Dinko Novoselic (pictured right) explains that, although appealing for decision makers and the public, guaranteed returns have hidden costs

Pension reform in CEE countries started in the mid-1990s. Governments across the region, from Estonia to Bulgaria, adopted a World Bank model and introduced mandatory, fully-funded private, or second pillar, pension funds. Hungary was the first to adopt the new system, other countries followed and with the recent introduction of second pillar pension funds in Romania pension reform in CEE countries looks complete.

However, while second pillar pension funds throughout the region are not identical, differing in contribution rates and age requirements, they have a number of common features. One of these is the giving of guarantees to fund members.

The region's second pillar pension funds operate as defined contribution (DC) schemes, and the guarantees embedded in the new pension systems, differ in their technical aspects. In most cases guaranteed returns are based on the average return of the pension funds on the market over the short term - usually from one to three years. Romania is the exception, with the simple principal guaranteed over the entire membership period.

Setting aside populist attacks on the general idea of the new pension systems evident in some form or another across the CEE, the system of guarantees is the main element of controversy. There is a fundamental difference between, on the one hand, the way that the guarantees are viewed by the general public and policymakers and, on the other, the way they are viewed by the pensions industry.

We in the industry look upon guarantees as a poison apple from a fairytale: very attractive from the outside but dangerous to those who bite.

To explain why they were adopted so widely in the region we need to go back a decade or so in central European history. The countries that emerged from decades of communist rule had undeveloped or sometimes non-existent capital markets, shaky banking systems, pyramid schemes and a financially uneducated public. This was not the best environment for shifting pension savings to capital markets via DC schemes. Safety and security of the new pension system were the main issues. So a public hungry for security ate the poison apple of guaranteed returns.

And looking back across the expanse of a decade and more, we can understand that while the hunger was undeniable, nobody saw the risks. The problem is that after 10 successful years, there are many who are again ready to eat the poisoned apple.

Both pension professionals and the public who so vigorously support guarantees tend to look at them as options. Supporters look at a guaranteed return as something that would give them a ‘best-of-two-worlds' outcome: full participation in times of booming capital markets and full protection in a crisis. We, on the other hand, look at it as a financial option: somebody writes it, somebody pays for it; there is a price and there is volatility.

And who pays for it? Well, this is an easy question: the members always pay for it. The main problem is that nobody is given the bill because the cost of a guarantee is not transparent. The bill is mostly presented in the form of an invisible opportunity cost. Even where a fund manager has been formally presented with a charge in a case where a guarantee is activated, the manager would indirectly shift this cost to the members by investing the fund assets in a way that minimises the risk of an activation.

It is easy to run a simple correlation calculation on monthly returns of pension funds in countries with guarantees based on average market return. In Croatia, for example, the number is above 0.9. This is an obvious illustration of the herding effect where, in a world of relative guarantees, different pension funds tend to have similar portfolios. In other words, in a world of relative guarantees risk is also relative.

Therefore, we have quite often seen pension fund managers buying expensive and illiquid domestic equities as part of a risk-minimising strategy. When faced with a minimal rate of return to be delivered, fund managers are put in the position of chasing short-term targets instead of focusing on delivering a higher long-term rate of return that corresponds to the long-term investment horizon of the fund.

This short-term focus influences asset allocation, making it inefficient either through a lower rate of return over the long term or through higher absolute risk.

Croatia is one example where allocation to equities, both domestic and international, has traditionally been lower than those allowed by pension fund legislation. Although Croatian pension funds are allowed to invest up to 20% of assets in international equities, the allocation is usually around 5%. This can be explained partially by a quite rational decision to avoid activation of guarantees in case of a major market crisis.

On the other hand, Polish pension funds offer an example of irrational risk taking through a high allocation to domestic equities. Their allocation to domestic equities has traditionally been very close to the legal limit. At the same time they lacked diversification because investments in international equities were significantly lower. So, it is obvious that the fund members pay for these irrationalities.

How much does it cost? Without going into the complex field of option pricing, a few factors are clear: the higher the volatility, the higher the price and the shorter the guarantee period, the higher the price.

We all know that domestic CEE markets are more volatile than developed markets, yet pension fund legislation in the CEE region tends to force fund managers to invest domestically, thus increasing volatility, which in turn increases the price that the members pay for their guarantees.

When I was first informed of the Romanian pension fund guarantees system, where members are guaranteed that at the time of retirement they would withdraw at least as much money as they had paid in, it struck me that if guarantees are perceived as being necessary, then this is the way it should be done. First, the guarantee is extended over the long term, making the option cheap. Second, it is intuitively understandable by the funds' relatively financially uneducated members.

The alternatives to this simple guarantee which we see elsewhere in the region include rules fixing complex formulae for the calculation of a guaranteed rate of return based on the average return on the market. Such formulae can be found in Poland, Slovakia and Croatia where no one actually understands what is guaranteed in the new pension system.

Finally, do members actually need the guarantees? Members need protection but at a reasonable price. The opportunity cost embedded in the new pension systems with relative guarantees is too high. Investment limitations for mandatory pension funds in the region are generally very strict which, by itself, creates opportunity cost. Adding more ‘protection' through guarantees creates a doubtful marginal benefit and an obvious marginal cost.

Members of CEE second pillar pension funds are young, mainly in their thirties, with decades of work ahead of them before they retire. In other words, second pillar pension funds have a long investment horizon. Our members do not need expensive over-protection when they can bear the risk.

A system of relative guarantees presents fund managers with a conflict of interest which is often resolved against fund members. Fund managers will always have guarantees in mind when deciding on asset allocation, tilting it in order to minimise the activation of guarantees. It would not be fair to say that the system of relative guarantees is the only reason for sub-optimal asset allocations, but it definitely adds pressure to deliver short-term results in line with market average.

The pension system should encourage fund managers to focus on delivering optimal risk-adjusted returns over a long period. Pressure for short-term results will come from pension fund competition and there is no need to exacerbate it through system of guarantees. Especially since the protection it offers does not appear to be rational.

Education is the most important issue here for the general public as well as for lawmakers and regulators. Only a financially educated public can accept risks as something that can be managed and diversified, but not annihilated or ‘legislated away' through the system of guarantees. Only a financially educated public can understand that investment guarantees in pension funds are the apples and that we do not have to taste them to figure out they are poison.

Dinko Novoselic is CEO of AZ mandatory pension fund, the second pillar pension fund owned by Allianz and Unicredito in Croatia, which is the market leader by both assets and members