A Czech'ered solution to the pension problem

By bne IntelliNews February 25, 2011

Nicholas Watson in Prague -

The Czech government said February 22 it expects its pension reforms, which include a tax hike and new private savings pillar, to be approved by parliament in the autumn of this year, ready for launch in 2013. But experts say the changes are unlikely to make it through in their present form and, some argue, would do little to address the main problems with the current system in any case.

On February 17, the centre-right ruling coalition presented the first draft of its planned pension reform, which is part of a regional trend of Central Europe and Eastern European governments attempting to rejig their pension systems to plug growing holes in their budget deficits, exacerbated by the global economic crisis, caused in part by the expensive and increasingly unaffordable pay-as-you-go systems currently in place.

Short of the "African model" where families comprise a large number of children who will care for their parents in old age, governments are finding there is no ideal fix to theses problems with their pension systems and should probably involve at least one of the following unpopular changes, which makes the problem so knotty for governments to deal with: to lower pension benefits; to increase the retirement age; to increase pension payments.

Tax and save

The Czech government's basic idea is to introduce higher taxes and private savings to try to balance the pension system, which showed a CZK29bn ($1.18bn ) deficit in 2010, which was about 0.8% of GDP.

The main plank of the reform is to offer people the option to allocate some of the money they currently have to pay into the pay-as-you-go pension system into private pension funds instead. The plan offers people the option to divert 3 percentage points of their current pension contributions (which now total 28% of the gross wage) towards the private part, on the condition that they contribute an additional 2% in excess of their current contribution, taking the overall contribution to 30% from 28%.

At the same time, the current pension fund providers would be transformed and licensed afresh, while new ones would be allowed to enter the market. There would be a strict separation between the assets of the fund and those of the clients. And funds would be required to offer several investment profiles for clients to choose from, with one "safe option" offering investments restricted to Czech government bonds.

Jan Mladek, an economic adviser for several administrations of the current opposition Czech Social Democratic Party (CSSD), which has heavily fought the proposals, says that thanks to a strong media campaign, at least the reform won't involve the compulsory savings pillar first promoted by the main party of the governing coalition, the Civic Democrats (ODS). That kind of reform has been given a bad name in the region by the Hungarian government's effective re-nationalisation of $14bn in private pension assets, which caused consternation from just about every quarter, from the EU down to many of its own citizens. "[The Czech government's proposal] will be a voluntary trap – you can walk into it of your own accord, but you won't be able to voluntarily walk back out," says Mladek.

The switch from a pay-as-you-go system into a (fully or partially) funded system always entails additional costs, as the diversion of part of the 28% social tax into private savings funds will create a wider gap; Finance Minister Miroslav Kalousek told Reuters that the opt-out reform would cost the state CZK20bn a year once the reform is in place by 2013. So to make the changes neutral for the budget, the government is unifying the VAT rates to a single rate of 20% (currently, the Czech Republic has two rates, 10% and 20%), to start as early as next year, which would bring in CZK58bn in revenue per year.

Drawbacks and clawbacks

The main criticism of the Czech proposals, even amongst those who say they are a step in the right direction, is that they leave too many questions unanswered. "The release of the government draft appears to be more of a trigger for discussion than a fully articulated and carefully crafted plan," says Petr Bittner, a macroeconomic analyst at Ceska Sporitelna, a division of Erste Group. "This is evident not only in the haphazard fashion in which the plan is being communicated to the public, but also in the fact that quite a few questions, some of them very important, remain unanswered."

Chief amongst them, he lists, is the question of what a person who opts to put money into the private savings pillar will get from the state-guaranteed part of his or her pension, in comparison with that of a person who chooses to remain in the current system? Also, would there be maximum limits to the fees charged by funds? How would the investment profile of the fund be regulated? (Bittner notes over-regulation can be as detrimental to the returns as under-regulation.)

The main criticism, though centres on the all-too-probable risk that only a small part of the population will opt in, which would mean at the time of retirement too many of the population won't have been saving and now find the state-guaranteed pension too low to live on. This could then lead to the part of the population that saved privately finding its savings confiscated as the overwhelming majority clamours to get its hands on other people's private money (see Hungary now). "The government needs to force or cajole - by at the very least saying outright how much the government pension will be and how much funds can add - a sufficient number of people to opt in. This way, they'll have their own money at stake in the future and won't be as easily tempted back into the state fold," says Erste's Bittner.

Then there's the problem that all these private pension pillars share, whether compulsory or voluntary, that whereas pay-as-you-go systems are mainly subject to demographic changes, private saving systems are mostly affected by developments on the financial markets, which, as recent evidence shows, are increasingly prone to increasingly larger shocks. While a person saving on a individual basis can always cash out of their investments, those invested in the second pillar are not given the opportunity to get out – not even if already retired. Thus, people are forced to run high risks and generate low yields, while many of them would run less of a risk and achieve higher returns if allowed to save on an individual basis, argues Marketa Sichtarova, chief economist at the financial advisory Next Finance.

Few, if any, doubt the current system needs reforming; government studies have shown it will eventually generate deficits growing to around 4% of GDP every year without any change. But critics like Mladek say the coalition's answer would preserve the current disadvantages and add others to them. "This includes an unnecessary increase in state indebtedness while the entire system generates pointless losses," says Mladek.

Even so, the coalition's proposal has at least one thing going for it that few would argue against: it has ignited a debate about pensions, raising the hope that people will be more interested in how their pensions will look and what options they have to do something about it - even if it is just having more kids.

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