Grubišić: Investments in the second pension pillar should be at least partially liberalized

A few weeks ago, the Association of Members of Mandatory and Voluntary Pension Funds was established with the primary goal of establishing a sober, reasoned, and fact-based dialogue with representatives of the legislature, regulators, and pension fund management companies, with a special emphasis on mandatory pension funds – the so-called second pension pillar (albeit with the inevitable addressing of the issues of the entire pension system), all from the perspective of more than 2 million members who currently manage 126 billion kuna in assets in private accounts.

The intention is to try to offer proposals through a partnership approach that will contribute to incremental changes in order to start creating a system that will provide the possibility of pensions that will deliver greater real purchasing power to future retirees than that enjoyed by current retirees. Part of the challenges related to the existing pension system arises from the small absolute amount that is deducted from salaries for pensions (primarily due to low wages suggesting low economic development) combined with a small relative share of actual investments in operational assets behind which productive activities stand.

‘Good-natured Ponzi scheme’

Namely, within the existing pension system, out of 100 kuna in pension contributions, 75 kuna goes to the so-called first pension pillar and is used for paying pensions to current retirees, while the remaining 25 kuna goes to the mandatory second pension pillar (fund). Contributions to the first pension pillar do not represent an investment as the money is immediately spent and does not generate any return for contributors. The only hope for contributors is that in the future there will be enough people whom the state can compel to contribute to their pensions.

Essentially, although this practice has come to be referred to as ‘generational solidarity’, an alternative name could be ‘good-natured Ponzi scheme’. The problem is that no one can guarantee the existence of a sufficient number of people who will contribute funds in the future and the level of productivity of their work. This is not solely a demographic issue but also involves increased labor mobility in the unified European labor market.

In this sense, part of the solution is sought through ‘private’ investment of the remaining 25 kuna in the second pension pillar. According to existing regulations, citizens have no choice but to allocate funds to one of four mandatory pension funds, which does not encourage competition as mandatory pension funds essentially have a monopoly over these contributions, and the existing structure of investments of mandatory pension funds shows that 60 percent of their assets are in Croatian government bonds, which is not in line with the fundamental principle of diversification in terms of concentration of assets in securities of the same issuer, and the fact that a government bond does not represent an instrument that pays interest (coupon) from inflows generated from productive business activities but from taxes paid by those same investors in pension funds, leading to the paradox that it is in the interest of members of the second pension pillar to achieve the highest possible return at a given level of risk, while at the same time those same members finance the interest that the state pays on bonds through various taxes.

On the other hand, if interest rates on bonds are low as is the current situation, this means limited need for tax payments, but at the same time it also means that we achieve modest returns on investment for all bonds issued under such circumstances. In fact, existing yields on government bonds are negative in real terms as nominal yields are lower than the inflation rate.

It is fair to state that the share of government bonds in pension portfolios has been smaller in recent years than it was. Pension funds within category A have achieved an annual return of 7.5 percent from the summer of 2014 to today (1.15 billion kuna in current assets), within category B from 2002 to today 5.5 percent (116 billion kuna in current assets), and category C from the summer of 2014 to today 4.7 percent (7.7 billion kuna in current assets). The weighted average annual return of all funds is around 5.47 percent.

Three essential facts

I am not inclined to criticize part of the public that views returns in the short term given that pension investment is a long-term game. However, it should be noted that a 1 percent higher annual return (with comparable risk) would mean 12 billion kuna more in assets or six thousand kuna per member.

This is not a criticism of historical returns, although it is legitimate to compare them with comparable portfolios or well-known global indices (e.g., the S&P 500 has achieved an annual growth of 7.08 percent from January 2002 to today), but rather pointing out three essential facts: (i) very small differences in annual returns over the long term have a significant impact on the total value of members’ assets, (ii) returns in pension funds are effectively lower from the perspective of members as they have (co)financed the interest on bonds through taxes, and (iii) 75 percent of the allocation for pensions (contributions to the first pillar) carries no return.

I believe that over time it is necessary to adjust the system in such a way that the share of investments in instruments behind which potential productive activities grow by opening up to the world (equity and debt securities of companies, ETFs that track global indices, investments in private equity and VC funds, etc.), along with a gradual continuation of reducing the share of Croatian government bonds.

In the long term, investments in the second pension pillar should (at least partially attempt to) be liberalized (in terms of voluntary membership and the possibility of using those funds) in order to develop awareness of the existence of that asset, the results it achieves, but also to develop competition where members (investors) will need to compete in the open market.

Finally, it is necessary to adjust the functioning of the first pension pillar. The Association will try to constructively assist in achieving the necessary gradual adjustments of the entire system for the benefit of all those who plan to achieve retirement based on work in Croatia.