Sunday, November 28, 2010



It was a pure coincidence, since one of our principals was just visiting Budapest for a meeting with one of our best-of-breed investment managers, but exactly when LMG was there the Hungarian government announced that it was considering a blackmailing operation that would basically nationalize the private branch of the pension system. In this little contribution we provide you with some basic information about the Hungarian move, and why we believe - using plain and simple economic math - that it is a disastrous one.

 Budapest by Night: 
Will the Hungarian government put its pension system back into the Dark Ages?

The Hungarian idea: How to get your hands on quick money

We often encounter it in our discussions with high level pension plan representatives and private clients when talking about pensions. Pensions are an odd savings product. Basically they provide premium paying members with some security for later so that they can cope with their income needs and liabilities after they retire. Knowing how much trouble people have with proper incorporation of risks, especially those that are further out in the future, we believe that it is an excellent idea for all societies.

Some kind of mandatory element within a pension system is not necessarily bad either. Reason being that people always tend to over-concentrate on short-term issues thereby underweighing the importance of the long-term. True: Keynes said 'In the long run we are all dead', but before that happens there is also a part of the long run during which we hope to still enjoy a happy life. But that has to be done without the support of large, work-related money inflows after retirement. Pension systems try to balance things out.

When countries set up pension systems, initially there is a situation with lots of people paying premiums and not that many people yet already entitled to retirement payments. In other words: initially the pension system is - before it reaches maturity and incoming cash flows are more or less balanced out by outflows - a nice aggregated savings account that is fed with new money on an ongoing basis.

Therefore no surprise that - when this system is growing - governments might treat it as a nice source of potential money if they can get their hands on it. In the Hungarian case the 2nd pillar of the pension system had a total value of Euro 9.6 billion. Taking into account a value of GDP of USD 129.4 billion (CIA Factbook, estimate 2009) and total government debt of 78 percent of GDP and a budget deficit of about USD 5 billion (2009 estimate) we can of course imagine the interest of the Fidesz government in the system at a time when many smaller European states are struggling with their finances (Greece, Ireland, Portugal, Iceland etc).

The Hungarian government was already aware of this and did already introduce certain elements into the system that according to LMG are less optimal. Example: the first pillar of the system (mandatory government pension component) translates into retirement payment levels of 100 percent for those who get their pensions fully from within the government pension system (per unit of premium paid), with those who also save via the private system getting only 75 percent of that. In other words: there is a kind of 25 percent penalty (with current Hungarian interest rates that translates into 4 years of interest!) for those allocating their funds in a more diversified way (partly via the government in the first pillar and partly outside via the private 2nd pillar). We believe that this is a huge discount, already an indirect way of blackmailing people to stay within the government system. Why? Well, the only reason can be that governments want to treat this first pillar as readily available quick money that they can either use indirectly (by pimping up the capital balance of the government) or worse: directly, by eating from the savings accounts in times of needs.

But now things are getting even worse. The government proposed people to re-enter completely into the government system stressing the fact that this would already immediately translate into this 25 percent higher value of the first pillar payments. But still: only 30 percent of people opted for this, with the rest being skeptical. And that is a clear indication that the reputation as a trusted partner of the government was not really that good. To make things even worse: the government did not leave it there. It went on to state that those that would not opt for this arrangement would loose their right within the first pillar altogether !! In other words: come back and be freed of the 25 percent discount or stay and be robbed of your premiums paid for the first pillar by forfeiting your right to retirement money from that pillar altogether. In other words: those who would continue to fund within the private system would pay a discount in pillar one of 100 percent making payments for that pillar just an ordinary taxation.

That is the same as blackmailing people back into a government-owned pension system. Yep, a true nationalization.

But quick money can be very expensive money

But quick money can be expensive money. And that is what is going on here. Suppose that the government can get back the full Euro 9.6 billion within its system for whatever goals it has in terms of short-term monetary and economic policy. Then it will also have to incorporate in its analyses that financial market participants and the population alike will further increase their risk premium in anything they do. Not just with respect to government related financial affairs but foreigner will do the same with their treatment of Hungary as a potential country to invest in.

Let's start with the first part: based on the numbers above the public debt of Hungary is about USD 100 billion. One percent additional risk premium due to government mistrust after this action would already translate into USD 1 billion additional annual interest.

Investments as a percentage of GDP in Hungary stand at 20 percent (CIA Factbook 2009 estimate). This translates into about USD 25 billion per year. Is it unlikely to believe that the aforementioned blackmail / robbery translates into 10 percent less investment willingness by Hungarians and foreigners? We don't really think so. That would already imply a downward pressure on investments of USD 2.5 billion. So, if we combine these two factors and assume that not a single government in the world - and definitely not within EU where Hungary is already a member - can get away with robbing Euro 9.6 billion in total, we will see that the added value of the action by the Hungarian government in terms of net cheap money value is maybe at best as large as 25 percent of the money that comes back. That is money they could technically eat way in the short-term compensating for it later by giving people back that 25 percent discount.

So that would imply a short-term additional source of funding of 25 percent of Euro 9.6 billion or rounded (Euro 2.5 billion). For that component the government could say: 'look, you guys have that in VALUE for LATER, but we pay you by cancelling that 25 percent discount within the first pillar' and 'And after all you cannot spend that money now anyway, because it is retirement income for later'. It would like a bookkeeping trick giving the government short-term cash.

But our negative 'opportunity cost' calculation did already add up to USD 3.5 billion. And that was an amount with potentially repetitive character. It takes ages to rebuild trust.

Therefore: instead of considering this robbery the Hungarian government should start to do what any government in financial crisis should do. Re-organize its finances and make sure that it introduces an austerity program that helps overcome the crisis.

Robbing pension pillars might seem an easy way out because a lot of people do often mistake short-term pension premiums for tax amounts (because of the fact that retirement money comes back to them so many years later), but especially in countries that do not take 'trust' and 'financial discipline' serious the overall costs can be huge.

What Hungary can learn from Chile

Emerging countries should learn from the example of Chile. The South-American country established a well-functioning pension system under former dictator Pinochet. Pinochet was definitely not a good leader for his people in many respects, but there was one thing he understood very well: army folks are not economists. He did therefore ensure that technocrats of the highest level created a pension system that installed a solid system of saving for later. While funding the system, the pension system as aggregate entity became one of the most important investors in the economy. The system encompassed rules that implied constraints on the amount of money that was to be invested abroad with the amounts/percentages to be invested in Chile itself not so high as to impose excess risk to the system. On the contrary, it created a purely technocrat investment structure that helped support the very cyclical Chilean economy (dependent to a large extent on copper sales and price levels in international markets) by investments in other industries and/or stabilization of investment levels as percentage of GDP.

 Pinochet did do good things as well: the Chilean Pension System

Also: the fact that the pension pillars were not as closely associated with government policy (always more short-term oriented than the long term goals of the pension system) did also provide it with 2 other advantages:
  1. Diversification: the government was now not the only entity controlling the economy. The pension system was a second important force. Diversification over 2 entities is indirectly a kind of risk diversification and that was something of great value in a cyclical economy.
  2. Integrated attention for both the short-term and long-term aspects of economic growth. With the government worrying by definition about shorter-term economic goals (and often bad at longer-term decisions that would often be associated with lots of costs now and returns further away in the future) and the pension system about the long-term economic policy of Chile as a country became more balanced as well.
Chile is still benefiting from that. Hungary seems to have forgotten all this. Both financial analysts and the European Commission have expressed their worries and condemned the Hungarian propositions. There is still time until January 2011 when the Hungarian government wants to finalize its decisions. Let's hope that they won't destroy their country's economic opportunities through this silly mistake! 

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