The problem of private pension funds

The problem with private (mandatory) pension funds is that they don't make money. More precisely, they don't make money for their clients. They probably do for themselves, but the returns that people who insure themselves with them receive are almost non-existent or even negative. At least most of the time. This is a problem. Because all working Bulgarians insure themselves in these universal and professional private pension funds.

We insure ourselves with them because they represent the Second Pillar of pension insurance in the country. It is mandatory, as is the First (state) Pillar, about whose practically bankrupt state we have already written several times (for example here and here). Of course, the situation with private funds is far better than that in the state Pensions Fund. At least because the money we contribute there is actually saved and invested, and is not spent on the current pensions of current pensioners. With private funds, at least, you can be sure that you will receive pensions. With the state fund, current workers unfortunately do not have this luxury.

But this does not mean that we should be uncritical of private pension funds. It does not mean that we should ignore the serious problems they suffer from. Even if their scale is not as frightening as that of the problems of the state pillar of the system. In order not to be voiceless, let's look at the data. All the data presented in this article are data collected and published by the Financial Supervision Commission (FSC), which are publicly available on the institution's website. The data that we will consider is about the return on universal pension funds in Bulgaria (those funds that provide insurance to the majority of the working population) over the last decade (2008 - 2017). What do they show?

Pension funds are losing money for their clients

The graph below (click on it for a better resolution) shows three variables. The blue columns show the nominal arithmetic average annual return that universal pension funds achieved in each of the years of the period under review. This is the return that the Financial Supervisory Commission publishes and is therefore most often quoted in the media when discussing the topic. The orange columns show the return after inflation. We get the numbers there after a simple calculation, in which we subtract the inflation rate from the nominal return for the respective year, according to NSI data. This shows the "real" return, because when there is price inflation, it means that the purchasing power of money (i.e. its real market value) falls. This is a standard calculation in investment circles, because the most basic goal of investing is precisely to protect our savings from inflation.

Source: FSC

The third (gray) column, however, is the most important. It shows the average level of profitability of the UPF after inflation and after the fee imposed on each contribution that comes to them. The red numbers show what this profitability was in each year of the period under consideration. It is important to note, however, that these numbers refer to the profitability only of the contributions that came to the respective fund within the specific year. They do not refer to the profitability of the money that was in the respective account before that, because it is about an "entry" fee that is paid once, when the monthly insurance in question comes to the fund. That is, the profitability of the entire batch is higher than the red numbers in the graph above. But they show us what happened to the savings of each worker in the first year of their entry into the average universal pension fund, after paying only the entry fee.

If you are not familiar, a certain percentage is withheld from each insurance contribution that enters the universal (and professional) pension funds by law (the Social Security Code). This is like an "entry fee" for the deposit of your savings. The Social Security Code regulates the level (maximum) of this fee, which for 2017 was 4.25%, in 2016 4.50%, and in the years before that 5.0%. A quick look at the terms published on the funds' websites shows that they benefit from the maximum allowable level of this fee. Such a type of fee obviously erodes the return on investment for the fund's client (the insured person), therefore, like inflation, it must be subtracted from the nominal yield.

After subtracting both the inflation rate and the entry fee, we get the data depicted in the gray columns. As can be clearly seen in the graph, in 7 of the last 10 years the numbers are negative. This means that after subtracting the inflation rate and the entry fee, universal pension funds (on average) have lost money for their clients in 7 of the last 10 years. And even in the years in which they have made some profit for their clients, it has been minimal and insufficient to compensate for the losses. In fact, even so, the data depicted above is rosier than reality. Because the entry fee is not the only thing we pay. There is also an annual management fee, which in most years of the period under review (before 2016) was 1% of the value of net assets. We have not calculated it so as not to complicate the calculation too much, but if we had included it, it would have turned out that UPFs in Bulgaria have made a real profit (after taxes and inflation) for their clients in only 1 of the last 10 years.

What is this due to?

In short – inadequate state regulation. But probably not in the way you think. The problem with state regulation of the Second Pillar of the pension system is not that it is too small and weak, but that it is too heavy and inadequate. There are several problems – first, there is not enough competition in the second pillar of insurance, second, the state is directly involved in the pricing of pension services, and third, the regulations on the investment activity itself are inadequate.

The first problem is perhaps the most serious. The operating universal and professional funds in the country are part of a handful of financial institutions. The barriers to entry for new players in the market are extremely high, due to very heavy regulatory requirements. And of course, since we are in Bulgaria after all, the consistency of the implementation of these requirements is always questionable in view of the problems with corruption at the state level. On the one hand, it seems logical to have serious restrictions on who is allowed to operate in the field of mandatory supplementary pension insurance. Precisely because it is mandatory - the state obliges you to save 5% of your gross salary and contribute it to some fund as pension insurance.

The regulatory framework is inadequate

Without competition, we cannot expect high quality – this is an economic axiom. When the sector is practically "barricaded" against the entry of new competition, it is not surprising that the quality of the services offered (profitability) is unsatisfactory. But beyond that, here we also come to the pricing of services in the sector. Why is it necessary for the state to regulate the level of fees in it and thus give carte blanche to pension funds in the Second Pillar to charge fees that far exceed the average levels in all other investment funds? Such regulation is unnecessary and to the detriment of the clients of these funds. In reality, if the fees were not so high, the real profitability that those insured in these funds receive would be much more satisfactory. As we saw above, the enormous burden of these fees is what erodes the profitability of insurance to the greatest extent, even more than inflation.

And now, as a final touch, come the regulations on the investment activity itself. The CSR regulates in great detail the permissible ways in which the funds from the Second Pillar of the pension system can structure their investment portfolios. This is the most delicate part, because on the one hand, the regulations in this area were created with good motivation. Their goal is to prevent the abuse of people's insurance by excessive investment in, for example, companies related to the fund owners. However, as you may have guessed, this is a problem only in the case where insurance is mandatory AND there is no competition in the sector. If there is competition between many different funds, this is not a serious problem, because clients could be redirected from funds with questionable investment policies to more reliable ones.

That is why the lack of competition in the sector is the main problem. And the regulations themselves, although well-intentioned, harm the profitability of these funds. On the one hand, because they force them to follow investment strategies that are not optimal for the financial interests of their clients and on the other, because they most likely artificially inflate investment costs. Within the framework of this article, we cannot embark on an in-depth analysis of the regulations on the investment activities of pension funds. This will be the subject of a more in-depth analysis by the EKIP in 2019. Here, we can only note that the regulations in this area are excessively restrictive and force the funds to invest in a way that lowers their returns.

Conclusion

These, in short, are the problems of the Second Pillar of pension insurance in Bulgaria. The problem is one – they do not bring profit to their clients. But in turn, it is due to a bunch of other problems related to the way in which state institutions regulate the sector. In the current situation, with this inadequate regulatory framework and with such low levels of insurance contributions (5% for the additional mandatory private insurance) do not wonder why the pensions that private pension funds grant are so low.

A regulatory reform that eliminates all of the above problems is necessary in parallel with the implementation of a comprehensive pension reform, which involves the transition to a fully market-based pension provision (as we propose in this report on the topic). This is the way to guarantee both the long-term financial sustainability of the pension system in Bulgaria and a decent income for all pensioners in the future. You can expect a more detailed analysis of the problems of the Second Pillar of the pension system in our country, as well as specific proposals for reform, from us in 2019. In the meantime, in the table below we attach a detailed breakdown of the profitability of all universal pension funds in the country for the last 10 years, for which we have complete data.

Source: FSC

We hope you found this article useful and remember that you should not rely on the state or anyone else to take care of your financial future. Take the investment of your savings into your own hands! At EKIP, through our investment podcast and Virtual Pension Fund, we try to share useful skills and information on financial and investment topics. There are so many freely available sources of information on these topics these days – you just have to ask to educate yourself!

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