competition and costs in the hungary 2 nd pillar

This version: 1/23/06 1

Competition and costs in the Hungary 2nd pillar

Gregorio Impavido

([email protected])


Content

• FSAP update 2005 TN– Impavido Rocha (2006)

• Structure, growth, investments (5 – 15)

• Performance and cost comparisons (16 – 24)

• Decumulation phase (25 - 26)

• Concluding remarks (27 - 33)


Not covered in this presentation (1/2)

• Description of 1997 pension reform– Palacios Rocha (1998)– Rocha Vittas (2002)– Gedeon (2001)– Gál Tarcali (2003)– Simonovits (1999), Müller (1999), Marin,

Stefanits and Tarcali (2001), Augusztinovics et al (2002) and Orbán Palotai (2005)

– …


Not covered in this presentation (2/2)

• Impact on financial market development– Impavido, Musalem, Tressel (2001 – 2003)– Vittas (1998, 2000)– Shah (1997)– Davis Hu (2004)– Blake Orszag (1998), Davis (1999)– …


Few MPFs are still in operation

1998 1999 2000 2001 2002 2003 2004 Second Pillar Number of funds 38 39 - 18 18 18 18 Total Assets (% of GDP) 0.3 0.8 1.3 1.9 2.5 3.0 4.0 Number of members (000) 1,347 2,064 2,193 2,253 2,214 2,304 2,402 Share of 6 largest funds (%) 83 84 84 86 87 - 83

• Decreasing number of funds with little impact on concentration

• Immature system covering 50% of labor force• Low-ish asset growth


The MPF market is concentrated

Assets Members Contributions (HUF 000,000) (unit) (HUF 000,000) Smallest MPF 1,003 2,840 320.3 Largest MPF 224,161 681,231 57,267.8 Average MPF 48,997 133,456 11,851.4 Market Total 881,944 2,402,210 213,324.9 Share of Largest Six MPFs 83% 87% 83% Herfindahl Index 1,491 1,638 1,510

• Market is concentrated with 6 largest MPFs representing around 85% of relevant measure


Three types of sponsors can be identified

Type of Assets Members Contributions Sponsor HUF 000 (unit) HUF 000

Min 1,003,353 9,141 347,000 Max 224,161,495 681,231 57,267,822

Average 76,904,851 214,356 18,605,398 Total Financial 769,048,517 2,143,569 186,053,986 F

inan

cial

G

rou

ps

(10)

% of Market 87% 89% 87% Min 4,410,819 8,195 986,141

Max 16,081,593 21,622 3,836,397 Average 9,201,794 13,746 2,097,909

Total Employer 46,008,972 68,733 10,489,545

Em

plo

yers

(5

)

% of Market 5% 3% 5% Min 1,523,589 2,840 320,274

Max 34,102,743 106,596 8,348,993 Average 22,295,590 63,303 5,593,792

Total Independent 66,886,770 189,908 16,781,376

Ind

epen

den

t (3

)

% of Market 8% 8% 8%

• On average MPFs sponsored by FIN are the largest


The growth of the system has been mixed

• Low asset growth due to stagnating contributions and membership in 2000 – 2002 (2nd Q. 2003)

0

100

200

300

400

500

600

700

800

900

1000

Dec-97

Dec-98

Dec-99

Dec-00

Mar-01

Jun-01

Sep-01

Dec-01

Mar-02

Jun-02

Sep-02

Dec-02

Mar-03

Jun-03

Sep-03

Dec-03

Mar-04

Jun-04

Sep-04

Dec-04

0

500

1000

1500

2000

2500

3000

Assets (HUF bln) Contributions (HUF bln) Members (thousand)


Determinants of low contribution growth

• Contributions represent the largest component of growth in initial years after reform

• Low membership growth and possible evasion compressed covered wage bill

• Stagnant contribution rates and decreasing contribution ceiling compressed contribution base

1998 1999 2000 2001 2002 2003 2004 Contributions (% of GDP) 0.27 0.49 0.61 0.66 0.68 0.87 1.06 Contribution rate (%) 6.0 6.0 6.0 6.0 7.0 7.0 8.0 Contribution base (% of GDP) 4.6 8.1 10.1 11.0 11.4 12.4 13.2 Determinants of contribution base: Membership (thousands) 1,347 2,064 2,193 2,253 2,214 2,304 2,402 Contribution ceiling/Average covered wage - 2.0 1.9 1.8 1.6 - 2.5 Covered wage bill (% of GDP) 22.1 22.4 22.2 23.5 23.9 24.2 - Memo item: Contribution base/Covered Wage Bill 20.7 36.1 45.7 46.9 47.5 52.4 -


High share of Government bonds

1998 1999 2000 2001 2002 2003 2004 Cash 10.8 2.8 1.3 1.1 3.3 0.7 0.6 Time Deposits/CDs 3.5 0.3 0.1 0.1 0.7 0.4 0.5 Government securities 76.7 83.4 77.6 80.0 68.0 69.9 72.7 Direct Equity 6.6 9.8 14.8 11.6 8.9 9.3 7.8 Corporate and FI Bonds 1.7 1.7 2.3 3.0 4.2 3.0 1.7 Investment notes 0.3 1.7 2.6 2.3 7.1 7.2 8.2 Other 0.4 0.3 1.3 1.9 7.8 9.5 8.5 Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Memo: Est. Total Equity 6.8 11.2 16.7 13.4 14.6 15.1 14.4 Est. Foreign Assets 3.5 5.6 8.3 6.7 7.3 7.5 7.9

• Investment portfolio concentrated in Government securities


Why such high share of Government bonds?

• Liberal investment regulation• Unsupportive fiscal policy• Low supply of alternative investment

vehicles• Low performance of equity market (0%

between 12/97 – 8/03)• Conservative asset management culture

of subsidiaries of continental Europe mother companies


Low investment performance

1998 1999 2000 2001 2002 2003 2004 2005 1 Net Nominal Rate of Return 15.7 17.1 7.9 8.0 7.4 3.4 16.3 13.0 Wage Growth 16.8 12.1 12.7 13.2 15.0 12.7 6.3 6.2 Inflation Rate (Aver) 14.2 10.0 9.8 9.2 5.3 4.6 6.8 3.9 Inflation Rate (Dec) 10.3 11.2 10.1 6.8 4.8 5.7 5.5 3.0 Notes: /1 estimates

• Av. Real Gross RR = 4.85% (weighted)• Av. Real Wage Growth = 5.27% • Possible reasons: low (but higher than equity)

performance of Govt securities due to high credit rating and possible unrealized capital losses due to recent hike in interest rates


Is the number of MPFs low?

Central Europe Latin America

Hungary 18 Argentina 12 Bulgaria 8 Bolivia 2 Croatia 7 Chile 6 Estonia 6 Colombia 6

Kazakhstan 13 Costa Rica 8 Latvia 5 El Salvador 2 Poland 16 Mexico 13

Peru 4 Uruguay 4

• Hungary is not unique.


Is the asset growth low?Country First Year of

Operation At 7th Year 2004

Hungary 1998 4.0 4.0 Argentina 1994 7.1 12.0 Bolivia 1997 20.9 20.5 Chile 1981 13.5 59.1 Colombia 1994 - 10.3 Costa Rica 2001 - 2.7 El Salvador 1998 13.7 13.7 Mexico 1997 5.7 5.8 Peru 1993 4.1 11.0 Poland 1999 - 8.0 Uruguay 1996 9.3 16.1

• Maybe, but….


Is investment performance low?

• Yes, maybe due to high sovereign credit rating for Hungary– CORR with S&P ratings 2000 = 0.18– CORR with S&P ratings 2004 = 0.33

Country

Average Accumulate

d Real Gross

Rate of Return

(% p.a.)

Average Real

Int. Rate on

Government

Securities (% p.a.) (2000 – 2004)

Average Sovereign

Spread (%)

(2000 – 2004)

S&P Sovereign

Rating

(2000)

S&P Sovereign

Rating

(2004)

Hungary 4.9 3.9 59 BBB+ A- Argentina 9.9 - 3,574 BB SD Bolivia 10.4 7.7 - B+ B- Chile 10.2 4.0 156 A- A Colombia 6.9 11.6 1/ 579 BB BB Costa Rica 6.7 - 327 BB BB El Salvador 9.9 - 315 BB+ BB+ Mexico 7.7 4.2 299 BB+ BBB- Peru 7.6 - 531 - - Poland 8.6 8.1 165 BBB+ BBB+ Uruguay 12.9 - 723 BBB- B


Lack of investment performance comparability limits competition

• Comparisons of investment performance across MPFs are impaired due to:– No true time rate of return calculations– RR calculations ignores operational costs– No rules on benchmark rebalancing– Brokerage fees not necessarily charged

against asset base


Costs cannot be readily compared1998 1999 2000 2001 2002 2003 2004

Weighted Averages Sponsor (%) (%) (%) (%) (%) (%) (%)

OP Fee (% contribs) MKT 5.6 5.7 5.5 6.4 6.8 6.8 6.5OP Fee (% contribs) EMP 6.1 5.9 5.8 6.4 6.6 6.6 6.6OP Fee (% contribs) FIN 5.5 5.6 5.5 6.4 6.7 6.7 6.5OP Fee (% contribs) INDEP 6.3 6.0 6.0 7.2 7.5 7.3 6.9

AM Fee (% AV. Assets) MKT 1.1 1.4 1.1 1.0 1.0 0.9 1.0AM Fee (% AV. Assets) EMP 0.1 0.6 0.4 0.4 0.3 0.2 0.3AM Fee (% AV. Assets) FIN 1.3 1.5 1.1 1.1 1.0 1.0 1.1AM Fee (% AV. Assets) INDEP 0.2 0.9 0.6 0.8 0.8 0.6 0.5

Total Fees (% contribs) MKT 6.1 7.1 7.2 8.8 9.7 9.6 9.8Total Fees (% contribs) EMP 6.1 6.5 6.5 7.3 7.6 7.3 7.6Total Fees (% contribs) FIN 6.1 7.2 7.3 8.8 9.7 9.7 10.0Total Fees (% contribs) INDEP 6.0 6.7 7.0 8.4 9.1 8.4 8.2

Total Fees (% Av. Assets) MKT 12.7 7.0 4.5 3.8 3.2 3.1 2.9Total Fees (% Av. Assets) EMP 12.5 6.1 3.8 3.0 2.4 2.3 2.1Total Fees (% Av. Assets) FIN 12.9 7.0 4.6 3.9 3.2 3.2 2.9Total Fees (% Av. Assets) INDEP 11.1 7.6 4.6 3.9 3.3 3.0 2.6

• OP Fees (admin 66%, guarantee 6%, supervision 5%, marketing 2%,…) out of the operational reserve similar to all funds

• AM Fees on top of operational reserve and different by type of sponsor


Contributions fees across countries

• Hungary fares better than most countries in terms of total fees over contributions at their 7th year of operation

0%

5%

10%

15%

20%

25%

30%

35%

40%

1 3 5 7 9 11 13 15 17 19 21 23Years of operation

Argentina Bolivia Chile El Salvador México Perú Uruguay Hungary


AM fees across countries

• Hungary fares worse than most countries in terms of total fees over assets at their 7th year of operation

0%

2%

4%

6%

8%

10%

12%

14%

1 3 5 7 9 11 13 15 17 19 21

Years of operation

Chile Argentina Bolivia Costa Rica El Salvador Mexico Peru Uruguay Hungary


Are current fees high or low?

• Mixed structure of fees and recent dominance of AM fee implies quickly rising (doubled in first 7 years) fees over contributions (fees are high)

• Average assets for Hungary inflates total fees over assets (fees are low)

• The FSAP TN concludes that fees are not particularly high today but they will be if fee structure is maintained in the long run

• Today fees are 2.9% of Av. Assets for managing a buy and hold laddered portfolio of government bonds with an inefficient contribution collection system, poor information disclosure, a low guarantee fee that is justified only because MPFs have no capital.


Maybe LR fees are better than current fees

• Current fees appear high due to the current small asset base (4% of GDP)

• Current total fees are not relevant because it ignores the fixed/variable fee mix and therefore, how quickly fees over assets are likely to fall over time (high fix fee -> fast decay)

• Then let’s project current fee structure over time


LR total fees over Av. Assets

1.18%

0.21%0.97%

0%

2%

4%

6%

8%

10%

12%

14%

TOT C OP C AM C Past

Note: Real wage growth = 4%, rate of return = 8%, asset management fees = 0.97% of assets, and operating fees = 6.49% of contributions. • LR fee of 1.2% is still high

– Especially since this projection ignores maturation of system and likely lower growth of assets starting with 2014


Segmentation of costs is still present in the LR

• LR fee of 1.2% for average MPF, 1.7% for highest cost MPF, 0.5% for lowest cost MPF.• Segmentation is still present: some MPFs are extracting a rent due to lack of readily comparable information on

performance and costs

1.18%

0.49%

1.66%

0%

2%

4%

6%

8%

10%

12%

14%

Average Cost MPF Lowest Cost MPF Highest Cost MPF

Note: Real wage growth = 4%, rate of return = 8%.


What are the LR costs for an individual?

• 1% AM fee over 40 years of contributions amount to 20% of contribution fees or final cash balance fee (25% compensation fee on contributions - APPENDIX B)

• Charge Ratios for average MPF in Hungary are worse than CR for most LAC countries (Whitehouse 2000) and Australia (Mitchell Bateman 2003) Mexico and Argentina are exceptions

• Important Caveat: exercise is mechanistic.


Decumulation phase (1/2)

• Pension funds can sell annuities– Single, joint, term level annuities with Swiss

indexation in 4 possible combinations

• No gender discrimination

• Weak reserving (no reserving for investment risk) and investment rules


Decumulation phase (2/2)

• Limit on discount rate for valuing liabilities inconsistent with fixed income AAA nature of such liabilities

• Operating reserve can be used to replenish technical reserves (explicit intergenerational redistribution inconsistent with DC nature of MPFs (Feldstein 2001))

• Lack of retirement products with varying longevity and investment risk sharing properties between providers and retirees


Concluding remarks: growth

• Mixed performance can be attributed to elements of reform reversal (contribution rates and switching) that have caused contributions not to grow as expected

• Mixed performance can be attributed to undiversified portfolios and relative low investment performance.


Concluding remarks: fees

• Comparing fees across countries is problematic due to the different design of different second pillars (coverage, target replacement rates, contribution rates)

• Total fees over contributions compare favorably with other countries but total fees over assets do not

• Long run fees appear high if assets do not grow more quickly and the current cost structure is unchanged (lower current average AM fees). This probably would suggest that short run fees are high too


Concluding remarks: cost segmentation

• While MPFs charge similar fees over contributions, MPFs sponsored by financial groups tend to charge AM fees that are on average 275% and 98% higher than fees charged by MPFs sponsored by large employers and MPFs considered independent. Nevertheless, they manage the same type of portfolio and are not associated with higher performance.


Concluding remarks: disclosure

• The segmentation in fees is due to the lack of readily available comparable information on cost structure. This has impaired competition.

• Comparability of investment performance also limits competition but not as severely as the lack of costs comparability.


Concluding remarks: prow low cost fund policies

• Further to increasing comparability, incentives for lowering costs could be introduced by changing the rules for the default fund for undecided members. Mexico is a good example.

• Similarly, switching in general can be facilitate through the use of internet based solutions. Mexico again.


Concluding remarks: retirement

• Only life insurance companies should sell annuities as they can partially hedge longevity with mortality systematic risk

• Given the presence of a 1st pillar with 45% replacement rate a richer menu of retirement products with varying degrees of longevity and investment risk sharing properties should be allowed

• MPFs should be allowed to provide lump sums or income drawdowns only to avoid undesired intergeneration redistribution. AM versus ALM.


Concluding remarks: retirement

• Swiss indexation is difficult to match and should be eliminated. Price indexation is easier to match provided you have a liquid mkt. of long duration CPI indexed bonds


End

competition and costs in the hungary 2 nd pillar

Documents

contribution ceilingaverage

share of largest

largest mpfs

largest component of

largest funds

reformlow membership

largest mpf224

mixedlow asset growth