## Appendix I. An Analysis of Price Competition in the Pension Sector

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### I. Introduction and Reform Design
- Reform implemented March 1999 introducing multi-pillar system replacing DB PAYG.
- Pillars:
  - Zero pillar: minimum pension guarantee.
  - First pillar: publicly managed NDC system.
  - Second pillar: privately managed, fully funded system (OFEs/PTEs).
  - Third pillar: complementary fully funded private sector.
- By 2005:
  - More than 70 percent of active contributors enrolled in the second pillar.
  - Pension fund assets about 9 percent of GDP and 10 percent of total financial assets.
- Policy issues identified:
  - Review competition policies that sustain small funds under strict fee caps.
  - Diversify portfolios via investment regime changes and domestic instrument development.
  - Strengthen internal risk management.
  - Elaborate regulatory framework for payout phase.

### II. System Rules, Coverage, and Key Statistics
- Participation rules:
  - Mandatory for workers under 30; workers 30–50 could opt to second pillar; >50 remained in old system.
  - Retirement ages: 60 (women), 65 (men).
- Contribution structure (percent of gross wages):
  - All workers: 19.52 percent to old age pensions.
  - 13 percent to disability and survivorship insurance.
  - 2.45 percent for sickness insurance.
  - Mixed system (first + second): 12.22 percent to first pillar and 7.3 percent to second pillar.
- Expected replacement ratio: 60 percent for average income, full career workers (first + second pillars).
- Minimum pension: around 25 percent of economy-wide average wage.
- Selected indicators (1999–2005) — preserved exactly as in source:
  - 1999:
    - ZUS contributions: 10.4 (% of GDP)
    - OFEs contributions: 0.4 (% of GDP)
    - Contributors: 13,270 (1,000)
    - Labor Force: 7,457 (1,000)
    - Coverage Ratio: 17,214 (%)
    - Pillar II Coverage: 56.2 (%)
    - Covered Wage Bill: 29.2 (% of GDP)
  - 2000:
    - ZUS: 9.2
    - OFEs: 1.1
    - Contributors: 13,059 (1,000)
    - Labor Force: 8,617 (1,000)
    - Coverage Ratio: 17,300 (%)
    - Pillar II Coverage: 75.5 (%)
    - Pillar II as % of General: 66.0 (%)
    - Covered Wage Bill: 27.8 (% of GDP)
  - 2001:
    - ZUS: 9.3
    - OFEs: 1.2
    - Contributors: 12,851 (1,000)
    - Labor Force: 8,595 (1,000)
    - Coverage Ratio: 17,229 (%)
    - Pillar II Coverage: 74.6 (%)
    - Pillar II as % of General: 66.9 (%)
    - Covered Wage Bill: 28.4 (% of GDP)
  - 2002:
    - ZUS: 8.8
    - OFEs: 1.2
    - Contributors: 12,761 (1,000)
    - Labor Force: 8,625 (1,000)
    - Coverage Ratio: 17,097 (%)
    - Pillar II Coverage: 74.6 (%)
    - Pillar II as % of General: 67.6 (%)
    - Covered Wage Bill: 27.3 (% of GDP)
  - 2003:
    - ZUS: 8.3
    - OFEs: 1.2
    - Contributors: 12,739 (1,000)
    - Labor Force: 8,705 (1,000)
    - Coverage Ratio: 16,991 (%)
    - Pillar II Coverage: 75.0 (%)
    - Pillar II as % of General: 68.3 (%)
    - Covered Wage Bill: 25.9 (% of GDP)
  - 2004:
    - ZUS: 8.0
    - OFEs: 1.1
    - Contributors: 12,857 (1,000)
    - Labor Force: 9,003 (1,000)
    - Coverage Ratio: 17,139 (%)
    - Pillar II Coverage: 75.0 (%)
    - Pillar II as % of General: 70.0 (%)
    - Covered Wage Bill: 24.9 (% of GDP)
  - 2005:
    - ZUS: 8.0
    - OFEs: 1.3
    - Contributors: 13,130 (1,000)
    - Labor Force: 9,215 (1,000)
    - Coverage Ratio: 17,283 (%)
    - Pillar II Coverage: 76.0 (%)
    - Pillar II as % of General: 70.2 (%)
    - Covered Wage Bill: 25.1 (% of GDP)
- Notes: (1) At least one contribution during the year; Source: Ministry of Labor and Social Security.

### III. Fiscal Impact and Transition Financing
- Financing options discussed:
  - Tax-financed transition: temporary burdens on current generations; can increase domestic savings and growth.
  - Debt-financed transition: explicit public debt rises; future generations bear imbalances.
  - Optimal mixed strategy: more debt finance early, more tax finance later.
- Empirical outcome for Poland:
  - Transition was fully debt-financed and accompanied by additional fiscal deterioration.
  - Between 1999 and 2003:
    - General government deficit (neutralizing losses) increased from -1.5 to -4.7 percent of GDP.
    - General government deficit reflecting all losses increased from -1.8 to -6.4 percent of GDP.
  - Increase in fiscal deficit (excluding reform effects) by 3 percent of GDP between 1999 and 2003:
    - Contributed to a 2 percent decline in national savings.
    - Public debt rose from 36 to 48 percent of GDP.
  - Fiscal costs of reform estimated at about 12 percent of GDP.
- Selected macro and fiscal indicators (1999–2005) — preserved exactly as in source:
  - 1999: (1) 4.1, (2) -, (3) -, (4) 0.7, (5) -1.5, (6) -1.8
  - 2000: (1) 4.0, (2) 18.7, (3) 36.9, (4) 2.5, (5) -1.8, (6) -2.8
  - 2001: (1) 1.1, (2) 18.0, (3) 38.8, (4) 4.6, (5) -3.7, (6) -4.8
  - 2002: (1) 1.4, (2) 16.1, (3) 43.6, (4) 6.6, (5) -3.2, (6) -5.0
  - 2003: (1) 3.8, (2) 16.6, (3) 48.5, (4) 8.7, (5) -4.7, (6) -6.4
  - 2004: (1) 5.3, (2) 16.2, (3) 46.9, (4) 10.5, (5) -3.8, (6) -5.6
  - 2005: (1) 3.2, (2) 17.9, (3) 48.3, (4) 12.7, (5) -2.9, (6) -4.7
- PAYG projections and fiscal outlook:
  - Fiscal deficits declined by about 2 percent in the last two years.
  - PAYG system projected to get close to equilibrium by 2014.
  - Pension expenditures projected to decline from around 10.6 percent of GDP in 2004 to 8.1 percent of GDP by 2014 due to:
    - expected increases in effective retirement age,
    - price-indexation of benefits,
    - expected reduction in disability pensioners.

### IV. Second Pillar: Market Structure, Operations, and Custody
- Market concentration and ownership:
  - Number of pension funds declined from 21 (1999) to 15 (2005).
  - Three largest pension funds account for 64 percent of total assets.
  - Five smallest funds account for 8.4 percent of market; smallest fund < 1 percent.
  - Seven largest funds controlled by insurance companies; three PTEs controlled by banks; two with controllers not linked to active financial holding groups.
  - High foreign ownership (AIG, ING, Aviva, Allianz, Winterthur); PZU is only larger PTE controlled by domestic insurer.
- Centralized collection (ZUS):
  - ZUS distributes contributions to second pillar among pension funds within two weeks from receipt.
  - Companies with >5 employees must submit contributions electronically: roughly 75 percent of labor force and 95 percent of total contributions.
  - Reconciliation problems now < 1 percent; PLN 1 billion from 1999–2001 still to be cleared.
  - Monthly flows volatile; volatility increased since 2003.
- Account management:
  - Most PTEs outsource to transfer agents: eight management companies, seven related to PTE financial groups.
  - Only four PTEs manage accounts internally.
  - Average cost of account management services: about USD 3.6 per member per year.
  - Contracts not standardized, limiting direct comparisons.
- Custody and operational risk:
  - All securities deposited at National Depository of Securities (KDPW).
  - All domestic transactions authorized by a custodian bank; six custodian banks exist.
  - Each PTE must select a custodian bank not related to the company.

### V. Asset Accumulation, Portfolios, and Returns
- Pension fund assets (Millions of US Dollars; % of GDP):
  - 1999: 544 ; 0.3
  - 2000: 2,396 ; 1.3
  - 2001: 4,869 ; 2.5
  - 2002: 8,223 ; 3.9
  - 2003: 11,986 ; 5.3
  - 2004: 20,943 ; 6.8
  - 2005: 26,396 ; 8.9
- Portfolio composition (end-December, % of total):
  - 1999: Government Instruments 53.2 ; Bank Securities and Deposits 2.1 ; Equity 29.9 ; Other Fixed Income 14.9 ; Foreign 0.0 ; Others 0.0 ; Total 100.0
  - 2000: 62.8 ; 2.1 ; 34.9 ; 0.2 ; 0.0 ; 0.0 ; 100.0
  - 2001: 67.1 ; 2.8 ; 28.3 ; 1.4 ; 0.4 ; 0.0 ; 100.0
  - 2002: 67.9 ; 2.6 ; 27.1 ; 1.0 ; 1.4 ; 0.0 ; 100.0
  - 2003: 61.6 ; 3.9 ; 32.0 ; 0.8 ; 1.5 ; 0.2 ; 100.0
  - 2004: 59.4 ; 4.5 ; 32.8 ; 0.6 ; 2.2 ; 0.5 ; 100.0
  - 2005: 62.5 ; 3.4 ; 31.4 ; 0.5 ; 1.7 ; 0.4 ; 100.0
- December 2005 comparative portfolio shares (selected row for Poland):
  - Poland: Government Bonds 62.5 ; Financial Institutions 3.4 ; Corporate Bonds 0.5 ; Domestic Equity 31.4 ; Foreign Assets 1.7 ; Other 0.5
- Equity concentration (end 2005):
  - Pension funds invest in 167 listed companies.
  - Share of largest companies in equity portfolio (%):
    - Top Five Companies: 52
    - Ranked 6 to 20: 16
    - Ranked 21-50: 18
    - Ranked 50-100: 7
    - Remaining Companies: 7
    - Total: 100
  - Share of combined pension fund equity holdings in company equity (%):
    - Top Five Companies: 10
    - Ranked 6 to 20: 8
    - Ranked 21-50: 22
    - Ranked 50-100: 27
    - Remaining Companies: n.a.
- Foreign assets low: 1.7 percent (2005); ceiling on foreign assets 5 percent.
- Historic rates of return and drivers:
  - Average historic real rate of return since 1999: 8.8 percent p.a.
  - Annual series (selected entries):
    - 2000: Real Annual Rate or Return 4.1% | Inflation Rate 8.6% | Real GDP Growth 4.1% | NDC indexation rate 3.8%
    - 2001: 3.5% | 3.6% | 1.1% | 3.0%
    - 2002: 12.7% | 0.8% | 1.4% | 1.1%
    - 2003: 9.1% | 1.7% | 3.8% | 0.3%
    - 2004: 9.4% | 4.4% | 5.3% | -0.7%
    - 2005: 14.2% | 0.7% | 3.2% | 4.8%
    - Average since 1999: Real Annual Rate or Return 8.8% | Inflation Rate 3.3% | Real GDP Growth 3.1% | NDC indexation rate 2.0%
  - High returns driven by capital gains from declining interest rates and buoyant equity market (WIG20 real returns ~25–30 percent p.a. in past three years).
  - Future returns depend on portfolio diversification and access to broader assets.

### VI. Market Limitations, Investment Regime, and Risks
- Domestic capital market concentration:
  - Government Debt: 32.2 percent of GDP; Equity: 31.9 percent of GDP; Corporate Bonds: 0.8 percent of GDP; Municipal Bonds: 0.3 percent of GDP.
- Table 18 holdings by holder (shares of total) — selected preserved values:
  - Pension funds: Government Debt 17.6; Corporate Bonds 1.7; Equity 8.6
  - Banks: Government Debt 22.8; Municipal Bonds 75.6; Corporate Bonds 35.7; Mortgage-Related Bonds 55.0
  - Foreign investors: Government Debt 22.1; Equity 49.4; Venture Capital 99.9; Mortgage-Related Bonds 26.9
- Investment ceilings and circumvention risks:
  - Investment fund quotas limit 25 percent may not restrict underlying assets of closed-end funds—route to circumvent ceilings (example: 5 percent foreign limit).
  - Ceilings on fixed-income instruments (selected entries preserved exactly):
    - Municipal Bonds: Traded Publicly 40% ; Non Traded Publicly 20%
    - Secured: Traded Publicly 40% ; Non Traded Publicly 10%
    - Corporate Bonds: Unsecured 10%
    - Mortgage Bonds 40%
    - Revenue Bonds 20%
- OTC trading risks:
  - Pension funds authorized to trade in OTC market which is not very transparent; OTC transactions not captured in price databases; opens room for price manipulation and hidden commissions.
- Foreign asset constraints:
  - Ceiling 5 percent; funds invested < 2 percent; commissions to foreign brokers cannot be netted from returns, reducing attractiveness.

### VII. Fees, Costs, Industry Profitability, and Competition
- Operational costs and fees:
  - Poland operational cost per contributor: USD 26 (selected countries average USD 65).
  - ZUS charges 80 bps of contributions for collection services.
  - Account management cost: about USD 3.6 per member per year.
- Fee levels and caps:
  - Total fees currently amount to 160 basis points of assets.
  - Contribution fee cap: 7 percent for new contracts after 2004; progressively reduced to 3.5 percent in 2014.
  - All but one PTE charge maximum contribution fee.
  - Projections (preserved exactly):
    - Table 13 Management Fee (% Total Fee) and Average Fee (% Assets)
      - 2005: Management Fee 30 | Average Fee (% Assets) Total System 1.51 | Smallest Five OFEs 1.61 | Largest Three OFEs 1.36
      - 2010: Management Fee 52 | Average Fee (% Assets) Total System 1.02 | Smallest Five OFEs 1.05 | Largest Three OFEs 0.93
      - 2020: Management Fee 83 | Average Fee (% Assets) Total System 0.61 | Smallest Five OFEs 0.69 | Largest Three OFEs 0.43
      - 2025: Management Fee 86 | Average Fee (% Assets) Total System 0.54 | Smallest Five OFEs 0.62 | Largest Three OFEs 0.35
    - Average ratio of total fees over assets projected to decline from 160 basis points to 50–60 basis points by 2020.
    - Total fees projected to cross the threshold of 100 basis points in 2010, declining further to about 50–60 basis points subsequently.
- Profitability (ROE) and consolidation risks:
  - PTEs ran losses first three years; last three years generated high stable returns "around 25 percent p.a."
  - Table 14 Annual Nominal ROE (selected):
    - PTEs: 2001: -28% ; 2002: 1% ; 2003: 28% ; 2004: 22% ; 2005: 24%
    - Banks: 2000: 15% ; 2001: 12% ; 2002: 6% ; 2003: 6% ; 2004: 17% ; 2005: 21%
  - Table 15 ROEs of Pension Fund Managers in Selected Countries (selected Poland entries):
    - Poland: 2004: 22.1 ; 2005: 27.8
  - Larger PTEs show stable high ROEs; smaller PTEs have volatile profitability and may struggle under declining fees, implying potential consolidation.

### VIII. Regulation, Supervision, Governance, and MRG
- Regulatory framework:
  - Law on Organization and Operation of Pension Funds enacted 1997; secondary regulation via nine Decrees.
  - Supervisory agency: KNUiFE; cannot issue binding secondary regulation; 21 supervisors for 15 PTEs in pension supervision department.
  - Licensing: minimum capital EUR 5 million; KNUiFE must answer within 3 months.
- Corporate governance:
  - Two-board system; management board at least 3 members (one with degree in Law or Economics); supervisory board at least 3 members with independence and qualifications requirements.
  - KNUiFE must approve board members; limited detailed duties and internal controls mandated.
- Minimum Return Guarantee (MRG) and Guarantee Fund sequence:
  - PTEs deposit 0.1 percent of NAV into Base Fund and between 0.3 and 0.4 percent of NAV into Additional Fund.
  - Sequence when MRG triggered:
    1. Use Additional Fund of affected PTE.
    2. If depleted, use capital of the PTE.
    3. Use Base Fund.
    4. Use Additional Funds of other pension funds.
    5. As last resort, state budget.
  - MRG parameters in Poland:
    - Min (50% of ARS, ARS - 4%)* ; 36 months ; Bi-annually ; Full disclosure yearly; Partial 2 x year
    - Band design, long assessment periods, and evaluation frequency reduce trigger likelihood but may intensify herding.
- Accounting, valuation, and audits:
  - Different valuation methodologies allowed; daily reporting to KNUiFE.
  - External audits have narrow scope; do not assess internal risk management quality.
- Investment regulation and market infrastructure gaps:
  - Ceilings by asset class; OTC trading allowed with low transparency.
  - Circumvention possibilities via closed-end funds.
  - Restrictions on non-sovereign fixed-income not ratings-based.
  - Foreign asset limit 5 percent.

### IX. Recommendations — Accumulation Phase, Market Structure, and Supervision
- Market structure and mergers:
  - Consider more accommodative merger policy as fee caps tighten to allow scale for small PTEs.
  - If strict price controls maintained, consider more extensive regulation to prevent quality loss.
- Investment regime and diversification:
  - Review limits on foreign investment, corporate bonds, and non-public bonds.
  - Raise foreign asset limit to a meaningful level; consider allowing netting of foreign broker fees under caps.
  - Allow use of FX forwards and futures for hedging.
  - Relax limits on unsecured plain vanilla corporate bonds with rating requirements; consider parity with equity limits.
  - Authorize commitments to closed-end investment funds for private equity exposure; monitor fee structures to avoid abuse.
- Portfolio choice and default funds:
  - Introduce multiple portfolios and a well-designed default portfolio (lifecycle or capital-protected).
  - Provide improved financial education and information to members.
- Valuation, trading transparency, and market infrastructure:
  - Improve valuation rules; consider single price per instrument.
  - Increase OTC transparency or require electronic trading platforms/exchange trading.
  - Require central deposit of fixed-income instruments in NDS to enhance liquidity.
- Supervisory enhancements:
  - KNUiFE to provide law interpretations, detailed sanction rationales, and migrate toward risk-based supervision.
  - Require external auditors to evaluate internal risk management and controls against standards (COSO, COBIT).
  - Increase ZUS transparency and external audits.
- MRG and benchmarking:
  - Introduce synthetic portfolio component in MRG benchmark to reduce inefficiency traps; design by independent advisors.

### X. Payout Phase: Design Options and Annuity Recommendations
- Payout phase scheduled to start in 2009; regulatory framework needs preparation now.
- Product and market design options:
  - Consider centralized Swedish-like model: central account management, blind accounts, competition among licensed asset managers, default fund for passive entrants.
  - If decentralized model, implement electronic quotation system to contain marketing influence and broker fees.
- Preferred annuity types:
  - Favor fixed and price-indexed annuities to protect against key retirement risks.
  - Consider adjustable annuities recalculating payouts every three years based on long-term rates.
  - Consider variable (unit-link) annuities to share upside gains and simplify ALM; pair with minimum fixed indexed annuity for downside protection for lower income workers.
  - Allow annuities with guaranteed periods to address unisex table effects and provide bequest elements.
  - Consider joint annuities for married retirees to protect spouses against longevity risk.
- Regulation and instruments required:
  - Capital rules penalizing asset-liability mismatches; adapt Solvency II style rules as appropriate.
  - Access to long-duration indexed fixed-income instruments and derivatives; implications for government debt management to issue inflation-indexed and long-dated securities.
  - Develop corporate bond, covered bond, and MBS markets; prioritize covered bonds and improve custody/depository infrastructure.
  - Address securitization impediments (SPV tax neutrality, transfer mechanics, asset segregation).
  - Strengthen KPWiG enforcement and consider reliance on SROs.

### XI. Price Competition, Switching, and Marketing Effects (Appendix I findings)
- Demand for pension products tends to be inelastic to returns and fees; more responsive to marketing/sales force.
- Empirical findings for Poland (2001–2005 panel regressions):
  - No evidence contributors switched towards better performing funds between 2000 and 2005.
  - Regressions of gross switchovers against lagged Return and Sharpe Ratio variables found variables not significant and predictive power close to zero.
  - Panel data regressions (2001–2005, quarterly) reported estimated coefficients (t-statistics) and very low R square values:
    - Return (t-1): -2612 (0.23); -3359 (0.25)
    - Return (t-2): -1893 (0.15)
    - Sharpe Ratio (t-1): 261 (0.87); 296 (0.80)
    - Sharpe Ratio (t-2): 265 (0.64)
    - D(Return): -985 (0.14)
    - D(Sharpe Ratio): -59 (0.14)
    - R square values: 0.0002, 0.0003, 0.0030, 0.0035, 0.0001, 0.0003
  - Conclusion: size of sales force and marketing likely the dominant driver of switchovers, consistent with other reforming countries.

*Source: Appendix I. An Analysis of Price Competition in the Pension Sector (technical note prepared by Heinz Rudolph and Roberto Rocha (OPD); Diego Sourrouille (OPD) provided research assistance).*

### Appendix I. An Analysis of Price Competition in the Pension Sector ............................. 52

### Appendix I. An Analysis of Price Competition in the Pension Sector

### I. Introduction
- In March 1999, Poland implemented a systemic pension reform introducing a multi-pillar pension system to replace the defined benefit (DB), pay-as-you-go (PAYG) system that had operated since 1949.
- The new system includes:
  - a minimum pension guarantee (the zero pillar);
  - a publicly managed, notional defined contribution (NDC) system (the first pillar);
  - a privately managed, fully funded system (the second pillar);
  - a complementary fully funded system operated by the private sector (the third pillar).
- By 2005 more than 70 percent of active contributors were enrolled in the second pillar, equivalent to more than half of the labor force; pension fund assets accounted for about 9 percent of GDP and 10 percent of total financial assets in 2005.
- The central revenue collection system generated scale economies and contributed to comparatively low levels of costs and fees in Poland; returns were attractive due to capital gains from the decline in interest rates and a buoyant equity market.
- Identified challenges and areas for policy attention:
  - review competition policies, particularly measures that maintain small pension funds operating while imposing strict caps on fees;
  - diversify portfolios via changes in the investment regime and development of domestic financial instruments;
  - strengthen internal risk management practices;
  - elaborate the regulatory framework for the payout phase.
- This technical note was prepared as part of the Poland FSAP Update (April-May 2006) and assesses structure and performance of the second pillar and its regulatory and supervisory framework; it also briefly analyzes capital market development and obstacles to the development of instruments suitable to pension funds.

### II. Overview of the Polish Pension System
- Background and objectives:
  - 1998 Parliament approval; implemented in 1999; Poland became the second Central European country to implement a systemic reform after Hungary.
  - Reform motivations: restore actuarial balance, diversify risks, and improve economic incentives.
- Design and rules:
  - Participation: mandatory for workers under 30; workers 30–50 had to participate in the NDC system but could opt into the second pillar; workers above 50 remained in the old system.
  - Retirement ages: 60 for women and 65 for men.
  - Contribution structure (percent of gross wages): total contributions to old age pensions and related insurance:
    - all workers contribute 19.52 percent of their gross wages to old age pensions;
    - 13 percent to disability and survivorship insurance;
    - 2.45 percent for sickness insurance.
  - For workers in the mixed system (first + second pillars): 12.22 percent to the first pillar and 7.3 percent to the second pillar.
- Expected outcomes:
  - The zero pillar provides a minimum pension set at around 25 percent of the economy-wide average wage.
  - The NDC first pillar indexes individual balances to the growth of the wage bill; the first and second pillars together should generate a replacement ratio of 60 percent for average income, full career workers (noted as lower than under the old system but seen as sustainable and in line with the average replacement ratio in the OECD).

### III. Structure and Performance of the Second Pillar
- Architecture:
  - Second pillar operates on a defined contribution basis with individual accounts in open pension funds (OFEs) managed by pension fund management companies (PTEs).
  - Third pillar consists of individual pension accounts and occupational pensions; government provides limited tax incentives for voluntary saving (exemption from capital gains tax).
- Special regimes and risks:
  - Special regimes exist for farmers and government personnel (public defense and security); farmers’ contributions cover only 6 percent of expenses.
  - A 2005 law allowed miners to be removed from the general pension system and access early retirement benefits according to pre-reform rules.
  - Concessions to special groups pose risks to the reform.
- Coverage and scale:
  - Coverage ratio around 75 percent of the labor force; by 2005 about 9.2 million active contributors to the second pillar, equivalent to 70 percent of total contributors and more than half of the labor force.
  - Flow of contributions to the second pillar reached about 1.3 percent of GDP in 2005.
  - Covered wage bill declined slightly to 25 percent of GDP during the first half of the decade; this is above the international regression line but lower than the Czech Republic, Slovakia (around 33 percent of GDP), and Slovenia (around 40 percent of GDP).
  - The 1999 reform imposed a contribution ceiling (2.5 times the average wage) which reduced the covered wage bill (likely in 1999).
- Comparative performance:
  - The young pension system has performed generally well compared to most other reforming countries.
  - Centralized revenue collection contributed to low costs and fees; returns benefited from declining interest rates and a buoyant equity market.

### IV. Coverage and Key Statistics (selected figures from Table 1)
- Table 1 excerpted indicators (1999–2005), presented exactly as in source:
  - 1999:
    - ZUS contributions: 10.4 (% of GDP)
    - OFEs contributions: 0.4 (% of GDP)
    - Contributors: 13,270 (1,000)
    - Labor Force: 7,457 (1,000)
    - Coverage Ratio: 17,214 (%)
    - Pillar II Coverage: 56.2 (%)
    - Covered Wage Bill: 29.2 (% of GDP)
  - 2000:
    - ZUS: 9.2
    - OFEs: 1.1
    - Contributors: 13,059 (1,000)
    - Labor Force: 8,617 (1,000)
    - Coverage Ratio: 17,300 (%)
    - Pillar II Coverage: 75.5 (%)
    - Pillar II as % of General: 66.0 (%)
    - Covered Wage Bill: 27.8 (% of GDP)
  - 2001:
    - ZUS: 9.3
    - OFEs: 1.2
    - Contributors: 12,851 (1,000)
    - Labor Force: 8,595 (1,000)
    - Coverage Ratio: 17,229 (%)
    - Pillar II Coverage: 74.6 (%)
    - Pillar II as % of General: 66.9 (%)
    - Covered Wage Bill: 28.4 (% of GDP)
  - 2002:
    - ZUS: 8.8
    - OFEs: 1.2
    - Contributors: 12,761 (1,000)
    - Labor Force: 8,625 (1,000)
    - Coverage Ratio: 17,097 (%)
    - Pillar II Coverage: 74.6 (%)
    - Pillar II as % of General: 67.6 (%)
    - Covered Wage Bill: 27.3 (% of GDP)
  - 2003:
    - ZUS: 8.3
    - OFEs: 1.2
    - Contributors: 12,739 (1,000)
    - Labor Force: 8,705 (1,000)
    - Coverage Ratio: 16,991 (%)
    - Pillar II Coverage: 75.0 (%)
    - Pillar II as % of General: 68.3 (%)
    - Covered Wage Bill: 25.9 (% of GDP)
  - 2004:
    - ZUS: 8.0
    - OFEs: 1.1
    - Contributors: 12,857 (1,000)
    - Labor Force: 9,003 (1,000)
    - Coverage Ratio: 17,139 (%)
    - Pillar II Coverage: 75.0 (%)
    - Pillar II as % of General: 70.0 (%)
    - Covered Wage Bill: 24.9 (% of GDP)
  - 2005:
    - ZUS: 8.0
    - OFEs: 1.3
    - Contributors: 13,130 (1,000)
    - Labor Force: 9,215 (1,000)
    - Coverage Ratio: 17,283 (%)
    - Pillar II Coverage: 76.0 (%)
    - Pillar II as % of General: 70.2 (%)
    - Covered Wage Bill: 25.1 (% of GDP)
- Notes: (1) At least one contribution during the year; Source: Ministry of Labor and Social Security.

### V. Fiscal Impact of the Pension Reform
- Financing approaches described:
  - Tax-financed transition: offset fiscal losses via tax increases or expenditure cuts; burdens current generations temporarily; can increase domestic savings and growth.
  - Debt-financed transition: finance fiscal losses via additional debt; explicit public debt rises and pension imbalances remain for future generations.
  - Optimal strategy likely mixed: more debt finance early, more tax finance later (cited literature: Kotlikoff; Corbo and Schmidt-Hebbel on Chile).
- Empirical outcome in Poland:
  - Transition was fully debt-financed and accompanied by additional fiscal deterioration beyond the fiscal effects of the second pillar.
  - Between 1999 and 2003 the general government deficit (defined so as to neutralize the losses) increased from -1.5 to -4.7 percent of GDP.
  - The general government deficit defined to reflect all losses increased from -1.8 to -6.4 percent of GDP between 1999 and 2003.
  - The increase in the fiscal deficit (excluding the effects of the reform) by 3 percent of GDP between 1999 and 2003 contributed to a 2 percent decline in national savings during the same period and to public debt rising from 36 to 48 percent of GDP.
  - The fiscal costs of the reform have been estimated at about 12 percent of GDP, but increases in public debt were also influenced by broader fiscal policy choices; had the government maintained the deficit (excluding reform effects) at about 1.5 percent of GDP, the debt-to-GDP increase would have been smaller.
- Table 2 selected macro and fiscal indicators (1999–2005), exact figures:
  - Columns: (1) GDP growth (%), (2) Gross Domestic Saving (% GDP), (3) Debt (% GDP), (4) Debt resulting from the Pension Reform, (5) Balance ESA95(a) (OFEs inside the General Government), (6) Balance ESA95(b) (OFEs outside the General Government).
  - 1999: (1) 4.1, (2) -, (3) -, (4) 0.7, (5) -1.5, (6) -1.8
  - 2000: (1) 4.0, (2) 18.7, (3) 36.9, (4) 2.5, (5) -1.8, (6) -2.8
  - 2001: (1) 1.1, (2) 18.0, (3) 38.8, (4) 4.6, (5) -3.7, (6) -4.8
  - 2002: (1) 1.4, (2) 16.1, (3) 43.6, (4) 6.6, (5) -3.2, (6) -5.0
  - 2003: (1) 3.8, (2) 16.6, (3) 48.5, (4) 8.7, (5) -4.7, (6) -6.4
  - 2004: (1) 5.3, (2) 16.2, (3) 46.9, (4) 10.5, (5) -3.8, (6) -5.6
  - 2005: (1) 3.2, (2) 17.9, (3) 48.3, (4) 12.7, (5) -2.9, (6) -4.7
- Sources for Table 2: MoF, IMF.

*Source: Appendix I. An Analysis of Price Competition in the Pension Sector (technical note prepared by Heinz Rudolph and Roberto Rocha (OPD); Diego Sourrouille (OPD) provided research assistance).*

### 16. There has been an improvement in the fiscal situation in recent years, and

### _cr07104 - 16. There has been an improvement in the fiscal situation in recent years, and

### Fiscal situation and PAYG projections
- Fiscal deficits have declined by about 2 percent in the last two years.
- Deficits should decline further, due in part to projected improvements in the balance of the general PAYG system.
- General PAYG system should get close to equilibrium by the year 2014.
- Pension expenditures of PAYG system are projected to decline from around 10.6 percent of GDP in 2004 to 8.1 percent of GDP by 2014 as a result of:
  - expected increases in the effective retirement age,
  - price-indexation of benefits,
  - an expected reduction in the number of disability pensioners.
- These reductions in expenditures should lead to commensurate declines in the PAYG deficit and in the overall fiscal deficit.
- Figure 3 (Balance of the PAYG System (% of GDP)) timeframe points listed: 1999 2004 2009 2014 2019 2024 2029 2034 2039 2044 2049.
- Source of PAYG projections: Ministry of Labor and Social Security (projections), IMF (estimates).
- Figures exclude second pillar, Farmers’ Pension System and Security Provision System Base.

### Financing the transition and economic effects
- Moving towards a more tax-financed transition is expected to:
  - enhance prospects of a stronger resumption of investment and output through stronger savings and capital market effects of the reform,
  - ensure a more fair distribution of the burden of the pension reform across generations.
- Potential savings and capital market effects depend fundamentally on the strategy for financing the transition and are closely related and mutually reinforcing.
- A reduction in the fiscal deficit would:
  - open more space for private investment,
  - allow larger issues of new financial instruments by private companies,
  - accelerate development of the domestic capital market,
  - avoid overburdening younger generations with excessive taxes while they cope with lower benefits and replacement ratios relative to current generations.

### Structure of the second pillar: market concentration and ownership
- Number of pension funds declined from 21 in 1999 to 15 in 2005, due to mergers among PTEs.
- The number of funds operating in the second pillar is still twice higher than the average of other countries (see Table 3).
- The three largest pension funds account for 64 percent of total assets of the system (Table 4).
- In Poland:
  - the five smallest pension funds account for 8.4 percent of the market,
  - the smallest pension fund account for less than 1 percent.
- Some pension funds have requested authorization to merge; resolution by KNUiFE is pending.
- Ownership links:
  - The seven largest pension funds are controlled by insurance companies.
  - Three PTEs are controlled by banks.
  - Two PTEs have controllers not linked to active financial sector holding groups.
  - Foreign ownership is high; most PTEs are controlled directly or indirectly by international groups including AIG, ING, Aviva, Allianz and Winterthur.
  - Among larger pension funds, PZU is the only PTE controlled by a domestic insurance company.

### Centralized collection, operational features, and account management
- ZUS centralizes collection of revenues for all social security contributions, including first and second pillars, and pays social security benefits (old age pension insurance, disability and survivorship insurance, sickness insurance, work accident insurance).
- ZUS must distribute contributions to the second pillar among different pension funds within two weeks from receipt.
- All companies with more than five employees must submit contributions electronically:
  - representing roughly 75 percent of the labor force,
  - and 95 percent of total contributions.
- Initially there were severe problems with ZUS’s collection and distribution systems; currently less than 1 percent of contributions have a problem of conciliation, although there are still PLN 1 billion from the 1999-2001 period that need to be cleared and allocated to individual accounts.
- Monthly flows of contributions are volatile and volatility has increased since 2003 (Figure 4). Possible causes: calendar of pension payments, IT problems; assessment was not conclusive.
- Account management:
  - Most PTEs outsource account management to separate transfer agents; there are eight management companies, of which seven are related to the financial group of the PTE.
  - Only four PTEs manage their accounts internally.
  - The average cost of account management services is about USD 3.6 per member per year.
  - Contracts with transfer agents are not standardized; differences in scope and quality of services limit direct comparisons across PTEs.

### Custody and operational risk containment
- All securities must be deposited at the National Depository of Securities (KDPW).
- All domestic transactions must be authorized by a custodian bank; custodian banks also provide asset valuation services.
- There are six custodian banks in Poland.
- Each PTE must select a custodian bank that cannot be related to the company.
- Use of KDPW and custodian banks contributes to containment of operational risks.

### Asset accumulation: size and growth of pension assets
- Pension fund assets reached 9 percent of GDP in 2005, accounting for more than 10 percent of the financial sector.
- Table 5: Pension Fund Assets, 1999-2005 (Millions of US Dollars; % of GDP)
  - 1999: 544 ; 0.3
  - 2000: 2,396 ; 1.3
  - 2001: 4,869 ; 2.5
  - 2002: 8,223 ; 3.9
  - 2003: 11,986 ; 5.3
  - 2004: 20,943 ; 6.8
  - 2005: 26,396 ; 8.9
- Pension assets-to-GDP ratio in Poland is higher than most other countries with similar implementation periods (Table 6).

### Portfolio composition and diversification
- Portfolio composition has been relatively stable (Table 7), end of December figures:
  - 1999: Government Instruments 53.2 ; Bank Securities and Deposits 2.1 ; Equity 29.9 ; Other Fixed Income 14.9 ; Foreign 0.0 ; Others 0.0 ; Total 100.0
  - 2000: 62.8 ; 2.1 ; 34.9 ; 0.2 ; 0.0 ; 0.0 ; 100.0
  - 2001: 67.1 ; 2.8 ; 28.3 ; 1.4 ; 0.4 ; 0.0 ; 100.0
  - 2002: 67.9 ; 2.6 ; 27.1 ; 1.0 ; 1.4 ; 0.0 ; 100.0
  - 2003: 61.6 ; 3.9 ; 32.0 ; 0.8 ; 1.5 ; 0.2 ; 100.0
  - 2004: 59.4 ; 4.5 ; 32.8 ; 0.6 ; 2.2 ; 0.5 ; 100.0
  - 2005: 62.5 ; 3.4 ; 31.4 ; 0.5 ; 1.7 ; 0.4 ; 100.0
- Around 63 percent in government securities, 32 percent in domestic equity, negligible investments in other instruments.
- Table 8 (December 2005) comparative portfolio shares for selected countries highlight Poland:
  - Poland: Government Bonds 62.5 ; Financial Institutions 3.4 ; Corporate Bonds 0.5 ; Domestic Equity 31.4 ; Foreign Assets 1.7 ; Other 0.5
- Derivatives are not allowed in Poland, while in most advanced reforming countries simple derivatives (e.g., currency forwards and swaps) are allowed for hedging.

### Market limitations and domestic equity characteristics
- Lack of diversification reflects:
  - investment restrictions,
  - limited supply of financial instruments in the domestic capital market.
- Polish capital market is dominated by government bond and equity markets.
- Markets for privately issued fixed-income instruments (mortgage-related securities, municipal bonds, corporate bonds) are negligible, amounting to less than 1 percent of GDP each.
- Equity portfolio details (Table 9):
  - Pension funds invest in 167 listed companies.
  - Share of largest companies in total equity portfolio (%):
    - Top Five Companies: 52
    - Ranked 6 to 20: 16
    - Ranked 21-50: 18
    - Ranked 50-100: 7
    - Remaining Companies: 7
    - Total: 100
  - Share of combined pension fund equity holdings in company equity (%):
    - Top Five Companies: 10
    - Ranked 6 to 20: 8
    - Ranked 21-50: 22
    - Ranked 50-100: 27
    - Remaining Companies: n.a.
- The five largest companies account for half of the equity portfolio; the other half is reasonably well diversified but liquidity constraints and combined pension fund holdings limit further diversification.

### Foreign assets and regulatory constraints
- The share of foreign assets is low: 1.7 percent (2005).
- Contributing factors:
  - ceiling on foreign assets is only 5 percent,
  - high domestic returns making foreign assets relatively less attractive,
  - commissions paid to foreign brokers or mutual funds cannot be netted from returns, and overall fees are capped, making foreign investments less attractive because commissions affect PTE profits and net worth.

*Source: _cr07104 - 16. There has been an improvement in the fiscal situation in recent years, and*

### 29. The portfolios of individual pension funds have become more similar in

### 29. The portfolios of individual pension funds have become more similar in

### Portfolio convergence across major asset classes
- Since 2002 pension funds have held more similar portfolios, as indicated by the reduction in the coefficient of variation of the equity share in the total portfolio.
- The coefficient of variation of the equity share was about 25 percent in 1999-2002 but declined sharply to 5 percent in recent years.
- The rapid convergence of portfolios in Poland after 2002 was apparently due to an episode where one pension fund triggered the minimum return guarantee (MRG) and the PTE had to honor the guarantee with its own assets.
- Pension funds are known to herd in other countries; herding is probably intensified by the presence of a minimum return guarantee.

### Differentiation within asset classes
- While the overall share of equity is similar across pension funds, equity portfolios differ notably in the share of small and medium size companies.
- Equity portfolios tend to be similar for the 20 most important equities (accounting for 75 percent of total equity portfolio), but become more differentiated for medium and small caps.
- Fixed-income portfolios are similar for the 10 most important government bond instruments, but become more differentiated for smaller issues.

### Historic rates of return and drivers
- Average historic real rate of return since 1999: 8.8 percent p.a.
- Historic context and annual values (Table 10):
  - 2000: Real Annual Rate or Return 4.1% | Inflation Rate 8.6% | Real GDP Growth 4.1% | NDC indexation rate 3.8%
  - 2001: Real Annual Rate or Return 3.5% | Inflation Rate 3.6% | Real GDP Growth 1.1% | NDC indexation rate 3.0%
  - 2002: Real Annual Rate or Return 12.7% | Inflation Rate 0.8% | Real GDP Growth 1.4% | NDC indexation rate 1.1%
  - 2003: Real Annual Rate or Return 9.1% | Inflation Rate 1.7% | Real GDP Growth 3.8% | NDC indexation rate 0.3%
  - 2004: Real Annual Rate or Return 9.4% | Inflation Rate 4.4% | Real GDP Growth 5.3% | NDC indexation rate -0.7%
  - 2005: Real Annual Rate or Return 14.2% | Inflation Rate 0.7% | Real GDP Growth 3.2% | NDC indexation rate 4.8%
  - Average since 1999: Real Annual Rate or Return 8.8% | Inflation Rate 3.3% | Real GDP Growth 3.1% | NDC indexation rate 2.0%
- High returns were driven in part by:
  - Large capital gains on the fixed-income portfolio resulting from the sharp decline in nominal and real interest rates in recent years — this source is practically exhausted given low interest rates across the maturity spectrum.
  - A buoyant domestic equity market: real returns on the WIG20 around 25-30 percent p.a. in the past three years — such yields cannot be sustained long-term.
- Future real rates of return will depend more on:
  - Progress in diversifying portfolios.
  - Extracting higher risk-adjusted returns on a wider range of assets, including foreign assets and private domestic fixed-income instruments.

### Cross-country comparison of second pillar returns (Table 11)
- Selected entries (Annual Rate of Return (%)):
  - Argentina: Average Nominal Since Inception 14.9 | Average Real Since Inception 9.4 | Nominal 2005 17.5 | Real 2005 4.6
  - Chile: Average Nominal Since Inception 22.9 | Average Real Since Inception 10.0 | Nominal 2005 8.6 | Real 2005 4.6
  - Colombia: Average Nominal Since Inception 20.7 | Average Real Since Inception 8.3 | Nominal 2005 24.8 | Real 2005 19.0
  - Hungary: Average Nominal Since Inception 11.0 | Average Real Since Inception 4.5 | Nominal 2005 12.5 | Real 2005 8.9
  - Poland: Average Nominal Since Inception 12.3 | Average Real Since Inception 8.8 | Nominal 2005 15.0 | Real 2005 14.2
  - Uruguay: Average Nominal Since Inception 23.0 | Average Real Since Inception 12.0 | Nominal 2005 9.7 | Real 2005 4.6
  - Average (selected countries): Average Nominal Since Inception 17.1 | Average Real Since Inception 8.0 | Nominal 2005 14.3 | Real 2005 8.3
- Note: Most Latin American countries publish gross rates of return while Poland (and Hungary) report rates net of asset management fees; differences may be slightly wider due to this.

### Convergence of rates of return and impact of the MRG
- The coefficient of variation of annual rates of return of pension funds declined significantly since 2001, reflecting convergence of portfolios, but returns remain moderately differentiated.
- Differentiation in returns is larger than in countries with similar frameworks (example: Chile), likely reflecting differences within major asset classes.
- High returns in recent periods have reduced the probability of triggering the MRG and allowed some differentiation of portfolios and returns.
- Recent regulatory changes reducing the effect of the MRG may have contributed to differentiation:
  - Extending the sample period from 24 to 36 months for evaluations.
  - Moving from quarterly to semiannual evaluations.
  - Imposing a cap of 15 percent in the weight of large pension funds for computation of the MRG.
- These measures have reduced somewhat the risk of triggering the MRG.

### Risk-adjusted performance
- Pension funds increased risk-adjusted returns in the last three years:
  - Sharpe ratios and Modigliani ratios have increased, suggesting reasonable investment policies given domestic market limitations.
  - Increased Modigliani ratios indicate pension funds have been more efficient than simply investing in a domestic equity index like WIG.
  - The increase in efficiency coincides with the period in which portfolios converged.
- Caveat: High returns were partly due to extraordinary factors; maintaining performance will depend on further diversification.

### Costs, fees, and operational efficiency
- Poland operates with low operational cost per contributor: USD 26 (compared to an average of selected Latin American systems USD 65).
- Table 12: Operational Costs of Pension Funds in Selected Countries, 2005 (Administration Costs / Marketing Costs / Other Costs / USD per contributor)
  - Argentina: 55.3 / 42.9 / 1.8 / 65
  - Chile: 71.4 / 25.9 / 2.7 / 75
  - Colombia: 87.5 / 6.2 / 6.3 / 78
  - Hungary: 65.5 / 4.7 / 29.8 / 29
  - Mexico: 25.7 / 36.8 / 37.6 / 61
  - Peru: 52.8 / 47.2 / — / 80
  - Uruguay: 47.5 / 25.5 / 27.1 / 32
  - Average: 58.0 / 37.1 / 15.1 / 60
  - Poland: 83.4 / 2.8 / 13.8 / 26
- ZUS charges 80 bps of the amount of contributions as a fee for collection services, indicating strong scale economies in revenue collection.
- Marketing costs in Poland appear extremely low; cross-subsidization by affiliated insurance companies may partly explain this.

### Fee structure, current levels, and projections
- Total fees currently amount to 160 basis points of assets.
- Fee caps and structure:
  - Fees on contributions capped at 7 percent for all new contracts issued after 2004; cap to be progressively reduced to 3.5 percent in the year 2014.
  - All but one PTE charge the maximum contribution fee.
  - Fees on assets are capped according to the volume of assets under management (marginal rates depicted in Figure 14; note: figures represent marginal rates).
- Average PTE currently charges a total fee of about 160 basis points (including both management and contribution fees); large differences across PTEs reflect differences in size.
- International comparison:
  - Pension funds in other reforming countries charged on average 300 basis points in the seventh year of operation; substantially higher than Poland’s average.
  - It took fourteen years for the average fee in Chile to decline to 160 basis points.
- Projections (Table 13):
  - Management Fee (% Total Fee) and Average Fee (% Assets) for Total System / Smallest Five OFEs / Largest Three OFEs:
    - 2005: Management Fee 30 | Average Fee (% Assets) Total System 1.51 | Smallest Five OFEs 1.61 | Largest Three OFEs 1.36
    - 2010: Management Fee 52 | Average Fee (% Assets) Total System 1.02 | Smallest Five OFEs 1.05 | Largest Three OFEs 0.93
    - 2020: Management Fee 83 | Average Fee (% Assets) Total System 0.61 | Smallest Five OFEs 0.69 | Largest Three OFEs 0.43
    - 2025: Management Fee 86 | Average Fee (% Assets) Total System 0.54 | Smallest Five OFEs 0.62 | Largest Three OFEs 0.35
  - The average ratio of total fees over assets is projected to decline from 160 basis points at present to 50-60 basis points by 2020.
  - Total fees are projected to cross the threshold of 100 basis points in 2010, declining further to about 50-60 basis points in the following decade.
- Implications and risks:
  - Under a conservative simulation, in the next five years small pension funds will have to reduce their fees by 55 basis points to meet ceilings.
  - It is unclear whether small funds will have sufficient scale to reduce costs, compete, and operate profitably within the ceilings.
  - Some regulatory changes (e.g., requirements for stronger internal risk management and controls) may increase costs, further stressing small funds.
  - Small funds have survived in part due to a system of lotteries that brings new members without costly sales forces; lotteries do not provide a basis for real competition with large funds.
  - As fees decline and profit margins are squeezed, small funds will be increasingly vulnerable to marketing tactics by larger funds, and this may constrain regulators' ability to impose cost-increasing quality improvements.

*Source: _cr07104 - 29. The portfolios of individual pension funds have become more similar in*

### 42. During the first three years the industry ran losses, due to the start-up costs

### _cr07104 - 42. During the first three years the industry ran losses, due to the start-up costs

### Profitability and Returns
- During the first three years the industry ran losses, due to the start-up costs and the small initial level of assets and revenues.
- In the last three years, PTEs have generated high and stable returns, "around 25 percent p.a.", similar to the average ROE in other reforming countries.
- Average ROE of PTEs has been higher than the average ROE of banks, which are subject to stricter capital requirements, manage a more complex business and bear much higher risks.
- ROEs of PTEs in Poland are comparable with those in other reforming countries.
- Pension fund administrators in other countries have also been able to recover initial costs within relatively few years and generate high ROEs in recent years.
- The pension fund management industry is primarily an asset management business with relatively low capital requirements.
- The concentrated structure and the persistence of high ROEs has become a policy issue in most reforming countries, including Chile.

### Tabled ROE Data (annual nominal return on equity)
- Table 14: Annual Nominal Return on Equity of Polish PTEs and Banks
  - PTEs: 2000: - ; 2001: -28% ; 2002: 1% ; 2003: 28% ; 2004: 22% ; 2005: 24%
  - Banks: 2000: 15% ; 2001: 12% ; 2002: 6% ; 2003: 6% ; 2004: 17% ; 2005: 21%
  - Source: KNUiFE, GIBS.
- Table 15: ROEs of Pension Fund Managers in Selected Countries (% p.a.)
  - Argentina: 2004: -10.0 ; 2005: 3.4
  - Bolivia: 2004: 38.8 ; 2005: 50.7
  - Chile: 2004: 21.0 ; 2005: 19.5
  - Colombia: 2004: 27.6 ; 2005: 29.2
  - Costa Rica: 2004: -18.9 ; 2005: 12.8
  - El Salvador: 2004: 30.8 ; 2005: 38.8
  - Hungary: 2004: 16.3 ; 2005: -
  - Mexico: 2004: 25.2 ; 2005: 15.5
  - Peru: 2004: 52.5 ; 2005: 41.1
  - Poland: 2004: 22.1 ; 2005: 27.8
  - Dominican Republic: 2004: -20.7 ; 2005: -5.8
  - Uruguay: 2004: 39.0 ; 2005: 39.6
  - Average: 2004: 18.6 ; 2005: 24.4
  - Sources: AIOS, KNUiFE, HFSA.

### Firm Size, Profitability Dispersion, and Consolidation Risks
- Important differences in profitability across PTEs of different sizes.
- Larger PTEs have been able to stabilize profits; smaller PTEs are still struggling to consolidate their financial situation.
- ROEs of large PTEs such as Commercial Union, ING and PZU have been high and stable in recent years.
- Profitability of small and medium PTEs has been volatile despite regulatory measures (e.g., favorable rules for allocation of new entrants).
- Uncertainty whether smaller PTEs will operate profitably in a scenario of declining fees.
- Projected decline in fees may be associated with further consolidation of the pension fund management industry.
- Figure 17 note: ROEs are calculated as simple averages. The ROE for the smallest five in 2002 was -102%.

### Regulatory Framework Overview
- Regulatory framework defined by the Law on the Organization and Operation of Pension Funds, first enacted in 1997 and amended since then.
- Secondary regulation defined by nine Government and Ministerial Decrees (investment regulation, valuation of assets, guarantee fund).
- Supervisory agency: KNUiFE; it does not have the power to issue binding secondary regulation.
- Other laws regulating capital market operations also affect PTEs.
- Framework generally sound but may need revisions in corporate governance, investment regime, and design of the MRG.
- Regulatory gaps have not caused major disruptions to date because instruments purchased by pension funds are still relatively simple.

### Licensing Criteria
- PTEs require a license issued by KNUiFE to manage an open pension fund (OFE).
- The minimum required capital to create a PTE is EUR 5 million.
- Licensing criteria include full identification of shareholders and fit and proper tests including broad qualifications for shareholders and senior managers.
- KNUiFE must provide an answer within 3 months after the application was filed and can reject a license.
- Changes in ownership, management, and bylaws require KNUiFE approval; Law does not specify a timetable for responses.
- No applications for new licenses in the past few years.

### Corporate Governance
- PTEs in Poland are joint stock companies managed by a two-board system (management board and supervisory board).
- General assembly appoints supervisory board; supervisory board generally appoints management board.
- Management board makes fundamental decisions including investment policy; supervisory board approves budget, financial plan, and audit reports.
- Committees (audit, remuneration, investment) exist in some PTEs but are not required by regulation.
- Management board must have at least 3 members and at least one with a degree in Law or Economics.
- Supervisory board must have at least three members; members of first supervisory board appointed for two years; successive boards not longer than five years.
- At least half of supervisory board members must be independent and at least half must have a degree in Law or Economics.
- KNUiFE must approve all members of supervisory and management boards.
- Regulatory framework lacks detailed guidance on duties of board members, minimum standards for internal risk management and internal controls.
- Some PTEs have voluntarily implemented risk management systems (e.g., appointment of a chief risk officer); quality of internal risk management systems varies across PTEs.

### The Guarantee Fund and MRG Sequence
- PTEs must maintain a Guarantee Fund to offset losses when returns fall below the Minimum Return Guarantee (MRG).
- Guarantee Fund divided into Base Fund and Additional Fund.
  - Base Fund is managed by the National Depository of Securities.
  - PTEs deposit 0.1 percent of NAV into the Base Fund.
  - PTEs deposit between 0.3 and 0.4 percent of NAV into the Additional Fund.
  - Additional Fund is invested in the same portfolio of the OFEs and is managed by the same PTE.
- The Additional Fund is equivalent to the minimum reserve requirement (encaje) used in Chile and other Latin American countries, but Poland’s charges (0.3–0.4 percent + 0.1 percent) are considerably lower than the 1–2 percent of NAV charged in those countries.
- Sequence for covering deficits when MRG is triggered:
  1. Use resources of the Additional Fund of the affected PTE.
  2. If Additional Fund is depleted, cover deficit with the capital of the PTE.
  3. Use the Base Fund if deficit persists.
  4. If Base Fund is depleted, cover deficit by Additional Funds of other pension funds.
  5. As last resort, deficit would be covered by the state budget.
- The sequence minimizes moral hazard by using specific reserves and capital before collective funds but may reinforce herding behavior.

### Accounting, Valuation, and Auditing Standards
- Regulatory framework allows different methodologies for valuing the same instrument, permitting different valuations of the same instrument across pension funds.
- All securities are deposited at the National Depository of Securities and held by an independent custodian bank.
- PTEs report asset values to KNUiFE on a daily basis.
- The Law provides general methodology for asset valuation; sufficient so far because pension funds are invested in traded stocks or fixed-income instruments which are easier to value.
- As portfolios diversify, differences in valuation may have a larger impact, possibly distorting valuations and comparisons across funds.
- Scope of external audits is relatively narrow and does not include assessment of quality of internal risk management and control systems.
- Annual audits review financial statements of PTEs but do not include review of internal systems and controls, providing little value to supervisors.
- Little interaction between auditors and supervisory authorities; external audit function seems under-utilized.

### Investment Regulation and Market Infrastructure Risks
- Investment regime is relatively simple and mostly based on ceilings by major asset classes; some specific limits by issuer.
- Investment limits set by a Resolution of the Council of Ministers, providing flexibility to introduce new instruments or fine tune regulation.
- Pension funds are authorized to trade in the over-the-counter (OTC) market, which in Poland is not very transparent and opens room for price manipulation.
- Transactions in the OTC market are only published in newspapers and are not captured in price databases used for valuation.
- Absence of detailed valuation rules exacerbates risks from OTC trading.
- KNUiFE asserts different valuation methodologies can be statistically equivalent.
- Deficiencies in risk management and internal controls in some PTEs and broker-dealers increase risks; Warsaw Stock Exchange does not act as a Self Regulatory Organization (SRO).
- Incentives exist for market agents to simulate transactions at artificial prices in the OTC market, potentially reflecting hidden commissions to asset managers.

### Circumvention of Investment Limits and Specific Ceilings
- Investment funds can be used to circumvent investment restrictions: 25 percent limit on holdings of investment fund shares/quotas does not restrict underlying assets of closed-end funds.
- Example: the 5 percent limit on foreign assets could be circumvented through holdings of shares of investment funds specialized in foreign investments.
- The 35 percent limit on investment fund quotas seems high for a pension system with 15 PTEs and other market actors; higher participation in investment funds raises probability of circumvention.
- Restrictions on non-sovereign fixed-income instruments are not based on ratings and may not reflect underlying risks accurately.
- Poland allows 40 percent limit for secured bonds (mortgage bonds 40%), 10 percent for unsecured corporate bonds, potentially discouraging corporate bond market development.

### Ceilings on Investment in Fixed-income Instruments (% of total assets) (Table 16)
- Municipal Bonds: Traded Publicly 40% ; Non Traded Publicly 20%
- Secured: Traded Publicly 40% ; Non Traded Publicly 10%
- Corporate Bonds: Unsecured 10%
- Mortgage Bonds 40%
- Revenue Bonds 20%
- Source: KNUiFE, NBP.

### Foreign Asset Limits and Strategic Implications
- Holdings of foreign assets restricted to 5 percent of the portfolio.
- Pension funds have invested less than 2 percent of their assets in foreign instruments.
- Ceiling may be low enough to discourage strategic allocation to foreign assets; managers may not invest resources in research when regulatory allowance is not significant.

*Source: _cr07104 - 42. During the first three years the industry ran losses, due to the start-up costs*

### 61. The MRG in Poland is similar to those adopted in most reforming countries,

### _cr07104 - 61. The MRG in Poland is similar to those adopted in most reforming countries,

### Design and effects of the Minimum Return Guarantee (MRG)
- Most second-pillar reforms adopt an MRG to avoid major discrepancies among returns of pension funds; the MRG is usually expressed relative to the average return of the pension industry and often accompanied by minimum reserves by the management company.
- Potential adverse effect: the construction may intensify herding behavior of pension funds because owners of the AFP risk losing capital if the return guarantee is triggered.
- Five major components of MRG design:
  - (i) the type of benchmark (relative, absolute, or a combination);
  - (ii) the width of the bands;
  - (iii) the assessment period;
  - (iv) the frequency of evaluation;
  - (v) the frequency and degree of disclosure of portfolios.
- Poland’s parameters (as summarized in Table 17) include:
  - relatively wide bands;
  - long assessment periods;
  - bi-annual evaluations;
  - bi-annual detailed disclosure of portfolios (with full disclosure yearly; partial 2 x year).
- Specific features providing flexibility to asset managers in Poland:
  - wider bands reduce risk of triggering the guarantee;
  - longer assessment period increases incentives to focus on medium-term returns but increases persistence of returns;
  - lower frequency of evaluation allows deviations to be corrected over time;
  - less strict disclosure reduces free-rider problems and increases incentives to invest in research and deviate from the benchmark;
  - a cap on the weights of large pension funds in the benchmark calculation (Weights have a 15% cap and shares of remaining funds are increased proportionally to reach 100%) provides margin for individual deviations.

- Table 17 (selected entries, preserved verbatim):
  - Argentina: Min (70% of ARS, ARS - 2%) 12 months Monthly
  - Colombia: Minimum Return = (A+B)/2 36 months Quarterly Full disclosure after 30 days
  - Chile: Risky funds = Min (50% of ARS, ARS - 4%); Conservative funds = Min (50% of ARS, ARS - 2%) 36 months Monthly Full disclosure after 10 days
  - Uruguay: Min (2% real, ARS - 2%) 12 months Monthly
  - Poland: Min (50% of ARS, ARS - 4%)* 36 months Bi-annually Full disclosure yearly; Partial 2 x year
  - Acronym definitions in table: ARS: Weighted Average Return of the System; RSP: Return of the Synthetic Portfolio; BVC index: Bogotá Stock Exchange index.
  - Source line in table: Source: SBC, SAFP, KNUiFE.

- Main risk of a relative-return benchmark:
  - Pension fund portfolios may be driven toward inefficient equilibria or inefficiency traps that become difficult to overcome (example: Chile in the nineties—equity portfolio increased to 32 percent of total assets, 80 percent in the energy sector; funds then stuck with risky portfolios to avoid triggering MRG until a buyout by large strategic investors allowed reduction).

### Investment horizons and asset allocation implications
- Observation: High proportion of fixed-income instruments with relatively short durations suggests pension fund managers operate with shorter investment horizons than optimal.
  - Pension funds hold relatively large amounts of short and medium-term nominal government instruments to avoid short-term interest rate volatility and low short-term returns; this strategy implies exposure to reinvestment risk.
  - Reference: Campbell and Vicera (2001) suggest the risk free asset for pension funds is a long term inflation indexed instrument; in a context of changing real interest rates, nominal bonds with relatively short durations become a risky asset because pension funds are exposed to reinvestment risks.

- Policy response in some countries:
  - Combined benchmarks (synthetic portfolio + weighted average of the system) used in Colombia to reduce traps and lengthen investment horizons; this may help explain greater diversity of pension fund portfolios in Colombia.

### Payout phase
- The payout phase of the second pillar has not been designed yet; workers enrolled in the new system will start retiring in 2009.
- Concern: Two-year “grace period” is hardly sufficient considering the wide range of options under consideration (number of providers, range of products).
- Successful payout phase may require providers’ access to adequate instruments to manage risks, such as indexed fixed-income instruments with very long durations and derivatives; these markets still need further development.

### Supervisory framework (KNUiFE)
- Institutional facts:
  - The Insurance and Pension Funds Supervisory Commission (KNUiFE) supervises the pension and insurance industry.
  - KNUiFE was created in 2002 from the merger between the State Office for Insurance Supervision (PUNU) and the Pension Fund Supervisory Office (UNFE).
  - The Board consists of five members: three appointed by the government, one by the Securities and Exchange Commission and one by the Office of Competition and Consumer Protection.
  - The Chairman is appointed for a five year term.

- Operational and legal limitations:
  - KNUiFE has enjoyed operational autonomy in practice but does not have the power to issue binding secondary regulation; secondary regulations have been issued through a limited number of Decrees.
  - KNUiFE does not provide interpretations of the law through guidelines or recommendations; rationale for sanctions has not been sufficiently elaborated.
  - Areas lacking detailed legal guidance include corporate governance of companies in pension fund portfolios.

- Supervisory capacity and approach:
  - Current approach: traditional, compliance-based supervision; pension supervision department has 21 professionals supervising 15 PTEs.
  - Off-site supervision analyzes substantial daily information and supports on-site inspections.
  - Gaps and future needs:
    - Need to migrate to a more preventive approach promoting sound risk management and internal control systems in PTEs.
    - Need to develop internal risk scoring systems to identify higher-risk areas and allocate supervisory resources effectively.

### The domestic capital market: structure and holdings
- Overall market concentration:
  - The Polish capital market is dominated by markets for government securities and the equity market; privately issued fixed-income instruments are extremely small.

- Table 18 (Stocks and Holders of Financial Instruments, 2005 — preserved values):
  - Total as % of GDP:
    - Government Debt: 32.2
    - Municipal Bonds: 0.3
    - Corporate Bonds: 0.8
    - Equity: 31.9
    - Venture Capital: 0.1
    - Mortgage-Related Bonds: 0.1
  - Shares of Total by holder (selected rows, preserved values):
    - Pension funds: Government Debt 17.6; Municipal Bonds -; Corporate Bonds 1.7; Equity 8.6; Venture Capital -; Mortgage-Related Bonds -
    - Insurance Companies: Government Debt 17.1; Municipal Bonds 2.0; Corporate Bonds 7.8; Equity 1.1; Venture Capital -; Mortgage-Related Bonds 1.2
    - Investment funds: Government Debt 9.3; Municipal Bonds -; Corporate Bonds 16.2; Equity 5.1; Venture Capital -; Mortgage-Related Bonds 0.0
    - Banks: Government Debt 22.8; Municipal Bonds 75.6; Corporate Bonds 35.7; Equity 0.2; Venture Capital -; Mortgage-Related Bonds 55.0
    - Other Fin. Intermediar.: Government Debt 2.4; Municipal Bonds 4.4; Corporate Bonds 6.0; Equity n.a.; Venture Capital -; Mortgage-Related Bonds 16.1
    - Retail: Government Debt 5.4; Municipal Bonds -; Corporate Bonds 6.9; Equity 5.9; Venture Capital -; Mortgage-Related Bonds 0.0
    - Corporates: Government Debt 2.1; Municipal Bonds 2.9; Corporate Bonds 25.5; Equity 7.7; Venture Capital -; Mortgage-Related Bonds 0.3
    - Foreign investors: Government Debt 22.1; Municipal Bonds 13.7; Corporate Bonds -; Equity 49.4; Venture Capital 99.9; Mortgage-Related Bonds 26.9
    - Other/non-identified: Government Debt 1.0; Municipal Bonds 1.4; Corporate Bonds 0.2; Equity 22.0; Venture Capital 0.1; Mortgage-Related Bonds 0.5
    - Total: 100.0 across all instruments.

A. The market for government debt
- Progress:
  - Government has lengthened maturity structure and established liquid benchmarks; since 1999 strategy aimed at reducing foreign currency risk, increasing average maturity, reducing refinancing risk, and improving market liquidity of domestic debt.
  - Domestic T-bills relative weight reduced from 12.7 percent in 2003 to 5.5 percent in 2005.
  - Liquidity built in five year fixed rate benchmark bond and to a lesser degree in the 10 year bond.
  - PD system introduced in 2002 played a key role in increasing liquidity.
  - Trading concentrated in OTC market (96 percent of total turnover in 2004).
  - Government issued only one inflation indexed debt, which is relatively illiquid and mostly held by foreign investors.
- Holdings and duration:
  - In December 2005, about 78 percent of government debt was held by domestic investors.
  - Average duration of portfolios of domestic investors: 2.87; average duration of overall stock: 3.86.
  - Pension funds’ portfolio duration: 3.07.
  - Defined contribution pension funds in switchable systems tend to operate with short investment horizons and avoid interest rate risks; most demand for long-term securities has come from defined benefit pension funds and insurance companies in Western Europe.
  - Figure 18 (Duration of Government Bonds by Holder) referenced; source: NBP.

B. The equity market
- Activity:
  - Equity market increasingly active in last three years; 68 IPOs between 2004 and 2005 (36 in 2004 and 32 in 2005).
  - Success driven by private equity exit sell-offs, new issuers by private mid-cap companies, and foreign issuers (five in 2004 and seven in 2005).
- Private equity industry:
  - About 30 private equity funds operate in Poland, managing investments of about Euro300 million, funded mostly from foreign investors.
  - More than 350 investments amounting to Euro1.8 billion have been divested since 1990.
  - Recent investments concentrated on buy-outs, replacement capital and expansion of mature companies; industry biased toward larger and less risky transactions.

C. Other fixed-income instruments
- Municipal bonds:
  - General obligation bonds have grown but stock remains very small.
  - Revenue bonds could become attractive; December 2005 saw a successful revenue bond flagship issue.
  - Some general obligation bonds issued at relatively narrow spreads and mostly purchased by banks.
- Corporate bonds:
  - Lack of development mainly due to low investment ratio and high liquidity of corporate sector; institutional and regulatory constraints also matter.
  - Deficiencies: lack of regulation on minimum disclosure requirements for issuers, deficiencies in depository functions (securities need not be deposited at the National Depository of Securities), lack of a culture of risk ratings.
- Mortgage-backed securities (MBS):
  - Market extremely small but could develop due to growth in housing loans.
  - Recommendation: priority should be given to covered bonds over more complex securitization schemes given preconditions and complexity of reforms required.

### Recommendations for the accumulation phase (market structure, competition, and fees)
- Consider a more accommodative policy for future mergers of pension funds:
  - Lottery mechanisms that allocate new entrants to smaller/high-performing funds may not work well when fees are reduced further because smaller funds may lack scale to operate profitably.
  - Larger pension funds may offset lottery effects with more intensive marketing.
  - It may be difficult to implement strict price controls and avoid concentration simultaneously under current institutional arrangements.
  - If current schedule for fee reductions is implemented it may be necessary to allow some PTEs to merge to gain scale and reduce costs.
  - If government pursues strict price controls, it will need to consider more extensive regulation of the pension business to prevent loss of quality in portfolio selection, risk management and services to the public.

*Source: _cr07104 - 61. The MRG in Poland is similar to those adopted in most reforming countries,*

### 80. If the government decides to continue pursuing the policy of promoting

### _cr07104 - 80. If the government decides to continue pursuing the policy of promoting

### Structural reform options for the second pillar (Swedish model)
- Recommendation: consider structural changes in the second pillar along the lines of the Swedish model.
- Key features of the Swedish model:
  - All basic services centralized, including management of individual accounts.
  - Central provider operates like a central clearing house and outsources asset management to a large number of investment funds.
  - Individual account holders can select freely among licensed asset managers.
  - Accounts are “blind” — asset managers receive only total volumes to manage and do not know individual identities.
  - Blind accounts eliminate incentives for expensive direct marketing and focus competition on returns.
- Implementation safeguards if Swedish model adopted:
  - Central provider must be properly regulated and supervised.
  - Maintain proper licensing requirements to avoid an excessively large number of funds, possibly including payment of a basic licensing fee.
  - Include a well designed default fund for passive new entrants.
  - Maintain minimum communication and information with members and promote that contributors select asset manager free from employers’ intervention.

### Vertical integration, cross-subsidization, and market monitoring
- Observation: ownership links between pension funds and insurance companies and common contractual arrangements open room for cross-subsidization within the group.
  - Pension funds and insurance companies share the same administration companies and have contracts with the sales force of insurance companies.
  - These arrangements can produce economies of scale but also enable price transfers.
- Recommendation: KNUiFE should introduce procedures to verify whether prices of these arrangements are in line with market prices.

### Investment regime — diversification and risk management
- Recommendation: review the investment regime to promote greater portfolio diversification of pension funds and give greater responsibility to PTEs in defining investment policies.
- Specific elements to review:
  - Limits on foreign investment.
  - Limits on corporate bonds and bonds issued by non-public companies.
  - Introduce minimum standards of internal risk management and controls alongside regulatory changes.
- Foreign assets:
  - Recommendation: raise the limit on foreign assets to a meaningful level to improve net, risk-adjusted returns.
  - Consider allowing PTEs to net fees on foreign investments from returns while imposing caps to prevent abuse.
  - Consider allowing pension funds use of foreign exchange forwards and futures to hedge currency positions.
- Corporate bonds:
  - Recommendation: relax limits on unsecured plain vanilla corporate bonds while promoting use of credit ratings.
  - Proposal: limit for investment in unsecured corporate bonds issued in the public market should at least be comparable to the limit for investment in equity, with only rated instruments eligible.
  - Regulation may consider increasing limit for non-public bonds when properly rated.
- Closed-end investment funds and private equity:
  - Recommendation: authorize pension funds to commit resources in closed-end investment funds (common practice for private equity).
  - Rationale: closed-end funds combine long maturities and high yields with management capacity (general partner) and permit deduction of fund managers’ fees from returns.
  - Note: private equity funds usually charge a management commission of about 2.5 percent of the fund.
  - Observation: tighter pension fund fee caps can incentivize greater use of closed-end funds; Chile later imposed caps on investment fund managers’ fees to prevent abuse.

### Portfolio choice and default portfolios
- Recommendation: consider introducing additional portfolios, possibly combined with a default portfolio for passive members.
  - Current system assumes a single portfolio for all contributors; multiple portfolios better match diverse risk-return preferences.
  - If portfolio choice introduced, accompany with a default rule for non-choosers (e.g., lifecycle or “no lose” portfolios with capital protection).
  - Need for more portfolios grows as payout phase approaches to avoid exposing retiring workers to wide equity/interest rate fluctuations.
  - Older contributors should have portfolios relatively immunized to equity and interest rate fluctuations, resembling portfolios of annuity providers.
  - Portfolio choice introduction should be accompanied by improved financial education and information flow to members.

### Minimum Return Guarantee (MRG)
- Recommendation: introduce a synthetic portfolio in the definition of the benchmark for MRG calculation.
  - Rationale: current benchmark based exclusively on average return of the system may create inefficiency traps.
  - Example concern: fixed-income portfolios of pension funds have shorter duration than other institutional investors and may not be optimal long-term.
  - Design principle: synthetic portfolio should be designed by a group of independent advisors to avoid conflicts of interest and political interference.

### Valuation and trading rules
- Recommendation: KNUiFE must improve valuation rules as portfolios become more diversified.
  - Issue: most fixed-income transactions occur in OTC markets with non-transparent prices; acceptable so far because government securities dominate, but future investments in less liquid instruments and derivatives will require better valuation rules.
  - Government should promote a single system of valuation for all institutional investors whose portfolios are marked to market (pension funds, banks, investment funds).
  - Interim step: KNUiFE should consider moving toward a single price for each instrument at each moment in time.
- Recommendation: provide a solution to pension funds operating through a non-transparent OTC market by:
  - Requesting enhanced transparency and disclosure of OTC markets; or
  - Forcing pension funds to operate exclusively through electronic trading platforms.
  - Note: countries like Chile and Colombia have required operation only through formal exchanges or electronic trading platforms; similar outcomes can be achieved with enhanced OTC transparency and disclosure.

### Supervisory practices and internal controls
- Legal interpretation and sanctions:
  - Recommendation: KNUiFE should provide interpretations of the law through guidelines or recommendations and elaborate the decisions underlying sanctions.
  - Example issue: professional secrecy obligations in the Pension Act may contradict Tender Offer Law principles regarding shareholder meeting voting; current uncertainties have created incentives for conservative PTE behavior, poor monitoring, and lack of efficiency in voting processes.
  - KNUiFE may consider elaborating resolutions and sanctions to PTEs to create jurisprudence for the industry.
- Supervisory approach:
  - Recommendation: adopt a supervisory approach emphasizing sound internal risk management rather than an excessively compliance-based approach.
  - Observation: some PTEs strengthen risk management due to internal group policy rather than regulatory requirements.
  - KNUiFE should ensure minimum standards of risk management and internal controls as portfolios diversify and new risks emerge.
  - Suggested first step: require external auditors to evaluate quality of internal risk management and controls against recognized standards such as COSO and COBIT.
  - KNUiFE may need to build capacity to adopt risk-based supervision.
- ZUS transparency:
  - Recommendation: increase transparency of ZUS, including periodical evaluations by external auditors about quality of internal control management.
  - Rationale: greater predictability to monthly contributions and shorter periods that resources remain in ZUS improve resource management efficiency.

### Preparing the regulatory framework for the payout phase (scheduled to start in 2009)
- Regulatory development areas:
  - Institutional arrangements (single versus multiple providers).
  - Regulations for retirement products (menu of products, marketing regulations).
  - Regulations for providers (investment, valuation, and capital rules).
- Comparative country experiences to inform design: Australia, Chile, Denmark, Sweden, Switzerland.
- Lessons from selected country models:
  - Australia:
    - Decentralized model with multiple providers and very liberal product regulation allowing lump-sums, phased withdrawals, and several annuity types.
    - Result: extremely low degree of annuitization; most retiring workers take lump-sums and, to a lesser extent, phased withdrawals.
    - Lesson: unrestricted lump-sum access leads to low annuitization and may cause inadequate pensions for middle and low income retirees and excessive recourse to the minimum pension guarantee.
  - Chile:
    - Decentralized model with careful evolving product regulation and sound provider regulation.
    - Restrictions on menu of retirement products reasonable and contributed to high annuitization while allowing some individual choice.
    - Market transparency improved via electronic quotation system; providers can price annuities freely by individual risk and capital rule penalizes mismatches.
  - Denmark:
    - Decentralized model with extensive risk-sharing arrangements.
    - High degree of annuitization, influenced by collective labor agreements and tax rules that discourage lump-sums.
    - Demonstrates complexities in regulating risk-sharing when provided by profit-oriented companies that combine accumulation and payout phases.
  - Switzerland:
    - Decentralized model with interventionist regulation including annuity price regulation.
    - High annuitization historically, but failure to adjust annuity prices to market developments may have led some companies to generate losses and exit market.
    - Shows difficulties and risks of regulating annuity prices (unisex mortality tables, discount rates).
  - Sweden:
    - Centralized, public-managed payout model with restricted menu of retirement products including two annuity types with risk-sharing (with-profits and variable annuities).
    - With-profits annuities priced with a very conservative cohort mortality table and very low discount rate; excess returns paid as next-year bonus.
    - Variable annuity operates like unit-link; retirees share market, longevity, and cost risks; mortality experience reviewed every three years and benefits adjusted.
    - Advantages: low operating costs, large risk pool, feasible risk-sharing in a non-profit environment.
    - Concern: system not sufficiently tested, vulnerable to political interference in pricing and asset management.
- Immediate Polish policy implications:
  - Start preparing regulatory framework for payout phase scheduled to start in 2009.
  - Some decisions can already be made, such as menu of retirement products.
  - Need to ensure a reasonable degree of annuitization to protect workers against market and longevity risks.
  - Possible solution: allow partial lump-sums provided remaining balance of first and second pillars can generate an annuity equal to a defined multiple of the minimum pension.
    - Example: in Chile this multiple is 1.5 times the minimum pension; it could be higher in Poland.
  - Phased withdrawals may need restriction to avoid segmentation of risk pool caused by mandatory use of the unisex mortality table (men tend to favor phased withdrawals; women tend to favor annuities).
  - Phased withdrawals could serve low income workers with payouts close to the minimum pension; these workers should probably be required to buy PWs and exhaust balances before government starts paying the minimum pension.

*Source: _cr07104 - 80. If the government decides to continue pursuing the policy of promoting (extracted content).*

### 101. Polish authorities should favor fixed and price-indexed annuities as this is the

### _cr07104 - 101. Polish authorities should favor fixed and price-indexed annuities as this is the

### Annuity product recommendations
- Favor fixed and price-indexed annuities because they "protect workers against the most important risks in the retirement phase, while also allowing other types of annuities."
- Consider adjustable annuities that "recalculate payouts every three years or so depending on the movements of long-term interest rates."
- Consider variable annuities on a unit-link basis to:
  - Allow annuitants to share upside gains.
  - Simplify asset liability management of providers, reducing capital requirements and allowing providers to offer better initial payouts.
- To reduce downside losses for lower income workers, offer these risk-sharing annuities "in combination with a minimum level of fixed indexed annuities."
- Consider allowing annuities with guaranteed periods to:
  - Reduce adverse effects of the unisex mortality table (gender imbalances).
  - Provide an element of bequest attractive to retiring workers.
- Authorities may consider imposing joint annuities on married retirees "in order to protect their spouses against longevity risk."

### Risk-sharing annuities and regulatory concerns
- Authorities are considering annuities with stronger risk-sharing features (with-profits annuities and variable annuities) that share market and longevity risks.
- Attractive features:
  - Address complex risks effectively.
  - Require less capital and reserves from the provider (in some cases no reserves at all).
  - Allow providers to offer better initial payouts.
- Regulatory and supervision concerns in a decentralized and competitive model:
  - Difficulty in regulating and supervising decentralized risk-sharing constructions.
  - Risk that providers may offer attractive terms to new annuitants to gain market share and later force a drastic adjustment on the whole pool to restore solvency, generating unfair distributions of wealth across cohorts.
  - Risk that shareholders may appropriate an excessive share of profits, claiming compensation for excessive equity risk.
- These risks explain why such arrangements "are not favored in most countries."

### Market structure, marketing costs, and consumer access
- If a decentralized model is adopted, introduce institutional arrangements to contain marketing costs and ensure access to best quotes.
- The electronic quotation system introduced in Chile is cited as a model that "has reduced the influence of insurance brokers and ensured access of retiring workers to the best quotes in the market."
- To contain marketing fees, consider:
  - Imposing caps on broker’s fees (as in Chile).
  - Forbidding insurance brokers to charge fees for second pillar annuities (as in Colombia).

### Regulation, supervision, and risk management
- Providers face complex market and longevity risks over long periods and "need to be properly regulated and supervised."
- Critical regulatory elements:
  - Capital rules that penalize asset-liability mismatches and address longevity risk effectively.
  - Adaptation of overall Solvency II style rules to the specific risks of the annuity business may be necessary.
  - Faster progress in ensuring sound risk management capacity in institutions.
  - Implementing risk-based supervision to ensure a resilient and stable market.

### Access to financial instruments and implications for debt management
- Annuity providers need access to proper financial instruments to hedge longevity and market risks.
- Proper asset-liability management requires:
  - A steady supply of indexed fixed-income instruments with long durations, with implications for government debt management strategies.
  - Access to derivatives and reinsurance to contribute to efficient asset-liability management.

### Developing financial instruments for accumulation and payout phases
- Expand supply of suitable domestic financial instruments by completing the privatization program, including divestiture of government participation in large conglomerates and floating remaining government-majority listed companies.
- Accompany privatization with better corporate governance standards in state-owned companies.
- Complete reforms to bring effective protection to minority shareholders; pension funds are major beneficiaries as important institutional investors.
- Facilitate development of the investment fund industry for investments in SMEs by reviewing regulatory framework for intermediate vehicles (limited joint-stock partnership and closed-end funds) and ensuring tax pass-through to these vehicles.
- Assess evolving patterns of demand for government bonds to ensure efficient debt management:
  - Currently, "longer maturities are primarily demanded by foreign investors, while pension funds seem to focus on short- and medium-term maturities."
  - Further lengthening of the yield curve to European standards may increase reliance on foreign investors and interest rate volatility.
  - Need for "more frequent and larger issues of inflation indexed instruments in the near future" as annuity providers may need these to hedge liabilities.
- Create conditions for a healthy sub-national bond market via coordinated policy measures to:
  - Eliminate moral hazard.
  - Improve market transparency.
  - Establish a level playing field.
  - Strengthen asset-liability management by local governments.
- Develop the corporate bond market by enhancing custody and depository infrastructure:
  - Consider requiring all fixed-income instruments be centrally deposited in the NDS to enhance liquidity.
- Address regulatory and legal impediments to securitization:
  - Mortgage-backed securities: allow lenders to hold related securities including subordinated tranches; explore ways to lift or facilitate the requirement that certificates cannot be issued until transfer of each lien is registered; allow banks to interact with SPV joint-stock companies.
  - Asset-backed securities: ensure tax neutrality of SPV; facilitate transfer of assets and liens; ensure asset segregation in case of bank bankruptcy; write detailed rights and duties of SPV company (capital, debt borrowing and bond issuance, enhancement support, regulations); adjust status of corporate bonds to structured finance specifics; allow acquisition of issued securities by the selling bank.
- Strengthen enforcement capacity of KPWiG:
  - Grant more authority over issuers and auditors.
  - Consider more reliance on well managed SROs.
  - Use check and balance mechanisms (independent board members, independent audit committee, custodians and trustees).
  - Introduce a risk oriented supervision approach.

### Price competition and consumer switching (Appendix I)
- In most reforming countries, demand for pension products is "inelastic to returns and fees and more responsive to direct marketing."
- In Poland, no evidence that contributors switched towards pension funds with better performance between 2000 and 2005.
- Figure A1 observation: "no clear correlation between growth in market shares and the efficiency of pension fund portfolios, as measured by Sharpe ratios."
- Formal test: regressions of switchovers of contributors against rates of return and Sharpe ratios for 2001-2005 rejected the hypothesis that contributors responded to measures of return.
  - The variables (rates of return and Sharpe ratios) "are not significant and the predictive power of the model is close to zero."
  - No major differences when model specified in first differences and with lags.
  - Findings are similar to other reforming countries (e.g., Chile), where "the only significant variable in explaining switchovers of contributors seems to be the size of the sales force."
- Panel Data: 2001-2005, Quarterly Observations. Dependent Variable: Gross switchovers.
  - Number of observations: 255, 240, 255, 240, 255, 255 (as reported across columns).
  - Estimated coefficients reported with t-statistics in parentheses include:
    - Return (t-1): -2612 (0.23); -3359 (0.25)
    - Return (t-2): -1893 (0.15)
    - Sharpe Ratio (t-1): 261 (0.87); 296 (0.80)
    - Sharpe Ratio (t-2): 265 (0.64)
    - D(Return): -985 (0.14)
    - D(Sharpe Ratio): -59 (0.14)
  - R square values: 0.0002, 0.0003, 0.0030, 0.0035, 0.0001, 0.0003

*Source: _cr07104*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr07104.pdf_