The Unbearable Burden of Debt

15. 3. 2017

How the privatization of pensions has ruined
public finances in Poland

In 1999, a radical pension reform took place in Poland. It established a new pension system with a much reduced pay-as-you-go first pillar, a mandatory personal second pillar and a third pillar with voluntary accumulation of savings for your future pension (the third pillar did not attract much interest, so it is of little practical importance). When assessing this reform, we should focus our attention on one of its results, namely the significant paring down of the first pillar, managed by the Social Security Institution (ZUS) and the introduction of the second pillar in the form of private pension funds administered by private financial institutions.

Such a shape of the pension reform in Poland resulted from the pressure of the World Bank and other international financial institutions. They became spokesmen and advocates of the interests of large global financial corporations, including insurance companies and banks. Based on the experiences of the privatization of the pension system in Chile (1981), these institutions perceived an opportunity for making huge profits should such privatization be extended to a large number of countries on various continents. They focused their interest on countries, which were relatively weak economically, for societies of highly developed countries were opposed to the privatization of pensions and staunchly resisted all such attempts by the financial sector.

Since mid-1990s the World Bank promoted a total or at least partial privatization of pension systems in the countries of Central and Eastern Europe. Very few countries of the region (the Czech Republic and Slovenia) managed to resist this huge pressure. Other countries, such as Poland, Hungary or Russia, strongly dependent on international financial aid, struggling with problems of political transition and high levels of foreign debt, were too weak to successfully resist the policy of the World Bank. Together with the International Monetary Fund, the World Bank used its loans and other instruments of pressure as a method of persuading these countries to privatize pensions through establishing a mandatory personal pillar within the pension system.

The essence of this privatization is the transfer of huge sums of money from social security premiums deducted every month from salaries of millions of employees to private financial institutions. This means that these financial institutions (mostly from the United States, Germany, France and other highly developed countries) receive a gigantic inflow of resources, which they may deploy as they wish. They may, for example, direct these funds to institutions connected with them and support groups of companies they choose.

Another reason that financial institutions are strongly interested in maintaining the mandatory personal pillar within the pension system is that for decades they may collect fees on pension contributions transferred by the government and on accumulated assets. This means that millions of employees in a given country were actually taxed for the benefit of private companies. Coerced by the government, employees have to share a part of their monthly salary with these companies. Financial companies are entitled to collect a fee on the funds belonging to the future pensioner throughout his or her working life, that is for about fifty years. In Chile it turned out after thirty years of functioning of mandatory pension funds that as much as one third of the contributions had been devoured by financial companies administering these resources. These factors explain why private financial institutions managing huge assets collected from large social groups are now so intensely lobbying in Poland for maintaining the mandatory nature of the second pillar.

It is the same strategy, which accompanied the introduction of Open Pension Funds (OFE) in Poland in the 1990s. A wide-ranging propaganda campaign in the media focused on showing the potential benefits of privatizing pensions and concealing the risks and costs involved. As a result, financial institutions succeeded in creating a positive image of the reform and a conviction that it would lead to high benefits, embodied by old age pensioners spending their twilight years in exotic countries under palm trees, shown on big posters all over the country. Only recently Polish society started to discover that the reform from 1999 does not mean higher benefits but on the contrary—they will be reduced by more than half. A European Commission report from 2012 predicts that in 2060 in Poland the benefit ratio will be just 22% while under the old system in 2010 it was 47%. Such a drastic cut in the benefits was imposed in order to at least partly cover the costs of the establishment of the mandatory personal pillar.

The most important consequence of establishing the OFE is a massive increase of public debt. About half of this increase since the reform in 1999 has been caused by the existence of the mandatory personal pillar. The OFE are responsible for more than PLN 300 billion of public debt, which at the end of 2012 constituted about 20% of Polish GDP (entire public debt was about 56% of the GDP according to Eurostat). So we can fairly claim that the creation of this pillar was a huge blow to Polish public finances and has become the main threat to government’s solvency.

To explain the mechanism of the increase of public debt caused by the privatization of pensions we should start with the fact that Poland never had and still does not have a budget surplus. But public debt is continuously high. And it was under such circumstances that in 1999 a huge expenditure was added, namely the mandatory transfer of public resources to private pension funds. The principle was introduced that about 40% of the contributions deducted from the wages of millions of employees would be transferred for investment on the financial market. If the OFE did not exist, these resources would have been used for paying out monthly benefits to about five million people. But since a significant part of the pension premium was directed to private funds, a huge gap appeared in the pay-as-you-go pillar that is the money needed to ensure the means for current pensioners.

It forces the government to borrow money in order to compensate ZUS for the reduction of the contribution, part of which is used not for current benefits but for market play. The public debt incurred by that has reached astronomic proportions and the interest on it constitutes a major burden on public finances. In 2013, the interest on the debt incurred by the existence of the OFE will be around PLN 18 billion, which is almost half of the amount provided in the budget for financing the entire Polish public debt. It should be added that in recent years the interest on Polish government bonds has been more than 2% higher than in the Czech Republic, where no mandatory personal pillar had been established and consequently this huge source of increasing public debt had not been created. The interest on Polish government bonds is among the highest in Europe, right after such countries as Greece, Portugal and Ireland.

Continued financing of the OFE through increasing public debt may be more and more difficult, for in a near future the debt-to-GDP ratio may surpass the limit mandated by the Public Finances Act (55% of the GDP under the Polish system of calculating public debt) and then the limit defined by the Constitution (60% of the GDP). If a continued increase of national debt proves unfeasible, further existence of the OFE will impose huge sacrifices on the Polish people. Drastic tax raises will be necessary as well as painful cuts in social spending, including hospitals, schools and benefits, and also in spending on infrastructure, including roads, electricity grids, security (the military, police, the judiciary). These burdens will be greater and greater, for after the temporary reduction of the contribution directed to the OFE, introduced in 2011, the contribution will be raised annually from 2013 to 2017.

Aiming at reducing public expenses, the government managed to pass an act in 2012 gradually increasing the pensionable age to 67 years, which means two more years than previously for men and as many as seven more years for women. This significant increase is the price, which Polish society has to pay for keeping the OFE. But even this price is far from sufficient to maintain a mandatory personal pillar from public resources for decades to come. A massive austerity program, difficult to accept by the people, will be necessary. In addition, the prospects of the Polish economy will be drastically worsened, for the economy will have to bear both the burden of debt caused by the existence of the OFE and the consequences of reduced government expenditure for development purposes.

Given all these negative consequences, we may ask why Polish society should be made to bear them. What does the mandatory personal pillar offer in return for the increasing debt, for the huge economic and social costs? What is the sense in accumulating financial assets in mandatory private pension funds? Will they really be able to guarantee a high retirement benefit promised by their creators, and are they able to do it regardless of the deepening process of aging? For the OFE was advertised as a solution impervious to demographic trends and ensuring respectable old age benefits.

By the end of 2012 the OFE had 16 million members and their assets were PLN 269 billion (that is a few dozen billion less than the PLN 300 billion which Poland has borrowed in order to finance the OFE). Before we evaluate the structure of the OFE’s portfolio, we should emphasize that Poland is financing the OFE through public borrowing. The idea of accumulating savings for pensions through accumulating debt is ridiculous in itself, regardless of the nature of these savings.

More than half of the assets in the OFE’s portfolios have been Polish government bonds, shares accounted for about one third, and other assets, including company bonds, for the rest. As far as government bonds in these portfolios are concerned, we should point to at least four anomalies involved.

The first one is that the government transfers premiums deducted from the salaries of 16 million Poles to private funds and has no money left for current benefits, so it sells bonds which are in part bought by the OFE (for the rest the government has to find other buyers in Polish and abroad). It means that the government is borrowing from the OFE—and paying interest on—the money it has just passed to them.

The second absurdity is that pension funds, that is intermediaries, are collecting fees on these bonds [sic].

The third anomaly is that the government securities in the OFE’s portfolios (just as the remaining bonds issued because of the existence of the OFE) will have to be bought out by all Poles, including the OFE members, which will result in higher taxes in the future; that is a huge burden for a less numerous generation.

And the fourth absurdity concerns the interest on bonds held in the OFE’s portfolios. The interest is the main source of the augmentation of resources for future pensions. The higher the interest on Polish government bonds, the more the OFE will “earn” for the Polish pensioner, the higher will be the sums added to his or her account and the higher will be the fee collected by the pension funds (a percentage of the market value of the assets). It means that the remuneration of the pension companies—90% of them owned by foreign financial institutions—for administering these assets is inversely proportional to the credit rating of Poland. The interest on Polish government bonds will be the highest when the country finds itself on the verge of bankruptcy. The mechanism of creating future pensions for more than 16 million people is based on this ridiculous dependence. Little wonder that highly developed societies did not want something so irrational and harmful in their own countries.

Another reason of their opposition to the privatization of pensions was the conviction that future benefits cannot be based on the obligation to invest in shares. Shares have always belonged to the most risky financial instruments. The financial crisis going on since 2007 has shown the huge scale of negative processes on the financial markets. The risk of investing in shares has increased significantly. In Poland, the main stock market indices are still more than 30% lower than in 2007. In the last few years there were several periods when OFE were incurring huge losses. For example, in 2008 they surpassed PLN 30 billion and were much higher than the contributions transferred by ZUS to the OFE. In 2011 ZUS transferred PLN 15 billion and this money was not only not augmented by the OFE but it was almost entirely lost (net assets went down by 12 billion). In May 2012 only, the OFE’s assets dived by almost PLN 5 billion. It shows the huge scale of losses suffered by the funds, which after all are investing money taken from the public purse. We could categorise it as a real plunder of public finances in a situation when some hospitals have no money to buy medicine for even the most seriously ill patients.

It is no consolation for an OFE member that the funds will perhaps rebound when the market recovers. Even if that happens, no one can guarantee that next year OFE will not lose several dozen billion PLN on the stock market. If fees were tied to profits produced for an OFE member—such a proposal has been mooted—it would be an incentive for these institutions to indulge in more risky investments in pursuit of higher profit. The profits could temporarily rise but the funds would not pay back the collected fee if the value of the risky assets would go down.

The OFE are simply impossible to reform. You cannot repair them. Profits produced by them for the future pensioner are shaky, reversible. Only the fees collected by financial institutions are irreversible and they significantly reduce the future benefit.

The establishment of the OFE not only solved none of the problems of the pension system but also created a large number of new threats for the Polish economy and future pensioners. Introducing a mandatory personal pillar in Poland was a big mistake. It proved to be a system, which is ruining public finances and leading to a huge national debt. It should be dissolved in its entirety, unconditionally and as soon as possible. An acceptable alternative would be to introduce the solution used in Hungary. When membership in private pension funds was made voluntary, the country got rid of this extremely harmful model. Less than 2% of the members stayed in the funds, the rest went back to the government system. It is to be hoped that also Poland will soon free itself from the OFE.

Leokadia Oręziak

Leokadia Oręziak is a professor at the Warsaw School of Economics.

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