Head of Pensions at Luminor Baltic
The pension reform is approaching us with the same unwavering certainty as the darkest time of the year.
We usually manage to cope with the unavoidable cold and dark season that hits us every year, but the pension reform as it has been declared entails many things new and unknown to us. The unknown always generates a great deal of questions and misunderstandings. Therefore, it might be the right time to revisit the main points of the planned reform.
For starters, the most confusing and controversial part – the objective
Every reform should have an objective. The pension reformers have said that their objective is to give individuals the freedom of choice. And the reform offers two of them. Firstly, the freedom to invest retirement savings more flexibly. Secondly, the freedom to not save for retirement at all.
Whilst the first freedom is understandable provided that it’s well organised and adequately regulated, the second one seems to be much more complicated. Especially in the situation where the proportion of the working population (taxpayers) and the elderly who depend on regularly collected taxes is changing strongly to the disadvantage of the working population.
What should ordinary people know?
Those who don’t know much about macroeconomic analysis and financial markets should proceed from a very simple rule: having less money saved by the time you retire is always worse than having more money.
Most of our population cannot approach their retirement with too much security – if a person who earns a salary which is not too far from the Estonian average for most of their life only relies on the first and second pillars (in the present format) in their retirement, they will have to cope with an income that is less than 40% of their last salary.
The further this salary is from the average towards bigger numbers, the worse the percentage or the replacement rate will be for the specific person. Although this replacement rate increases a little in the case of a salary that is below the average, the absolute amount coming from the first and second pillars is still very small.
Two factors with the biggest impact on pension
There are many factors that determine the amount of the final pension a person will receive in the future. However, only two of them are really significant.
Firstly – what will the first pillar, i.e. the part of the pension system funded by the working population, be like in the future? The first pillar depends primarily on the total number of working people (or the proportion of them and old-age pensioners), the effective tax system (i.e. the format and level of taxes) and the solidarity of the first pillar pension, i.e. the extent to which the first pillar pension depends on the pensioner’s previous salary and how much the pillar aims to guarantee minimum subsistence to all pensioners.
There is no need for a long analysis to understand that the latter two are political decisions, which apply exactly for as long as the next political decision is made. The first, i.e. the demographic situation, is a longer process and to some extent can be predicted as well. In the longer term, it depends on the migration policy or society’s tolerance of immigration and how much the society supports the lives of families with children (e.g. pre-schools, schools, hobby clubs).
However, it’s important to remember that the first pillar is not a pool of assets. It is the sum of taxes collected at a certain moment, which is then converted into the pensions of the respective period via the social system. If there are no taxpayers, there is no tax revenue and no first pillar pension.
The second important factor in securing a good retirement is the personal savings accumulated in addition to the first pillar. Irrespective of their content and format. Be it property, forest, an investment portfolio consisting of various financial assets, gold, bitcoins, a collection of rare clay pitchers and the units of second and third pillar pension funds. In this (not final) list, the difference between the second and third pillar is that the first one is mandatory and the second comes with tax benefits.
It’s important to understand that savings do not appear from thin air – the only way to save is to spend less of your income on consumption, whether this income is regular or one-off. Regular saving is a difficult activity that requires consistency: the more automatic this process is and the fewer temptations our daily lives offer to push us off track, the easier the process of saving will be.
But let’s go back to the reform. Today, many of us should be interested in what our options are, how the reform will affect us and which threats lurk in the deepest corners of the reform.
It’s extremely important to understand that if a person wants to take care of their retirement themselves, then the decisions made today belong to each and every person themselves. The decisions made in relation to the reform by the persons surrounding them cannot influence the optimality of their decisions.
Leavers have no impact on remainers!
The main thing that interests everyone about the pension reform is how it will affect or jeopardise them. Many future pensioners who would prefer to continue saving in the selected second pillar fund are now scared that the leavers may also have an impact on their retirement savings. This fear is actually unfounded: most Estonian pension funds will cope very well even if many people decide to leave. And those who leave a fund will not take a single cent of the remainers’ assets with them. For example, if a third of unitholders decided to leave a fund, then the share of the fund’s assets that corresponds to them will be sold. The fact that a third of the unitholders leave cannot have a direct impact on the remaining two thirds.
If we think about the market price of the financial assets in a specific fund, bigger pressure to sell may affect the price of some of them. However, this will have a proportional effect on the leavers and the remainers alike. If the pressure is temporary (and one-off flows almost always are), then leavers will suffer more because of it whilst the remainers will benefit from the recovery following the pressure.
So, if you want to continue saving in the second pillar, you have the freedom to decide for yourself!
Pension investment account still taking shape
We don’t know yet what the personal pension investment account solution will look like technically. In general, it should be similar to the familiar investment account and give an individual more freedom in investing the money held in and regularly paid into their account via the pension system.
Which instruments will be allowed in the account, can there only be one account or more (with different service providers), what will the reporting obligations be like, which regulations will apply to investment advice related to the account – none of these questions have been answered yet.
As with every service, investment service has its price. So does a pension investment account
Whilst the finer details of the pension account are still unclear, there is one thing that is certain: the share of expenses tends to increase quickly when you invest small volumes. It’s not about the greed of the financial institutions that provide investment services to private persons. The whole machinery that keeps the financial system going is bulky and the majority of the fees are based on pieces, not volume. Making small investments cost-effectively, i.e. together, is the very reason why financial innovation created investment funds a long time ago (the possibility to spread risks by investing small amounts is also an added value).
So, before the pension investment account is taken into use, we must pay attention to all of the fees generated by the one-off reinvestment of the assets as well as the constant investment of the money added to the account.
Although the possibilities created by the pension reform will probably be discussed considerably in the nearest future, individuals have at least eight months before they have to make their first decisions. There is no rush!
Those who see themselves playing a more active role in the management of their pension assets in the future should use the remaining time to educate themselves. They should study how financial systems work and at least learn the main characteristics of equities and bonds; study the term ‘diversification’ (and the old wisdom of putting all your eggs in the same basket) and the functioning principles of classic investment funds and ETFs (because these are the assets that should, above all, belong to long-term portfolios with limited investment volumes). And lastly – before you transfer your assets from one system to another, you should make sure that you understand the long-term cost levels of the various solutions (incl. the investment of the regular amounts received).
Those who are seriously considering leaving the savings system must decide whether they really are brave enough to let their wellbeing in retirement depend on the first pension pillar, which is financed with the regular labour taxes paid in the future.