Private pension funds in Hungary : early performance and regulatory issues

Despite the limited scope resulting from the high payroll taxes for the compulsory, unfunded public pillar in Hungary's pensions system, the early voluntary private pensions fund performance has been encouraging. Investment returns have been well above the inflation rate and participation has expanded rapidly. However, the sector is highly fragmented and regulatory weaknesses exist: no compulsory use of custodian and licensed asset managers; use of book values and cashflow accounting rather than market values; costly tax treatment, benefiting high income earners while not providing incentives to non-taxpayers; infrequent statements and inadequate information fund performance disclosure; no minimum relative profitability levels guarantees; and a need for strengthened and more effective supervision. Without systemic reform the private pension fund potential will remain limited. Hungary's pension system suffers from the same problems that afflict most pay-as-you-go (PAYG) systems in Eastern Europe: high system dependency rations, low retirement ages, lax disability pension criteria, increasing evasion, heavy pension costs, and large deficits. In May 1996, Hungarian authorities decided to create a mixed system of two mandatory pillars and one or more voluntary pillars. The first pillar will offer all eligible Hungarian workers a basic PAYG pension, while the second pillar will be a fully funded, privately managed, decentralized system based on individual capitalization accounts. The private pillars should boost economic growth by developing capital markets and removing labor market distortions. Systemic reform faces two challenges: whether to impose the mandate on individual workers or their employers, and how to build a mandatory pillar on to existing voluntary pillar institutions. The author suggests the use of a hybrid mandate combining an employer mandate with the right for workers to opt out and join an independent fund as a compromise. Most other regulatory issues would apply with as much severity under a compulsory private funded pillar as under a voluntary one.