Friday, September 21, 2007

Romania: Pension Overhaul

Oxford Business Group Latest Briefing

It is rare day when rhetoric reflects reality. Particularly, when the rhetoric in question is political. But, as with all things, there are exceptions to even this steadfast rule. On September 17, the Romanian government, along with 17 private funds, launched the much-anticipated mandatory private pension scheme. The speeches, which accompanied the announcement, were laden with rhetoric. For once however, the themes and imagery used were appropriate for the scheme, its timing, impact and place in the Romanian historical record.

President Traian Basescu called the programme a "heavy blow" to the "paternalistic state". Varujan Vosganian, the minister of economy and finance, said it represented "the end of the process of transition from a socialist economy to a capitalist one". The programme from the outset was dubbed the "second pillar" for its place as one of the main foundations of the Romanian economy.

While many may regard these words as flamboyant there is some truth to them. The state pension scheme was among the final bastions of the old communist system to remain intact. Its mismanagement and inequitable method of calculating pensions was a glaring example of Romania's troubled past.

The replacement of this "old pillar" will have as much of an effect on the way the Romanian population saves for retirement as it will on the rest of the economy.

The programme has the potential to reshape Romania's capital markets sector, the population's view of savings and investment and close some of the final holes in Romania's notorious grey economy.

More than 3m salaried employees will be invited to join the private pension funds. Half of them, those under 35 years of age, are required to choose among the 17 funds available within four months. Those who do not choose one by January 17, 2008, will be automatically assigned a fund at random.

As the funds have no history in the market - and thus no track record of investment success or failure - pensioners can base their decisions only on the advertising campaigns of each fund. Knowing this, the funds have deployed an army of some 250,000 marketing agents whose primary goal is to lure people to their respective companies.

Those aged 35 to 45 can choose a fund at any time until they turn 45 but are not obligated to do so. If they do not join the optional pension scheme, they will have to relay on the state pension. Under this scheme pensioners get an average 100 to 200 euros a month when they retire. To be eligible men must be aged 63 - with 31 years of work - while women can retire at 57 and nine months - with only 25 years and nine months of work.

Currently employees contribute 9.5% of their salaries to the state pension fund. In the new scheme, 2% of this will be redirected towards their chosen private pension fund. The percentage will then increase annually by 0.5% over the next eight years up to a maximum of 6%.

While this may appear small compared to pension schemes in more developed economies, its impact on the Romanian economy promises to be enormous. This is particularly true for the country's capital markets sector. Management companies estimate that private pension funds will reach their first billion euros in managed assets by 2010. These assets will continue to increase over the following 10 years and should reach, by some estimates, 10bn to 12bn euros by 2020.

The scheme will almost certainly increase the exchange's daily volume of trading, which has struggled to pick up pace. The number of Romanians actively investing on the Bucharest Stock Exchange stands at around 10,000 to 15,000. If passive investors - those who invest in mutual funds or who have an insurance policy with a savings and investment component - are included the number increases to around 300,000. This is only a fraction of the number of people who are about to descend on the market via the mandatory pension funds.

Increased volumes and higher market capitalisation are exactly what most analysts have said the market needs to attract more companies to its indexes. Analysts hope the government's stake in the scheme's success will foster quicker market reform, more state privatisations and an overall improvement of the regulatory environment.

The state hopes the scheme will also give an incentive to those who have been hiding portions or all of their income from the state to come clean. As the scheme is percentage-based, individuals will be able to deposit into their pension fund only money they admit having.

In the old system there was an incentive to hide money as individuals had to pay a portion of their income in pension taxes. As this money did not come back to them directly, many were apt to hide money to avoid paying the tax. Under the new scheme, their money will be invested into accounts in their names in amounts that correspond to their admitted income. While this change will not completely remove the incentive to cheat, government officials believe it will lure a large portion of people back into the light. This in turn may improve government coffers and provide officials with a more complete picture of the economy as a whole.

Despite this long list of benefits, there are risks. Only a small fraction of those who will be forced into the private pension scheme have any formal education in stocks, derivatives or currency trading. Optimists may argue that fund managers will provide a buffer to this inexperience but it is almost certain that some investors will lose their savings. If that happens, the government will have to step in to support them in their retirement.

Whether this scenario is common or rare depends on the whims of international investment climate, the responsibility of fund managers and the speed at which the average Romanian is able to learn the basics of investing.

Such worries may have traction among average Romanians who are wary of pension funds - due to their dubious past in the country. In 1992, a pyramid investment scheme called Caritas attracted up to 50% of the population's private savings before it reached a point when it could no longer make promised payments. Some 4m Romanians lost their money in the scheme.

The funds, politicians and regulators worked hard on Monday to convince Romanians the new programme is nothing like Caritas or the old scheme. Among the most compelling arguments was the imagery of the pillar. In their speeches it came to represent the new Romania. The pillar certainly looks to be more soundly built than the last. This may allow it to hold more weight and in turn allow for a bigger structure above it. Few would argue that a bigger house is better. What about a bigger more robust economy?

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