Tim Gosling in Prague -

In May, Slovakia become the latest Central European state to put pension reform into reverse in a bid to shore up its budget. Whilst the move may offer some respite from the crisis in the short term, looking further ahead analysts worry that the region's governments are "accelerating towards a brick wall".

Pledging to reel in the budget deficit after returning to office in April, Slovak Prime Minister Robert Fico recently announced a raft of new taxes, as well as a cut "to 5-6%" of the current 9% of a contributor's tax base that flows to private pension funds. That makes Bratislava the sixth CEE country since the crisis hit in 2008 to roll back pension reforms enacted in the last decade or so.

Joining Lithuania, Latvia, Romania and Estonia, which temporarily stemmed contributions to private pension systems in 2008-09, Hungary and Poland started kicking at the second pillar early in 2011, peeling back pension reform conducted in the 1990s by diverting compulsory private pension contributions to the state.

Whilst Warsaw's cut (from 7.3% to 2.3% of wages) in contributions to private pension funds is permanent, the Poles have been restrained compared with Hungary, which obliterated the second pillar when it halted all mandatory contributions and essentially nationalized over €10bn in private pension assets. The country has spent the time since mopping up those fund mangers that remain. Aegon, one of the world's largest pension fund operators, finally took the hint in March and closed its fund. "In Hungary they didn't just cut the flows, but took the stock," says Peter Kadesca, director of asset management for Aegon in CEE. "Around 96% of savers returned to the state. It made us ask if it was worthwhile to operate a fund fighting for just 4% of the population. At first, we thought it would be okay, as the government promised to return to the private pillar in December - but that never happened. We were left with a very small fund with no growth prospects."

Storing up trouble

Whilst Hungary is an extreme example, the temptation of huge volumes of funds sitting within the grasp of governments is easy to understand in the midst of crisis, especially as the EU puts a new emphasis on fiscal management. As the International Monetary Fund (IMF) pointed out in a 2011 report, the recent austerity drive implemented by Brussels in a bid to rein in debt and deficit levels acts to penalize those countries that rolled out a second pillar in the last decade or so. With flows diverted to private funds, CEE states still waiting for the payout phase have had to raise borrowing and loosen deficit limits to meet ongoing obligations.

However, as Juraj Kotian, economist and head of fixed income at Erste Bank, points out, countries in the region are storing up a lot of trouble for later. "In the short term, it significantly helps governments with fiscal consolidation," he agrees, "but for the sustainability of the pension system, it's pretty dangerous. It increases the future liabilities of the government, as the negative effects of demographic trends grow. It's like accelerating a car as a brick wall approaches."

That brick wall is built of an ageing population. According to the IMF, the demographic dependency ratio (pensioners to working population) of the new CEE member states (Bulgaria, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia and Slovenia) was around 17% in 1990, but threatens to rise to a projected 63% by 2060. Kotian estimates there are "currently, around six workers to each pension in Slovakia; in 2050, there will be only two."

Yet given the time it takes for the benefits of pension reform to be felt - not only the relief for the state system, but also employment levels, national savings rates and capital market development - it takes no little determination to stay the course. The pressure is so great right now that even insurers such as Aegon can comprehend the pullback. Kadesca suggests that "the politicians and people don't care so much about the longer term right now, and I think the markets understand that."

Kotian, noting that "there's still discussion and pressure in Slovakia over whether private pensions can provide a solid payout at all," suggests that this empathy between the markets and the governments could be in for a further test. "We're likely to see further a further squeeze on flows to private funds in Poland and Slovakia as the crisis deepens," he predicts.

The long road back

Complicating matters further, the slow results of pension reform will make it harder for governments to go back to a second pillar once the economic crisis passes. "I'm not sure these countries can simply return to the second pillar," says Kotian. "The transitional period and costs are a clear disincentive for politicians. Uncertainty in the system over both the accumulation and payout phases will make both providers and savers wary."

Whilst at pains to stress it is merely a personal view, Kadesca suggests that would very much be the case for Aegon in Hungary. "It's just my opinion - decisions like that are made in Amsterdam - but without very strong guarantees, I think we would be unlikely to go back to Hungary."

There are alternatives on the horizon in the region however, with one country headed in the opposite direction. The Czech Republic, nowadays a favourite amongst austerity-minded economists, is leading its first major attempt to overhaul its pension system since the fall of communism with a plan to introduce an opt-out second pillar in January. The scheme, which is forecast to cost the state over €800m in lost revenue in the first three years, will see private funds receive 3 percentage points of the social security contribution - currently 28% of wages - with savers required to make an additional contribution of 2% of their wage.

In the run-up to the reform, Prague has increased the retirement age, reduced disability payments and pension payout growth, and amended the first pillar - moves the IMF has welcomed as a "resolute" implementation of reform. The Washington-based lender said the changes have already improved the system's sustainability "considerably", cutting forecast deficits in the state pay-as-you-go scheme for 2040-2060 from 4-5% to 2% of GDP. "I hope they go through with it," says Kadesca, who disagrees with critics of the Czech reform who say it should have been made mandatory. "There have been mistakes made in the region. To an extent, I think making private funds mandatory can be an excuse to close them later."