Pensions Systems in Ireland and Poland, a quick comparison

Thursday, July 14, 2011 » posts.tags:

When Poland in 1999 reformed its pension system it displayed –despite some important mistakes that we will elaborate further– not only a courageous vision, but created a system that is inherently healthy and was an important investment in all the future generations. Pensions were to be taken from the current balance of the country and to be held on private accounts. That would free the state from an impossible situation at periods when the relative income for the state would be weak, providing critical strength in such difficult moments.

There is one generation that pays the cost. The generation that is working now funds the state pension system that is financing pensions not from its savings but from the current income. That generation will not only fund the old system but also save for its own pension. On top of that, this generation, should not expect anything from the old pension system when they retire. I believe that we all can be proud to pay this cost and free future generations from this burden. Besides –as Mr. Rostkowski rightfully notes– that will provide Poland a competitive advantage in the decades to come when other countries –such as the Czech Republic– fill face the bankruptcy of their state pension system and will have to make the switch in a later generation.

Unfortunately the difficult moments –that the new system would protect us from– came before the change was completed. The so needed reform of Polish public finance that made such a good start came to a grinding halt under the PIS rule and the economic boom of 2003–2007 was not used to make these important changes. Despite this Poland did well during the Global Meltdown and is still “first in class” in Europe. But during the crisis the public debt rose to almost the critical limit of 55% of GDP. Above that limit, Poland will face serious austerity measures from Europe, that seeks above all financial stability.

The government needed to act fast and strong at the eve of 2010. The state pensions system was a big chunk of the budget and that was an easy target: in one move the public debt could be reduced to a safe 47% of GDP. They decided to reduce the contribution to the private OFEs from 7.3% to 2.3%, and use the difference –5%– to fund the bankrupt state system. Unfortunately, the government made one important mistake. In stead of explaining that this is evil and that it is temporarily it decided to lie and pretend that the move was good and make the move permanent. The day that it was announced –December 2010–, Mr. Rostkowski explained that it would not change anything: “If we would give the money to the OFE, then they would buy bonds and so finance the public debt to pay for the state pension system. This is just a short-cut.” Once can of course ask why a government would introduce such change if it would not change anything. In any case, Mr Rostkowski is right from the point of view of the balance of the state, and yes, it has the advantage that Poland will not show 55% of debt, but 47% or so and hence pay millions less on interests (not only a lower outstanding amount to pay on but also a lower interest rate because a debt/GDP ratio of 47% looks better than 55%!). Unfortunately nothing can be further removed from the truth than this statement when your point of view is taken! From your point of view what happens is that the monies that were destined to be invested on your behalf on your account in order to contribute to your pension … well, they are now used to pay the pensions of the people that are now living from the state pensions system. The cash is gone, and there is nothing real –only virtual money, similar to Monopoly money– it leaves us with nothing more than a claim to the generation of your children and hope that they do display the same generosity as we do now.

It is sad that a system that proved not to function is allowed –as a vampire– to suck the blood of an inherently healthy system and by doing so crippling that healthy system. But this might be just what we need for a while (it could be the least of two evils!). However it has to be noted that the fact that this is hidden in a mist of half-truths does not help anyone.

Most reactions in Poland focussed on the risk that this Rostkowksi-reform would dry up capital acquisition of private companies (OFEs invest roughly 40% in equities) and hence hinder economic growth seems to me a true but very limited problem. Poland is one of the stronger economies and it has a great future. The fact that the economic growth will continue to be strong should support the stock exchange and while the growth might be slower, I believe that companies will still be able to find funding and support economic growth. The main problem is the one described above: presenting the vampire as the good one and crippling the inherently healthy pension system on the long run.

But when I speak of the reform of 1999 as an “inherently healthy system”, then I refer strictly to the essence of it as described above: funding of a private account and paying pensions from savings (not from current income). Many things –while historically forgivable to a limited extend– are an outright crime to the taxpayer. Let’s run through a few examples.

There are two major problems: the system feeds on a distorted view on how free market competition can be healthy (and thereby limit the potential to tailor investments to the investor’s need) and second it is expensive … very expensive, because it is designed in mistrust of the efficient asset management industry.

To illustrate these problems, we will use a hypothetical example of Mr Berczyk K., who earns 1000 PLN a month and we assume an allocation of 7.3% on top of that to the private pension fund. So, if you earn for example 4500 PLN just multiply all the numbers by 4.5 to find your figures.

Let’s start by choosing a reference. I work in Ireland now and co-run a very small pension fund of only 20 (twenty!) employees. The pensions fund is a simple securities account with a large provider and all costs are paid by the employer (so separate from the pensioner’s savings). This small fund gives me enough purchasing power to bargain a 0% entrance fee and a 0.5% management fee on a global equity fund (while of course having a wide range of –free to choose!!– funds for all employees in the system! Let’s name the Irish investor Paddy and let’s make abstraction of the huge differences in salaries between Ireland and Poland and hence assume that he earns exactly the same as Berczyk. The polish investor will not even get the benefits of global diversification and –what is infinitely worse– not the benefit of free choice of strategic asset allocation (but more about that later), on top of that he pays 3.5% entrance fee and an average management fee of 1.38% (2009 figures, the 2010 numbers should be lower).

We further assume simply a stable risk premium of 3% above 3% long term interest rate and assume that both Mr Berczyk K. and Mr. Paddy O. (from my small pension fund) are 20 years old and retire at 65 years old. If we only look at the difference in costs and assume an average return of 5% per month for both of them, then Mr Paddy will retire with 164 thousand euro and Mr Berczyk with 138 thousand, a dazzling 20% difference! But, Mr Paddy is free to choose his own strategic asset allocation. Assume now that he simply chooses for equities till he’s 55 years old and the last ten years uses fixed income investments, while Mr Berczyk will always have a 50/50 investment over bonds and equities. In that case we expect Paddy to retire with 121 thousand euro in his pocket and Berczyk with 90 thousand, a difference of almost 35%. But that is not the most important here. Paddy can as he get closer to retirement change to a safer strategic asset allocation and completely eliminate the risk of a large market drop-off in the last years (when there is no chance that his investments will recover till retirement, because the time is too short), while Berczyk cannot. If the markets drop off a cliff the month before Berczyk' retirement (assume 30%), then Berczyk will have to live with about 50% of Paddy!

Sure, a 30% drop-off is extreme on a diversified portfolio, but of you have been working 45 years for those savings even a 5% drop-off will not make Berczyk smile. It is not too difficult to eliminate most of the cost inefficiencies, but the worst of all inefficiencies is the fact that Berczyk cannot change his strategic asset allocation. And that can be changed without any effort at all: simply delete the ridiculous law that forces OFEs to copy each other or face penalties and rather encourage that they offer a 3 or 4 different risk profiles for the investor to choose from. The actual system where a pension fund that differs in performance risks to have to pay into the fund is a very costly one (the owners of the pension funds are very cautious after the many mood changes of many governments, but especially the last will make a PTE their worst investment … that is probably the most important reason of the high management fee). That system is of a demagogic importance, but intelligent people as Mr Rostkowski and Mr Tusk should be able to look through that and do what is best for the Polish Citizens: change those rules and explain why.

On top of that, if we assume –in the worst scenario– the reduced payments of to the private system, Berczyk will have only 20K, that is six time less than his twin brother in Ireland. For the rest he would have to rely on the charity of the working generation in the future to continue to add something to his pension from the running balance. That new generation could then well be in an impossible situation because of the extra pressure that Mr Roskowski added to the current national balance (combined with some future problems).