POLISH PENSION REFORM

1. POLISH PENSION REFORM Presenter: Dariusz Stanko Ministry of Labour and Social Policy

2. Strengthening the link between contributions and benefits: Polish NDC (first) pillar

3. Why NDC in Poland ? High pension expenditure due to: Relatively generous pension formula on average 80% replacemet rate little link between earnings history and pension level Early retirement wide-spread early retirement privileges average retirement age: 55 for women, 59 for men virtually no incentives to postpone retirement Public preferences: pension should be linked to paid contributions Long-term outlook: population ageing, thus need to prolong working lives and increase retirement age

4. New systemArchitecture

5. Design of the new pension system in Poland (1) New Polish pension system is: defined contribution with two accounts: non-financial and financial The old-age contribution was divided into: NDC 12.22% of wage FDC 7.3% of wage Rates of return: In the NDC are linked to the wage fund growth In the FDC depend on the financial market returns Persons below 30 (in 1999) have both NDC and FDC accounts Persons aged 30 to 50 had a choice of one (NDC) or two (NDC+FDC) accounts 53% of them chose to have two accounts Persons over 50 years of age stay in the old system

6. Design of the new pension system in Poland: Close link between contributions and pensions: Shorter working lives Lower wages Result in lower pension savings Promotes: Longer working lives Higher earnings

7. First TierNDC Pensions

8. First Tier Initial Capital

9. First TierDemographic Reserve Fund Created in 2002. Year 2009 – an extension? Funded part of the public tier (currently 0,4% of NDC pension contributions) Accumulates surplus in order to finance upcoming deficit Allows to adjust to demographic fluctuations Reduces dependency on the state budget Since recently – equity part; passive investment

10. FRD (Demographic Reserve Fund): Investment limits

11. Asset allocation of FRD

12. FRD: Investment strategy Passive investment for stock portfolio Replication of WIG, monthly purchases low investment costs (0,06% of average assets) reduction of systematic risk List of stocks kept changing each month: weights of companies in WIG index are variable, structure of WIG subject to periodic modifications, turnover for some companies comprising first 30 companies with the biggest shares in WIG were not sufficient for investing in them resources of FRD.

13. Performance of FRD1 Jan 2005 – 30 Sep 2006, stock portfolio

14. Performance of FRD1 Jan 2005 – 30 Sep 2006, bond portfolio

15. Treatment of special privileges for certain occupations

16. Earlier retirement (I)Only in the old pension system (but miners are exception): Jobs with unhealthy or special conditions or requiring special abilities. Applicable to workers born before 1 Jan 1949 and workers who fulfil those conditions before the end 2008:- f: @ 55 yrs old – 30 contributory and non-contributory years or @ 55 yrs old – 20 years of contributions and unfit to work- m: @ 60 yrs old – 25 years of contributions and unfit to work Also, those born before 1 Jan 1949 can retire earlier – before 60 years old (women) and 65 (men) if their rights come from separate regulations: war disabled, war heroes, civil workers, forced mine workers during the II WW, disabled due to work accidents, working in special conditions etc.

17. Earlier retirement (II)Only in the old pension system (but miners are exception): Early retirement despite of age: teachers born before 1 Jan 1949 with 30 yrs work experience, 20 years must be in special conditions etc. railway workers (f55, m60) parliament and upper house members, who till the end of 31 Dec 1997 had met conditions for earlier retirement, i.e. 30 years’ contribution period for women and 40 – for men, Carers of children with special needs

18. Early retirement and labour market outcomes Increase in early retirement provision is accompanied with drop in employment rate of older workers Rising inactivity rate of people 55+ does not correspond to rising employment of younger workers

19. Separation of social assistance from social insurance

20. Minimum pension guarantee Topping up pensions to the level defined by the law: Due to the indexation mechanism, relation between minimum pension and average wage is likely to fall Since it adds to joined benefits from the first and the second pillar, possible solutions in the funded pillar affect the probability and value of potential payout (option): - minimal required rate of return - investment limits - payout options (programmed withdrawal) etc...

21. Minimal benefits from social insuranceas of 1 March 2006 Requirements: m : 65 yrs old and 25 years of contributory and non-contributory periods f: 60 yrs old and 20 years of contributory and non-contributory periods Current value of benefits (from March 2008): minimal pension, minimal total disability pension, minimal survivor pension 636,29 PLN minimal partial disability pension 459,57 PLN Exchange rates: 1 PLN = approx. 2,4 USD; approx. 3,6 euro

22. Impact of reforms on labor costs

23. New systemContributions Contribution is paid by employee and employer: old-age: 50% employee, 50% employer disability: 50% employee, 50% employer sickness: 100% employee work injury: 100% employer (0,67% - 3,6% according to risk level)

24. Pension systemProjections for the future - no reform Pension expenditure would increase: from 11% of GDP in 2000 to 17.3% in 2050 By the same time, the number of pensioners would double from 7 million in 2000 to almost 15 million in 2050, of which: more than 10 million old-age pensioners Total pension deficit would exceed 7% of GDP Based on Social Budget Model, the Gdansk Institute for Market Economics

25. Population structure in Poland

26. Types of financial consequences of pension reform Long-term: reduction of long-term pension system liabilities (implicit debt) Short and medium-term: increase or decrease in the public finance deficit due to pension related expenditures (explicit debt)

27. Transition costs In multi-pillar pension systems a part or the entire contribution is transferred to pension funds current pension payments require financing a transition deficit occurs Options to finance the deficit: current revenue from tax or other sources for example privatisation in Poland pension savings or public expenditure savings changes in pension formula changes in retirement age changes in pension indexation future revenues - increased explicit debt

28. Misunderstandings regarding reform costs Transfer of a portion of contribution to funded pension scheme is not a cost (but strains on liquidity) it reveals a portion of the implicit debt and it reduces future public finance obligations Increased funding requirements can be offset by higher debt, purchased by pension funds Pension funds assets invested into equities stimulate investment and economic growth It is better to turn a portion of pension liabilities into savings now than to have much greater problems with redeeming such obligations in the future

29. On macroeconomic level.... Pension expenditure exceeding 10% of GDP Unbalanced pension system requiring state budget subsidies Between 1999-2006 the overall level of subsidies increased mailny due to inbalances in the pension system – transition costs accounted for less than a half of total subsidy

30. Long-term projections Main ways of expenditure reduction: increase in retirement age actuarially balanced pension benefits Rate of return on NDC accounts equal to the wage bill growth Takes into account both changes in wage level and number of covered workers Benefit indexation – below wage growth level several amendments up to date, but revenues grow faster than expenditures

31. Change in pension expenditure level is not correlated with multi-pillar system implementation Design of the PAYG system matters more in that respect

32. Impact on adequacy? Compared to the value of contributions paid: Value of pension accounts in OFE are much higher than in ZUS Relatively low wage growth Good returns on financial markets If the current developments are continued, expected pensions could be higher Value of individual accounts – ZUS and OFE

33. Future pension level

34. Summary Transition costs in Poland include most importantly the coverage of increased deficit in PAYG scheme: pensions are paid according to the old system rules part of contributions is invested by pension funds level of transition financing: 1.5 per cent of GDP The adequacy of future benefits does not depend on the financing, rather on the type of pension system (DB vs DC)

35. Introduction of the second pillar and readiness conditions

36. Pension funds in Poland

37. Size of the Polish mandatory pension savings industry (Nov 2007)

38. Members and average premiums as of end of November 2007

39. Second pillar in Poland (I) Act of 28 August 1997 on organisation and operation of pension funds (Ustawa o organizacji i funkcjonowaniu funduszy emerytalnych z dnia 28 sierpnia 1997 r.) (Dz.U. 1997 nr 139 poz. 934) OFE - open pension fund (art. 9-26), the fund's Articles of Association (art.13, changes: art. 22-23) A depositary (art. 157-165), paid by OFEs: 2006 – 17,38 m zl (3,21% of operational costs) PTE – a general pension society (art. 27-52): The governing bodies of the society: the Management Board, the Supervisory Board, the General Meeting the Audit Commission

40. Safety mechanisms legal and physical separation of pension fund from managing company legal requirements for PTE and its staff depositary (custodian) investment limits supervision and control by KNF mandatory minimum rate of return so-called cascade of guarantees (Guarantee Fund) minimum pension Treasury as the last resort

41. Guarantee Fund (art. 184 and next ones)

42. Reality of the protection of the whole system?

43. Average industry rate of return

44. Mandatory minimum rate of return

45. OFEs’ rates of return for the period: 30-09-04 and 28-09-07

46. Deficit in the open pension fund

47. System of return guarantees

48. Fees for participating in OFEs Amendment of pension law (15 October 2003) – substantial changes in commissions. Three main sources of income for PTEs: distributional (up front) fee management fee transfer fee (for changing membership in a fund)

49. Up front fee Charged as a % of contribution entering an account of an insured

51. Depends on the results of a fund in comparison to competitors. It can be between 0% (the worst) and 0.005% (the best) net assets per month. Management fee – VARIABLE part

52. Ri – rate of return of a fund, RMIN – rate of return of the worst fund, RMAX – rate of return of the best fund. VARIABLE part – example:

53. Costs of open pension funds 2006 Open pension funds: 1,49% of average yearly assets Mutual funds (stable growth): 1,67% of average yearly assets Fees in open pension funds regulated, more transparent – cheaper? Mutual funds are expensive in Poland, however.

54. Readiness conditions IT infrastructure Wide political consensus „Window of opportunity” (Polish case) Market infrastructure (depositary banks, clearing houses, size and liquidity, instruments available vs investment limits) Staff (managers, investment advisors) People’s ability to understand financial markets and financial information (informed choice?, drivers for competition?)

55. Lessons learnt

56. First pillar:Information is a challenge The philosophy of the new systems is to assign contributions to individual accounts This requires efficient and well designed IT technology But also ways to avoid errors made by those who transmit information: employers banks Contributions that are not assigned and not registered and do not increase individual’s pension rights

57. First pillar ZUS - Correctness of information

58. First pillarAccount statements First account statements for 2001 – summarising contributions paid mailed in 2003 In subsequent years: Contributions for current periods (up to 2005) Plus contributions paid in 2000 In 2007: first information on full NDC account status

59. First pillarInitial capital Initial capital calculation turned to be a difficult administrative task Equivalent of retirement of 11 million individuals Problems in retrieving past wage and earnings history Changes of the employers Creation and destruction of companies But: problem would have been more acute in the future Initial capital calculation completed by the end of 2006

60. First pillarPension debate after 1999 Still different retirement ages for men and women at 65 and 60 respectively No political nor social consensus to equalise retirement ages Problem of falling future replacement rates: Particularly for women due to lower retirement age Increased indexation of notional accounts from inflation plus 75% of real wage bill growth to inflation plus 100% of real wage bill growth Financial stability of the pension system in the long run Poland assessed as low risk country in long-term perspective Early retirement Preservation of early retirement rights for additional year until the end of 2008 – watering down the initial reform plan Still no decision on the bridging pensions that replace early retirement for some groups

61. Conclusions Lessons up to date Quality of information must be assured All participants are equally responsible for adequate performance of the system Computer system is important…. …. as well as system managers Proper identification should be ensured Procedures should be designed to avoid errors Implementation takes time – also as far as retrieving past wage history Difficulties in overcoming societal believes: Retirement age of women Widespread early retirement widely accepted Political opportunity needs to be seized: all reform items should be placed as soon as possible

62. Raising retirement ages for women Reducing the poverty risk for women Promoting more gender equality Re-defining the role of minimum pension Current indexation mechanism is reducing the role of minimum pension guarantee Projections show its limited role in reducing the poverty risk for those with low wages and short working careers Re-design is needed to develop adequate poverty protection mechanisms in the future Relatively fast economic growth may lead to increased income differences between retired and working generations Building pension-literacy so that people react to the incentives OFE – multifunds, investment limits, performance evaluation needs to be revised/introduced Annuities market

63. Pros and cons of the reforms undertaken

64. curbing the implicit debt, showing explicit debt – long-term financial stability adjusting to current social and demographic situation labour market incentives externalities (growth, savings, capital market development, financial market stability, mgmt efficiency etc.)

65. Management of the transition and reform process

66. Transition method – by cohorts Method of calculating accumulated capital in the previous system – by initial capital (not by bonos de reconocimiento) Financing of transition costs – privatization revenues, government taxes Government Plenipotentiary for Pension Reform – „super office” Stability of political commitment – cases for revising of the reform (miners, Slovak case – euro problem etc.)