Dealing with demographics

Author: | Published: 18 Mar 2015
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Christian Petter of BNP Paribas looks at how European countries are balancing short and long-term goals in the face of an ageing population

Countries in the CEE (central and eastern Europe) and SEE (south-eastern Europe) regions are feeling the immediate pressure of the aftermath of the financial crisis and the future pressure of demographics. Some are strong enough to withstand the temptation, and so should western investors.

The question many countries, including those in the CEE and SEE regions, are now facing is whether a bird in the hand is really better than two in the bush. Over the past decades, many countries in the region have started to build an often mandatory pension system which some politicians under pressure of short-term market evaluations feel the need to tap for short-term budget hole fixes.

But such an approach lacks long-term vision and puts too much emphasis on the often very gloomy short-term outlook for the region, which is often distorted by misinterpreted dependencies on Russia or the oil price.

Taking a look at the figures on CEE and SEE countries reveals the debt situation is in fact often better than in many other European countries. In a talk in Zurich in January this year, Martin Janssen, head of the Ecofin (Economic and Financial Affairs Council) group, pointed out "only Luxembourg, Denmark and a few Eastern European countries (such as Russia, Bulgaria, Estonia, Latvia and Lithuania) are within the Maastricht criteria".

It must be conceded that the economic outlook for the region is not too rosy. However, recent investor surveys show interest in emerging markets, including Eastern Europe, is slowly coming back with the first signs of recovery.

Similarly, the analysts at Erste Group see the economic outlook for many countries in the region improving and over the mid-term most will be back to economic growth, albeit sometimes from a very low starting point.

If these countries stick to the course they started of accumulating supplementary pension assets in funded pension solutions, they will also be prepared for future demographic challenges. This in turn means that, over the long-term, their overall economic situation could improve more significantly than that of countries which have not yet started to tackle their pension problem – including western European countries like Austria.


One case in point is Croatia, where the pension system is growing more than the economy. In the third quarter of 2014, pension assets in the three mandatory second pillar funds amounted to 20% of GDP, having increased 14% over the last nine months to K65 billion ($11.5 billion).

"I would say there is a lack of understanding by the capital markets about the existence of a fully funded system that will support public spending by paying pensions. It is something that should be taken into account but my impression is that we are not capitalising on that" Dinko Novoselec, president of the Association of Croatian Pension Fund Management Companies, was quoted in Investment & Pensions Europe magazine in January.

"Croatia is at least trying to tackle future challenges regardless of short-term bumps"

As of February 5 2015, the Standard & Poor credit rating for Croatia stood at BB+; Moody's rating for Croatia sovereign debt was Baa3 and Fitch's credit rating for Croatia was BBB-, as listed on to the online platform

According to the Croatian Agency for Financial Sector Supervision (HANFA) the average annualised return from the second pillar stood at 7.5% for the period between 2002 and 2013 when the mandatory system was first set up. These returns are significantly higher than the average wage growth during that period at 3.8% and will therefore help the Croatian people cope with what is one of the most difficult demographic situations in Europe.

The World Bank states that 'Croatia is one of the oldest and rapidly aging transition economies with significant challenges faced by the pension system', especially in the first pillar. Statistics reveal 17.3% of the population are over 65 and the old-age population dependency ratio stands at 23.8%. Only Bulgaria and Latvia are facing similarly difficult situations.

Over the past years, pension reforms in Croatia saw a few ups and downs in the wake of the financial crisis. However, the European Commission confirmed in a 2014 report that the country had already taken 'significant measures' in the field of pensions, but added the reform would need 'stepping up'.

Regarding the mandatory pension funds, the government is obviously keen to develop them further, having allowed life-cycle choices last year. This means people can choose different risk strategies within the pension funds. On the one hand, this transfers risks to the members, but on the other hand an informed member can make an investment decision suitable for their current living situation, age range or personal preferences.

Additionally, investment regulations were loosened, allowing higher equity quotas and more foreign currencies in the portfolios.

The economic situation remains a worry but most analysts, including the World Bank, OTP Bank and Raiffeisen Research, agree the Croatian economy will most likely stop shrinking this year and even see growth next year. These forecasts are based on various measures introduced by the government as well as an initiative for more (part) privatisations which could also involve the Croatian pension sector.

At the time of writing, the Croatian mandatory pension funds were among the bidders for debt to be issued by the state-run motorway operator. However, it must be kept in mind that unions are very strong in Croatia and mostly opposed to full privatisations.

Nevertheless, it can be said that Croatia is at least trying to tackle future challenges regardless of short-term bumps contrary to a trend of myopic assessments.


On Romania, economic analysts are much more enthusiastic. In a research paper, OTP Bank pointed out the country 'became the good guy' in the CEE region in 2013 with over three percent growth and less than three percent deficit. For 2015, entities like the European Bank for Reconstruction and Development (EBRD), the main institutional investor in Romania, the International Monetary Fund (IMF) and the European Commission (EC) forecast economic growth between 2.5% and almost three percent. With the IMF, Romania reached an agreement in principle to cut the 2015 deficit to 1.8% of GDP on a cash basis.

All these measures are mainly taken to ensure Romania's goal of being able to join the euro by 2019. Although analysts expect these ambitious goals to be derailed following the surprise win of right-centre alliance candidate, Klaus Iohannis, Raiffeisen Rearch noted it does not expect 'major political slippages in the near term'. Even if the agreement with the IMF should falter, 'a public budget deficit of around two to 2.3% of GDP should not worry investors too much' the analysts stressed.

These debt cuts had also helped Romania regain the investment grade status in Standard & Poor's rating in May 2014. The agency added in a statement issued in the autumn of last year the economic growth 'should aid moderate further consolidation of government finances' and make it more likely for reform programmes to 'exceed expectations'.

A development that has already exceeded expectations in Romania was the increase in second pillar pension assets by 37% last year. This was 'driven mainly by good investment returns' of 8.7% on average for the seven funds in the system, according to the local pension fund association APAPR (Asociatia pentru Pensiile Administrate Privat din Romania). Since inception in 2008, the average annualised return in the mandatory second pillar is 11%.

The World Bank noted in its most recent assessment of the Romanian pension system that 'reforms have contributed to poverty reduction, but further reforms are needed to meet the challenge of an aging population' – an assessment which is true for almost any country in Europe. However, in Romania, initial reforms helped to stabilise the public pension deficit at three percent for 2012 and 2013. The organisation warns 'the aging population and shrinking labour force' will further challenge the pension system. But compared to Croatia or Bulgaria the situation is slightly better: the old age dependency ratio in Romania is still under 20% and the quota of people aged over 65 stands at 13%.

A look at the overall amount of accrued assets of just over L19 billion ($5.8 billion) in relation to the country's GDP reveals a very low percentage at just over three percent. Despite this seemingly minor role of pension assets in the state finances, it has to be stressed that Romanian pension funds are investing over 90% of their assets within the country, rendering them important institutional investors for the country's economy and stock exchange.


Looking at Bulgaria, there the verdict was still out at the beginning of the year on how new reform proposals for the pension system might impact the second pillar. But people in the local pension industry as well as European organisations, including Pensions Europe, are trying to reason with the authorities to take a longer-term view.

Over recent years, there had been rumours and calls from the opposition parties to use the money in the second pillar to improve state finances, but the government had shrugged off this temptation. Pension assets accrued in the mandatory second pillar amounted to more than Lev6 billion ($4.2 billion) and annualised average returns for the two-year period between 2013 and 2014 were calculated at 5.45%.

Most Bulgarians are saving in one of the 10 so-called universal pension funds and in total the pension assets make up around eight percent of GDP.

The government had considered forcing people to choose between the first and the second pillar with no chance of changing their minds at a later stage. In turn, the attractiveness of the first pillar was increased last year. From July 2014, automatic indexation was implemented based on what the IMF calls the golden Swiss rule, linking pension increases to the average growth of insurable income and CPI (consumer price index) inflation. Further, the gradual increase in retirement age was halted. However, the IMF pointed out the authorities 'recognised the importance of pension sustainability and saw the halt in increases to the retirement age as temporary'.

The World Bank halved its economic outlook for Bulgaria since June 2014 to just over one percent, but added it was 'more optimistic about Bulgaria's economy in 2016 and 2017, with growth forecasts of two percent and 2.7%, respectively'. Already in 2013, the organisation warned the government public funding of the first pillar pension system would have to increase because contributions to the PAYG (pay as you go) pillar were too low.

So, like many countries in Europe, Bulgaria is facing the problem of a soon unsustainable first pillar, especially with an old-age dependency ratio of almost 25%, fiscal challenges (despite being one of the very few European countries to achieve the Maastricht criteria). On the other hand, it has established a long-term hope of a mandatory second pillar helping with future demographic challenges.

Planning ahead

In our view, despite the bleak short-term outlook on most economies in the CEE and SEE regions, these countries have made a first step in tackling the problem all European countries are facing: the lack of sustainability of PAYG pension systems. Looking ahead, old-age poverty will present a much bigger and more long-standing challenge to the economies than most economic crises.

In Japan, the model old-age society, with one of the highest old-age dependency ratios in the world at over 40%, old-age pensions are financed by a mix of first and second pillar as well as personal savings, but mostly by many people working well beyond retirement age. Although many European countries are yet to achieve a sensible old-age participation rate when it comes to the labour force, the proliferance of elderly supermarket cashiers is not the future vision for the European social system.


Christian Petter

BNP Paribas Investment Partners
Mahelrstraße 7/18
1010 Vienna
T: +43 (0)1 513 26 84 -0
F: +43 (0)1 513 26 84 -20

So the question is how investors should assess individual countries' attempts to deal with pension problems and future demographic challenges, even if sometimes these might lead to short-term effects on the immediate economic growth. Sometimes two birds in the bush can be better than one in the hand – because they are further from the reach of short-term financial needs. In a financial environment, where quarterly statements are sometimes deemed outdated and live-streaming of information aided the arrival of high-frequency trading, it is often difficult to take a really long-term view on investments. But particularly when it comes to retirement savings, it is much more important to be aware of a country's ability to deal with future retirement issues than to consider its short-term fiscal status.