Compulsory pension fund assets and membership in central and eastern Europe (CEE) continued to expand last year, driven partly by above-EU average economic and wage growth. The mandatory second pillar pension system in Poland, the largest CEE country, is by far the biggest, with total assets of €30.6bn at the end of 2006 and 12.4m contributors, according to the Polish Financial Supervision Authority.

Commercial Union Pension Fund, part of the Aviva group, remains the largest, with assets totalling €8bn and 2.6m members at the end of 2006, and a return of 15.4%. “The main contributor,” says Michal Szymanski, CIO and member of the fund’s management board, “was the outstanding performance of the local equity market.”In 2006 the Warsaw Stock Exchange’s broad WIG index rose by 41.6%, the WIG-20 index by 24% and the small cap index by a stellar 132.4%.

The strong contribution from equities is also highlighted by Grzegorz Chlopek, vice-president and CIO at ING Nationale Nederlanden Polska PTE. ING runs Poland’s second-largest pension fund with assets under management of €7bn). It returned 16.5% at the end of 2006. “Returns from long-term bond holdings, which accounted for 62% of pension fund portfolios at the end of 2006, were indifferent in 2006, averaging 4.3% in 2006,” says Chlopek.

“The outperformance of small cap stocks continues to present the biggest challenge for pension funds in 2006 and demands astute stock selection,” he adds. “It’s a liquidity challenge. By Polish standards these are small companies and from the pension fund perspective hardly investable for large institutional investors. The challenge is how to grab this performance while at the same time having all the risk measures in place.”

While the outlook for equity markets remains favourable, with GDP forecast to rise by 6% this year, rising interest rates can potentially dampen consumer demand. “A further risk is the possibility of a stock market liquidity bubble,” notes Szymanski.

Polish funds have a high exposure to equities, an average 34% at the end of 2006, which is close to their maximum limit of 40%. The maximum 5% on overseas investment also keeps the funds tied to Polish stocks. The constraints imposed by these limits have already been evident this year.

In the first two months, pensions funds were net buyers of domestic stocks, while between April and June they were net sellers. Nevertheless, the overall allocation increased to nearly 39% in May because of rising prices. “Because of the 40% limit, pension funds had to sell, otherwise they would have no further buying opportunities,” says Chlopek.

The level of the limits themselves are currently less of an issue than restrictions on other asset classes, which work against portfolio diversification and risk minimisation, Chlopek adds. In practice the funds have only three (Polish) classes: equities, bonds - mainly government issues as the corporate market is still too small - and cash and bank deposits.

The 5% overseas investment limit remains contentious. The Polish authorities claim that, since the funds only average around 1%, they do not need a higher cap but, as Chlopek points out, the 5% legal limit makes it too expensive. “Much of the cost of investment has to be covered by the pension fund company, not the fund members, which presents a conflict of interest for the companies.”

Additionally, overseas investment is restricted to entities with credit ratings, based on debt repayment criteria, which paradoxically excludes some of the world’s largest companies in terms of equity capitalisation.

In contrast to Poland, Hungary’s pension funds have traditionally invested largely in bonds, but this is now changing radically. To date, Hungarian mandatory pension fund members have only had the option of one portfolio. On average at the end of 2006 these portfolios comprised 69% bonds (primarily government securities), 10% stocks and 14% investment notes. But by 2009 each company will have to offer their members three portfolios with different risk profiles depending on the time left to retirement: a bond-weighted conservative portfolio for members with less than five years left, a balanced portfolio for those with five-15 years, and a dynamic one for the youngest members. The conservative portfolio allows a maximum 10% of stocks, the balanced one 10-40%, and the dynamic one a minimum of 40%. Riskier assets such as real estate will be prohibited in the conservative portfolio, while dynamic portfolios can invest up to 20% in property.

OTP mandatory pension fund, the country’s largest, had an equity exposure of 15-20% in 2006, says managing director Csaba Nagy. According to data from the Hungarian Financial Supervision Authority, the fund’s return was 8.44%.

OTP will be offering its new investment portfolios in 2008, a year ahead of the legal deadline, emphasises Nagy. He is looking forward to new asset classes for pension funds to invest in and a more dynamic environment. “As a result of the legal changes, we will be raising our equity exposure, and we expect to invest in other asset classes,” he says. “The Budapest Stock Exchange performance has been very good but, to diversify, we will be looking at foreign investment possibilities as well.”

These asset allocation shifts will have implications for other sections of the portfolio. “If we start to buy foreign equities, we will have to change the proportion of Hungarian bonds, so we need to evaluate the effect,” he cautions.

Estonia’s mandatory pension system already offers a choice of portfolios: a bond-based conservative portfolio and so-called progressive, equity-weighted one. Some pension fund asset managers also provide a balanced fund with an intermediate risk profile. With a population of only 1.34m, Estonia’s system is among the smallest.

Although membership of the system, in operation since the start of 2002, is inevitably levelling off - the number of subscribers at the end of 2006 was up by 8% to nearly 520,000 - the rate of asset growth over this period soared by 70% to €475m. This reflects Estonia’s exceptionally strong growth in 2006, with real GDP up by 11.4% year-on-year and average wages up by 16.5% in nominal terms.

Equity-weighted portfolios have proved the most popular - progressive structures accounted for 72% of total funds by assets, and balanced funds 18% - and they provided better returns last year. According to Fabio Filipozzi, fund manager at Hansa Investment Funds, returns ranged from 0% for the K1 conservative fund to 9% for the K3 fund, which has a 50% equity weighting.

Vahur Madisson, fund manager at SEB Ühispanga Fondid, says that SEB’s progressive fund returned 9.2% and the balanced fund 8.5%. The voluntary third pillar funds run by both companies, with significantly higher equity portions, had even higher returns. “We have been overweight in equities, at the expense of the bond markets, as we expected continued strong global economic growth in tightening monetary conditions,” he says.

Estonian pension funds have a high overseas exposure by regional standards. “The portfolio in 2006 was skewed towards equity, in particular east Europe, on the view that a convergence of east European countries would have been positive for these economies overall, and for equities in particular, thanks to the growing interest of international investors,” says Filipozzi. Almost half of Hansa’s pension fund equity allocation was in east European and Russian stocks. West European issuers dominated the bond allocation although Hansa increased its holding of Baltic and other east European bonds on the same reasoning as its equity strategy.

Future returns on Estonian pensions are thus especially dependent on global markets. “There are a number of challenges ahead: the residential and mortgage market meltdown and its spill-over to the rest of the US and other economies; continued tightening of credit and liquidity conditions; and high commodity prices and capacity utilisation affecting inflation,” cautions Madisson. “But this is counterweighted by strong growth in emerging markets that will start to finance much of the liquidity withdrawal in developed markets.”

In Slovakia, where collections started in March 2005, assets are currently growing at a fast rate from a relatively low benchmark, although the system does face potential contraction as a result of finance ministry proposals to allow contributors the opportunity to opt out in the first half of 2008. At the end of 2006, assets totalled €828m, a year-on-year growth in euro terms of 234%. Around 1.54m workers (60% of the workforce) have signed up.

The system is similar to Estonia’s. Pension fund companies must offer three portfolios: a conservative one based only on bonds and cash or bank deposits; a balanced fund with a minimum 50% bond/cash allocation and a maximum 50% in equities; and a growth fund with a maximum 80% equity allocation. Workers with 15 years or less left to retirement can only choose a balanced or conservative fund. Up to 70% of assets can be invested in foreign securities.

As in Estonia, the majority of subscribers (68% at end-2006) have opted for growth funds, followed by balanced funds (29%). With the funds still in the early stages of asset accumulation, their allocation strategies show considerable diversity.

At AXA, which this March took over the three funds run by Winterthur, the growth fund returned 4.94% in 2006, the balanced fund 4.6% and the conservative fund 3.45%, according to portfolio manager Erik Osusky. Term deposits accounted for the main class in all three portfolios (59% in the conservative one, 29% in the balanced fund and 54% in the growth fund).

Bond allocations ranged from 29% for the conservative and balanced funds to 23% for the growth fund. The balanced fund had a 13% equities share and the growth fund 16%. Osusky attributes the performance to money and bond market developments, with the central bank raising interest rates to dampen inflation and help Slovakia meet the Maastricht criteria for adopting the euro in 2009.

By contrast, ING ran portfolios with heavier bond and equity weightings. Its conservative fund, which returned 3.2%, invested 66% of assets in bonds and 34% in money market instruments, the balanced fund had 71% in bonds and 14% in equities, and the growth fund 66% in bonds and 18% in equities.

“In the case of the conservative fund it was difficult to invest in bonds and keep to all strict legislation requirements,” says Pavol Ondriska, investment manager at ING dss. “ING’s Slovak pension funds were among the first to build up an equity portfolio, which meant that our performances were hit more seriously by the sell-off in June 2006.”

Geographically, the equity allocation went as high as 50% in the euro-zone, 20% in the Czech Republic, Poland and Hungary, 15% in Japan and 15% in the US. In 2007 the CEE and Japanese portions fell slightly in favour of the US.

The bonds were all Slovak koruna denominated, reflecting in part the high cost of currency hedging: all the assets in conservative funds, and up to 50% in the balanced ones must be fully hedged against currency risk. In this context adopting the euro will make life significantly easier.

“At present the Slovak market is very illiquid, with high bid-offer spreads in the case of bonds and no suitable domestic stocks to invest in,” complains Ondriska. “If Slovakia accepts the euro in 2009 as planned, our universe of potential investments will spread significantly.”