The Bank of Estonia presented its initial effects analysis today, work on which began immediately after the extent of planned changes accompanying plans of rendering the second pension pillar voluntary became clear. The central bank will publish the full version of its analysis in late October.

The Bank of Estonia finds that the government's plan to amend the pension reform could lead to a short economic growth spike if the number of people who decide to withdraw funded pension sums proves noteworthy. This temporary acceleration would be followed by growth slowing or even turning into a recession that would impact people's income. The competitive ability of exporting companies is believed to take a hit when initial growth from consumption slows, while labor costs remain high.

The abolition of mandatory funded pensions would increase the risk of poverty among the retirement-age part of the population as people would be given a chance to spend their savings in a very short window," the Bank of Estonia finds.

"The second pension pillar needs repair so people could make the most of their savings in their old age," said Bank of Estonia Governor Madis Müller. "However, the effects analysis of planned changes suggests the plan would not benefit pensioners in the long term. The possibility to spend pension savings in a short time could lend the economy temporary momentum through a spike in consumption, while it would likely be followed by an equal slowing. What this is in essence is abolition of mandatory pension. This presents the problem of bigger poverty risk for people who have reached the retirement age and additional pressure on the tax burden."

Müller emphasized that national and funded pensions are mutually complemental. Abolishing one pillar could mean a 30 percent reduction in pension, contributing to risk of poverty in the future.

Surveys have shown that people who decided not to join the second pillar have not invested 2 percent of salary on their own. While those who did join the system usually have other liquid assets, like real estate.

Estonian pension funds will hold €5 billion by 2021. Recent surveys suggest a part of people will immediately withdraw pension savings to spend them. Consumption will pick up even more should the state decide to direct recent second pillar contributions into a general pension hike. In summary, rendering funded pension voluntary would boost consumption and growth in the short term.

Growth to be followed by a slump

A hike in consumption following withdrawals in 2021 would translate into price, salary and import advance. Later, once people have spent their second pillar savings, consumption would fall and jobs created in its wake would disappear. Temporary growth would create price and salary pressure. However, prices and labor costs would not come down as quickly once the economy starts to cool again, which is why the competitive ability of Estonian companies could take a hit.

Effects would also be negative for pension funds. Even though the lion's share of pension fund investments have been made abroad, funds have been investing in Estonia more in recent years, helping the development of local companies.

The Bank of Estonia believes pension funds should invest mostly abroad as it helps dissipate risks and ensure better productivity. In recent years, when funds invested in Estonia, money was placed primarily in bonds, equity and real estate funds. Over the years, the relative importance of highly liquid investments has fallen and that of non-liquid investments grown. The assets of the five least liquid funds make up a third of all pension fund assets. Withdrawals from the second pillar could force some funds to also sell less liquid assets. The planned changes are believed to hamper funds' capacity for making less liquid transactions that would in turn result in lower productivity. Fire sales would cost both people leaving the fund and those sticking with it.

The central bank's recommendations

Before making fundamental changes to the system of pensions, it is important to clearly describe what the new system hopes to achieve and strike a social agreement as broad-based as possible. The necessary integral picture should offer clarity in terms of the relative volume of state pension in the future, people's own contribution and the cost of the pension system.

The Bank of Estonia advises against rendering funded pension voluntary as it might result in smaller pensions down the line. The step would also create pressure on higher taxes.

Because withdrawals of pension savings are forecast to bring about growth inconsistency, the government would do well to avoid spending additional tax revenue and extend the minimum period of withdrawals.

Secondly, the government is urged to think of ways to motivate people to continue saving money through the funded pension system if the system is made voluntary.

Additionally, ways should be sought of how to protect unit-holders who have invested in second pillar funds that have invested the most in the Estonian economy and have less liquid assets.

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