over the government seizure of private pension fund bonds. According to Fitch Ratings analyst Matteo Napolitano, the move “did not represent a change in our overall assessment of Poland’s creditworthiness.” He adds that Fitch was impressed that after the government used the pension fund bond holdings to reduce the budget deficit and public debt, it announced constraints on the growth of future debt.
Foreign portfolio investors were at first taken aback by the bond seizure. They feared that the government might follow the move with an expropriation of equities from the pension funds — and then sell off those shares, depressing the stock market. When that worst-case scenario didn’t happen, the market quickly recovered, says Matthias Siller, London-based investment manager for Baring Emerging Europe.
Siller expects pension fund equity holdings to decline in coming years because contributors will increasingly opt for the state social security system. “If you are a 25-year-old Pole, you have no incentive to apply for a private pension fund,” he explains. “That means the pension funds will be starved for net inflows and over time will suffer negative outflows and eventually self-liquidate.” But by then, Siller predicts, a growing number of domestic mutual funds and foreign equity funds will have taken up the slack.
Equities have received a boost from the overall positive outlook for the economy. Since joining the EU in 2004, Poland has averaged 4 percent annual GDP growth. It is the only European country not to have suffered a recession during the global financial crisis. Economic expansion slowed to 1.6 percent last year because of fiscal tightening as the government sought to keep the debt-to-GDP ratio below the 55 percent threshold. But following the bond seizure, says Piotr Kalisz, a Warsaw-based economist for Citigroup, “the government dropped its more restrictive fiscal policy, and this has really helped economic growth.”
Before the Ukraine crisis the consensus among economists and government officials was that Poland would grow by at least 3 percent in 2014. That figure may be harder to achieve because Russia and Ukraine, whose economies have been hit hard by the recent conflict, account for almost 20 percent of Polish exports.
But with political risks rising in Russia and Turkey, emerging-markets investors are viewing Poland as a safe haven in its asset class. “It’s in a much stronger position than others,” says David Reid, London-based co-manager of BlackRock Emerging Europe, which has some $300 million invested in Polish equities. He dismisses the significance of the private pension system’s troubles. “It has not had a big effect on us,” Reid says.
But the weakening and possible demise of private pensions leaves Poland with the same demographic dilemma that led to the creation of the Pillar II system. In its March report the OECD recommended that Poland raise the retirement age for women to 67 from 60 by 2030 — a decade earlier than the government is proposing — to ensure the solvency of the social security system.
“The longer-term issues have not gone away,” says the World Bank’s Murthi. “All countries in Central and Eastern Europe are aging, so there is strong pressure to think about appropriate pension policies.”
The consequences for Polish capital markets could be profound. According to the EBRD’s Turnbull, the assets of private pension funds will shrink by as much as 75 percent. “The government effectively got rid of a very valuable source of long-term funds,” he says. “This comes at a time when banks are showing constraints in lending because of tougher Basel III requirements and insurers are facing a lot of uncertainty because of Solvency II.”
In his recent television interview, former Finance minister Balcerowicz declared that the government’s bond seizure was “perhaps the worst antireform in Poland since the fall of Communism.” Other observers note that government policy has shifted from economic liberalization to more-immediate growth concerns. “The years of Balcerowicz are over,” says Eurasia Group’s Petrova.
Indeed, they are. • •