The office of Mikhel Oim, executive chairman of Hansa Fund Management, is in Tallinn’s burgeoning modern business sector, which spreads out below the picturesque old walled town. Its location mirrors the country’s pensions sector, which has seen new second and third pillar schemes grafted onto a crumbling Soviet-era PAYG first pillar.
Hansa Fund Management is one of the five pension fund management companies providing second-pillar pensions. “In July we celebrated the third anniversary of our reformed pension system,” he says. “And to date there have been no major problems.”
On Estonia’s re-emergence as a sovereign country on the collapse of the Soviet Union in 1991 it began transforming itself into a market economy. And in the decade and a half since, the country has proved to be among the most adept at switching its focus from east to west.
The pension reforms that created a mandatory second pillar and a voluntary third pillar were a key element of the renovation.
The first pillar is funded by a 20 percentage points slice of a 33% of each employee’s gross salary social tax paid by employers. The second pillar contribution level was set at 6% of a participant’s gross wage, consisting of the diversion of four percentage points of an employer’s first pillar tax, which will be offset by a reduced state pension to the beneficiary, and an additional 2% to be paid by an employee. Those born in or after 1983 were obliged to join the second pillar funds and those aged over 60 were barred from switching but the reform’s success was to be measured by the uptake of those who could choose.
In the event, the response far exceeded all expectations and by 2004 some 453,000 of the 600,000 people actively participating in the labour force subscribed to second pillar funds, putting EEK4bn (€256m) into the system, rising by EEK2.5-3.0bn a year. “This is a huge amount for Estonia where GDP was EEK139bn in 2004,” notes Raivo Sormunen, editor and analyst at Estonian business newspaper Äripäev.
Members must be offered two options, a pure fixed rate fund and one with 50% equity, and most providers offer one in between. “The rationale was widely understood, and the 50% equities option has proved the most popular, although more elderly participants have generally gone for the bond-only option,” explains Tõnno Vähk, head of LHV-Seesam Asset Management.
“Gross salaries in Estonia are about EEK6,000-7,000 a month,” Vähk adds. “So 6% of a gross salary means about e30 a month per person, and with up to 500,000 people making contributions that means some e10-15m flowing into the system. And that’s a lot of money in Estonia.”
But is it enough in investment terms? “I think that pension funds have already reached critical mass so we can trade with market-sized amounts,” says Siim Valner, fixed income portfolio manager at ERGO Asset Management. “The size of the funds is not a hurdle.”
“We saw 2003 and 2004 as quite difficult years but after the tumult of setting up the system now it has stabilised and the system is now well established in peoples’ minds,” says Silja Saar, managing director at Sampo Baltic Asset Management. “However, we have not yet seen what would happen should markets become more challenging. But then again, the combination of contributions from the state system as well as the member means that people are not so sensitive about seeing the performance increasing and decreasing. And as there are regular contributions, downturns help them to buy units cheaper.”
Vähk is also upbeat on the second pillar outlook. “The markets might change direction and we could see negative returns, but people can’t withdraw money from the schemes, they’re in for the long term so we will be OK,” he says. “A crash might knock confidence, but even if a fund lost 10% of its value, returns have been so good up to now that the system would be secure. And people would not lose their savings because there is a state guarantee fund as the final safety net.”
The smallness of the local markets has not proved to be the problem seen elsewhere in emerging Europe. “When we launched the second pillar we knew that our local stockmarket would be too small, so on the investment side we have been given a relatively free hand,” says Saar. “We can invest all over the world.”
“Earlier this year Hansabank, the stockmarket’s largest listing, delisted after Swedbank acquired the 40% it didn’t already own,” says Oim. “But the money that minority Hansabank shareholders received is looking for a new investment home and this, together with the availability of pension fund money, is acting as a catalyst to encourage new stockmarket listings.”
“There have been two domestic IPOs this year and we are expecting one or two others this year and a few more next,” says Valner. “But because the local markets are quite shallow, some 90% of the pension money is invested outside the Baltic States.”
“Estonia was not in the first wave of changes and so could learn from the mistakes of others,” says Vähk. “There are no limits on investing abroad and you are not fined if your returns is below the average of your competitors as elsewhere in the region, and this allows you to concentrate on getting the best returns.”
But there has been a regional bias in equity investments, notes Andrei Zaborski, manager of SEB Ühispank Investment Fund’s conservative fund. “Central and eastern Europe have been seen as good markets, so all equity portfolios have considerable exposure to those markets because they offer a high return.”
“We are overweight in CEE – our home region,” Valner concedes. “Anyone underweight in new EU member states, taking into account their economic dynamics and political stability, probably needs to go back to school.”
But for Saar, this is a potential danger. “Local players should not stick to emerging Europe,” she warns. “It has been the trend and one that has worked very well because these markets are very popular and will continue to be so. But if our portfolios are well diversified in the future I don’t see there will be a problem.”
“Bond portfolios have most of their investments in western Europe, largely the Euro-zone which, because the fixed currency exchange rate means we don’t have to hedge euro positions,” says Zaborski. “But Estonia’s double taxation agreement with the US means that we are not interested in US issuers as we would be taxed on those investments.”
And the authorities have imposed some investment restrictions. “The major limits are that you cannot put more than 5% of a portfolio into any one investment, except if it’s an investment fund when the ceiling is 10%, there’s a 30% limit on open currency positions and instruments must be listed or rated,” notes Vähk. “Also 3% on the bond side may be in non-investment grade paper.”
“The Investment Fund Act, which regulates pension funds, restricts the use of derivatives,” says Zaborski. “Legislators appear to have had too little knowledge about the requirements of portfolio management techniques, the use of derivatives as hedging tools or even just what kind of elements there are in the derivatives universe. For example, the law does not support hedging through indices. So, while hedging through derivatives could be easier, faster and cheaper we don’t do it because either we don’t have the opportunity or we are afraid of using those instruments because we are aware that there may be different understandings between a fund and the supervisor. We feel it’s better to avoid the subject altogether and as a result we may fail to meet our investment objectives and underperform our benchmark.”
For Vähk the second pillar is secure and the new front is on the third pillar. “People have two options,” he says. “They can take a voluntary pension from one of the second pillar pension funds or they can take out a contract with a pension insurance company. But the insurance companies more or less oblige their customers to take a life policy with the pension, which makes it expensive and reduces the amount put towards the pension. Nevertheless, they have been successful in attracting subscribers to their schemes, using links with banks and contacting their existing client base to cross sell their pension products.”
Saar is looking further ahead. “What I see as a potential over-the-horizon challenge is the effect of the EU’s broadening of the possibilities for people living and working outside the Baltics,” she says. “The world has opened up and this may have inferences for us that we cannot begin to imagine today in terms of competition. The idea would be that you could work in Estonia but you could be connected to a pension fund somewhere else or visa versa, and this could be challenging.”

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