Private Pension Funds: Solutions and Alternatives

LFMI, in co-operation with the parliamentary Budget and Finance Committee, held a seminar “The Law on Pension Funds: Solutions and Alternatives,” November 19 The seminar was designed to address the main problems and solutions regarding the draft law on pension funds and to review world-wide practices in establishing and regulating pension funds. The event was co-sponsored by the US Agency for International Development, the World Bank, and the United Nations Development Program. The seminar drew over 70 participants, including members of parliament, top government executives, pension and capital market specialists, and the media.
Ways to protect the interests of pension fund members were analysed by David Lindeman of the World Bank. Rafael Rofman, Head of the Economic Research Department of the Argentinean Pension Funds Supervision Institution, spoke about the origins of pension fund risks and risk management mechanisms. Finance Vice-Minister Laima Urbšienė presented the government’s position on the law on pension funds. State policy in providing for fully-funded pension insurance was related by Prof. Kęstutis Glaveckas, Deputy Chairman of the parliamentary Budget and Finance Committee. LFMI’s Social Policy Analyst Audronė Morkūnienė looked at major solutions and alternatives of pension fund models. Interaction between pension funds and assets management companies on the capital market was investigated by Bronius Žibaitis, Executive Director of the Assets Management Company of Vilnius Bank. The Free Market presents LFMI’s President Elena Leontjeva’s paper on the premises and effects of the arrival of pension funds in Lithuania.
The Arrival of Pension Funds in Lithuania: Premises and Outcomes
The agenda of the conference contains a number of words denoting the choices we have. These words are alternatives, options, ways. Today – when the draft law on pension funds is on its way to parliament – is probably our last chance to speak about alternatives. Later on we will speak about a concrete model and about the enforcement of one provision of the law or another. Today I would like to reflect on why a draft law on pension funds saw the light of day and what the main prerequisites for private pension insurance are.
When pension reform is launched, people should be given a possibility to use private retirement provision. The changing demographics and other downward trends suggest that people can no longer hope for, nor rely on, the steadily shrinking government largesse. This means that the earlier we start getting ready for other options, the easier it will be to change the paternalist way of life and to prevent major downfalls. In promoting private retirement provision, we have always stressed that it is not a governmental but a market solution. As people opt for private insurance on the market, they choose the MARKET with all its features. As we all know, a market may rise but it may also fall. What is important is that these rises and falls are dependent on the market itself. Sadly, state interventions result in market fluctuations being triggered not by market forces but by governments.
Think about what would happen in Lithuania if most people started to accumulate retirement provision on a private basis. The money otherwise handed over in taxes to the government and redistributed through the state budget would be accrued in private funds and invested in the market. Invested in effective ways, it would bring in maximum possible returns.
Much has been said today about obstacles to effective investment performance. Let me reflect briefly on some of them. First, the role of guarantees. We have heard compelling arguments against investment return guarantess in voluntary supplementary insurance. I believe that we in Lithuania should stick to this principle too. Investment return guarantees significantly affect insurance performance. We have analysed the experience of countries with operating private insurance funds. They suggest that retirees in countries with the lowest guarantees are averaging the highest returns, while in countries with the biggest guarantees returns constitute a mere 4 to 5 percent. Investment returns in the countries with minimum guarantees exceed 10 percent. Now think about what level of returns such investments would bring for a person with an insurance record of 30 years.
If private pension insurance is to be launched, government interventions in the market should be reduced to the utmost. If we want companies capable of an efficient use of resources to succeed on the market and generously repay their investors, they must operate under conditions of free competition. This means that none of them should be allowed to prosper at the cost of subsidies. Moreover, if competitive conditions are distorted, a bankrupt company may devour the investments of future pensioners. But it will be no consolation to know that the company itself is not at fault; that it is state intervention that put it out of business. So before launching private pension funds, government interference should be terminated and the market should be allowed to operate. Returns would then be easy to predict and would tend to even out over time.
When we contemplate pension reform, we should remember that the primary purpose of private pension funds is to provide retirement provision. Pension funds should not be saddled with the task, however significant it might be, of revitalising local industries or capital markets. The main concern of pension funds is to secure maximum returns and safety for the insured. For this reason, no restrictions should be placed on pension funds’ investments abroad or any sectors of the domestic economy.
The draft law on pension funds have seen many metamorphoses. One of the disputes was related to whether pension funds should operate under a defined-benefits or a defined-contributions scheme. The decision was almost unanimous that a defined-benefits system is unacceptable for Lithuania. It involves a great deal of risk and is being discarded around the world. We should therefore start with defined contributions, which secure that all investments will return with an increment, whatever size it is. It is interesting to note that while we are talking about a defined-contributions scheme, the latest amendments to the draft law sound like defined benefits.
I would now like to look at the role of normative guarantees. The draft law proposes that minimum investment returns be tied to average annual interest rates on bank deposits. For one thing, the minimum annual return requirement may lead a pension fund to bankruptcy, because some years may not bring any returns at all. No one has answered so far where the money required in such cases should come from. Financiers understand pretty well that every financial system should be coherent and sound. If money is lacking, no spells and no fine words will create it. So a system like this is very likely to provoke failures, scaring off many potential market entrants.
Another reason why minimum returns are unacceptable is that a rising market may bring higher returns than the banking sector. If a minimum is used as a benchmark, the system (especially an uncompetitive one we are likely to have) will provide only minimum returns. All pension funds will tend to pay, even at the best of times, only the mandatory amount equal to the average interest rates on bank deposits. Why? Because there will be no incentives to pay more. On the other hand, pension funds will have to form reserves for bad years. The system will level out the benefits which could be offered by different pension funds, thus predisposing them all toward average interest rates in banks. Is this what people seek through pension funds? Not at all. People use pension savings in order to take advantage of capital markets.
The draft law states that pension funds will offer pension programmes. These programmes are supposed to differ in their investment policies, strategies and risks. But what’s the point in offering different programmes – one oriented toward shares, another toward treasury bonds, etc. – if, in the final analysis, each programme supplies de facto the same minimum return? Obviously, a system like this is not beneficial for the insured. If the government wants to take care of those people in society who are unable to take care of themselves, it may require at worst one mandatory programme with minimum returns. All others who are ready to take market risks and responsibility for their own lives will not be humiliated and will enjoy freedom of choice.
Asset management companies will play an important role in developing a pension fund system. In Lithuania, however, asset management companies may be reluctant to get involved due to double barriers imposed on the system. Under the draft law, pension funds are subject to strict minimum capital and capital adequacy requirements. The same requirements are applicable to asset management companies. Under such conditions, no one will be willing to start up a pension fund beside a management company, to put four million litas in each and to discharge other overlapping liabilities.
Critics charge that pension funds will benefit only a small group of well-off individuals but will fail to meet the needs of the general public. Yet, if proper conditions are created, pension funds will be able to do both. To achieve that, however, government solutions and people’s thinking should change. We should renounce state paternalism. If people realised that they should take responsibility for their lives, they would do that right away.
Sadly, there are no signals from the state in that direction. Quite the contrary. A law has been passed lately stating that part of revenues from excise duties will be used to support culture and sports, those very areas of life where market relationships are evolving and people are beginning to take initiative and use their talents and property to offer private solutions. As the old system is being reanimated, people are being discouraged from starting, say, an arts business and urged to register with the Ministry of Culture an organisation that will be financed from the ministry’s budget. Of course, one cannot expect that pension provision will be treated differently. After all, the same laws apply everywhere. If officialdom encourages people to use private insurance but at the same time spends taxpayers’ money to finance their less important private needs, people won’t know by what rules to live.
Let me also mention changes to the tax code which should enable people to invest in private pension funds. Such changes are no doubt essential but not sufficient. If we want middle-income people to rely on private pension insurance, we should think about lifting the total tax burden carried by them. One newly adopted law promised that taxes levied on large foreign investors will not be raised. Sadly, no such law was promised for the people and investors of Lithuania. If people are relieved from some taxes but forced to surrender through other taxes the same amount of money, they will not be better off as a result.
Another concern is whether private pension insurance should be mandatory or voluntary. If the state social insurance system were confined solely to the provision of minimum pensions, a ceiling would be put on social security contributions. If only minimum pensions were secured, people would start thinking about private insurance. Large-scale insurance would be achieved not through coercion but naturally, since people would expect but minimum benefits from the state. Many people would choose private insurance and there would be no need for any mandatory systems. What is more important, lower taxes and social security contributions would furnish real money for that purpose. Such reforms are crucial if we want not five percent but most people of Lithuania to turn to private pension funds.
Seminar Conclusions
Seminar participants concluded that the requirement for minimum investment returns stipulated in the pension fund bill would prevent the rise of pension funds in Lithuania and undermine the interests of pension fund participants.
According to the bill, every pension fund is required to secure for its members investment returns not lower than average interest on residents’ bank deposits. If real income happens to be lower, a pension fund will cover the shortall from equity capital. If equity capital fails to meet the shortfall, the pension fund will be pronounced bankrupt. A single case like is likely to undermine public confidence in capital markets and private fully funded insurance.
The draft law requires that minimum investment returns must be secured every year. This requirement may prove hard to fulfil. Interest rates on government securities fluctuate mostly due to political and exchange rate risks, but they are expected to drop and become stable in the future. The value of shares on the capital market fluctuates, making it hard to secure investment returns on a yearly basis. Given that pension funds make long-term investments, fluctuations in the prices of securities tend to even out over time. Therefore the requirement to guarantee minimum profitability on a yearly basis is unjustifiable and inexpedient.
The draft law is intended to create a system of large, robust and reliable pension funds by placing on them strict capital requirements. Yet, this may inhibit the rise of pension funds, thus failing to create conditions for extensive competition. It is anticipated that despite the growth of the capital market, pension fund members will receive levelled, close-to-minimum investment income.
This shows that instead of protecting the interests of pension fund participants, the requirement for minimum investment returns will have adverse effects.
If pension funds delegate the task of managing their assets to asset management companies, all pension fund liabilities to members will be shifted onto the asset management companies. These will be required to guarantee minimum profitability of pension programmes and to discharge other liabilities. The seminar concluded that such a model would not be viable as no prerequisites would exist for establishing and running asset management companies.
If asset management companies assume pension fund liabilities, they will be subject to the same equity, capital adequacy and reserve requirements as pension funds. This means overlapping requirements – and operational constraints for that matter – which will discourage the use of asset management companies in pension insurance.
The purpose of delegating asset management to management companies is to enhance professional administration of pension fund resources. This approach is widely used around the world. Management companies may even be oriented to operating on one market or another. Under the conditions stipulated by the current pension fund bill, pension funds will not be interested in hiring management companies. These, in turn, will not be willing to conclude agreements required by the law. This will no doubt suppress the development of pension funds.