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Success Stories Assistance Areas SEED Reports Contact Information Last updated: 47     Pension I USAID POLAND PRIVATE PENSION FUNDS ASSESSMENT DRAFT FINAL REPORT    March 15, 1996   TABLE OF CONTENTS EXECUTIVE SUMMARY i SCOPE OF WORK AND METHODOLOGY 1 Scope of Work 1 Approach and Methodology 2 Definition of Pension Fund 2 FINDINGS 4 The Current Private Pension Market 4 Tax Treatment of Private Pensions 10 Capital Markets 11 Pension Reform Plans 14 ISSUES 17 Private Pension Market 17 Tax Incentives 18 Regulatory Framework 18 Capital Markets 20 BACKGROUND ON MINIMUM LEGAL AND REGULATORY REQUIREMENTS 22 Rationale 22 Objectives 25 Minimum Legal Requirements 26 RECOMMENDATIONS 32 NEXT STEPS 35   EXECUTIVE SUMMARY Project Purpose USAID/Poland requested technical assistance from Price Waterhouse LLP to assess opportunities and constraints for development of a voluntary, private pension funds in Poland. This report reviews the current financial markets, including the legal and regulatory framework, to identify potential impediments to private pension fund development. We also identify potential Government of Poland counterparts to work in this area. The technical recommendations contained within this report represent alternatives for consideration by the Government of Poland and USAID. Poland currently does not have a "true" voluntary private pension fund market. Investment companies and life insurance companies market products which could provide a pension. But because investment products allow withdrawals on demand and insurance policies can be refunded, these products are not designed for long term investing. Insurance policies are designed to pay benefits in case of death, not to provide a retirement income. People are interested in private pension funds, however, to assure that they will have adequate income in retirement. These issues are addressed in detail in pages 4-11 of the report. Private pension fund market development would benefit from fiscal incentives. The Government of Poland offers no tax exemptions, tax credits, or other form of incentive for private pension funds. The market acceptance of insurance products sold as pension products and investment funds sold as pension programs reveals much. The insurance products are popular, although they may be used primarily to evade taxes. The Pioneer investment trust retirement program, offered by 400 companies enjoys no tax privileges and has modest employee acceptance. Back to Top   SCOPE OF WORK AND METHODOLOGY Scope of Work USAID/Poland requested technical assistance from Price Waterhouse LLP to assess opportunities and constraints for development of a voluntary, private pension funds in Poland. The private pensions system is expected to supplement the pensions paid by the Polish state system, Za~klad Ubezpieczen Spolecvlych (ZUS). Although state pensions are considered inadequate, ZUS operates at a deficit and has a deteriorating fmancial condition. According to the experts, ZUS may be insolvent within a few years, thus reform is essential. This technical assistance project is designed to support the Government of Poland's plans for pension system reform. The scope of work involves the following principal tasks: • Assess the current private pension fund market in Poland. This task requires identifying the players in the market and products offered, to the extent that these exist. Products must be analyzed to see if they meet the criteria for pension funds. Also, this task requires assessing the potential demand for voluntary private pension funds. • Assess the legal and regulatory framework to support pension fund development. This task requires identifying the players in the market and products offered, to the extent that these exist. Products must be analyzed to see if they meet the criteria for pension funds. Also, this task requires assessing the potential demand for voluntary private pension funds. • Assess the legal and regulatory framework to support pension fund development. To carry out this task, the legal and regulatory framework for capital markets and insurance must be analyzed from the perspective of private pension funds' requirements. These analyses will indicate areas where existing legislation may be unsuitable for private pension funds. • Assess the capacity of financial intermediaries to support private pension funds. Because private pension funds typically invest in the financial markets, financial intermediaries play a key role in private pension fund development. The breadth and depth of the capital markets, the ability of financial intermediaries to carry out transactions, and market transparency must be evaluated. • Identify Potential ways to remove structural impediments to private pension fund development in Poland. Approach and Methodology The Price Waterhouse (PW) approach called for a mufti-disciplinary team comprising pension funds, capital markets, and local specialists to assess the potential for the private pension funds market in Poland. This work was carried out during November and December 1995. Our methodology was to collect information related to private pensions from primary and secondary sources. The team conducted interviews, reviewed official statistics, collected market reports, and studied academic papers. The PW team interviewed financial sector market participants and regulators in the following areas: insurance, capital markets, banking, and, of course, pension funds. Each of these financial sector participants are related to private pension funds. Insurance companies typically sell pension type products and dominate the private pension market in some countries. The capital markets are essential to pension funds as an avenue for investment. If the capital markets do not exist or do not function well, then the prospects for private pension funds diminish somewhat. The banking system underpins the entire financial sector because of the payments function. Private pension funds typically rely on the banking system to collect and/or transfer pension system collect and/or transfer contributions to fund managers. The banking system also may be used to make pension payments, for example, if retirees receive their pensions in check form. Finally, pension funds themselves, to the extent that they existed, were studied. The list of meetings with contact information is provided in calendar format as Appendix A to this report. We have also included minutes for each meeting with market participants in Poland. These minutes are presented as Appendix B. This report is based on a limited review of Poland's financial sector undertaken in a relatively short period of time. While a number of key participants in mapy of the major market institutions were interviewed, due to the exigencies of time not every key participant could be interviewed. With those caveats in mind, we offer these preliminary findings, and recommendations. Definition of Pension Fund Part of the scope of work is to assess the existing private pension fund market in Poland. To do so requires a working definition of a pension fund. This definition is important because in some economic transition countries such as Russia, Ukraine, and Moldova, team members have observed entities which call themselves pension funds but are not. At best, such entities might be investment funds; at worst, they are pyramid schemes. Loosely defined, a pension fund is a vehicle for providing income to retirees and people who can no longer work due to disability, as well as their survivors. For purposes of this paper, private pension funds refer to privately managed pension funds belonging to individuals or entities sponsoring them, such as employers. A primary difference between private and public pension systems is that the former tend to accumulate assets to pay future pensions, while the latter often operate on a pay as you go basis. The exception is book reserve private pension plans, such as German corporate pension plans. Book reserve pension plans obligate companies to pay pensions, but do not require assets to be set aside to meet this liability. Book reserve pensions are not advisable for emerging markets because of the high uncertainty of pension payment. For the purposes of this paper, we also assume that private pension funds accumulate monies for long term investment. Because pensions are long term obligations, pension fund managers generally seek long term investment alternatives. These criteria for defining private pension funds will be applied to various investment vehicles in Poland as part of the market assessment. Back to Top   FINDINGS The Current Private Pension Market Poland does not currently have a private pension market. Certain products sold by insurers or trust funds are packaged as pension programs. These products do not meet the definition of Poland private pension funds because they tend to act as shorter term savings products. Participants generally have access to these funds at their discretion and for purposes other than to provide retirement income, as described below. Although the products sold in Poland do not meet the definition of pension products, there is demand for Buch products. The demand is from individuals who perceive problems with the public social insurance system, consisting of general social insurance (ZUS) and farmer's social insurance (KRUS), which pays inadequate pensions. Even though pensions are low, pension expenditures exceed contribution revenues. Because ZUS operates on a pay as you go basis, the Government of Poland makes up the difference. State subsidies have increased from 14.5 % of total revenues to the social insurance fund in 1990 to 24.3 % in 1994 as shown in the table below. SOCIAL. INSURANCE FUND INCOME 1990-1994 (Billions of old Polish zlotys*) Source of Funds 1990 1991 1992 1993 1994 Total Revenues 60,674.0 113,312.5 188,944.0 251,192.0 340,562.0 Contributions 83 .9 % 78.9 % 73.3 % 73.3 % 75.4 State subsidies 14.5 % 19.5 % 26.2 % 26. 3 % 24.3 Others 1.6% 1.6% 0.5% 0.4% 0.3% * The exchange rate was 22,500 old Polish zlotys per US$1 in 1994 These financial problems persist, despite the high contribution rates to ZUS. Pension contribution rates increased from 38 % to 45 % from 1990 to 1992. Current contribution rates to ZUS are broken down as follows: Unemployment and disability: 3.3 % of taxable wage base Pensions and retirement: 45% of taxable wage base These public pension contribution rates are among the highest in the world. The employer pays the entire contribution for his or her employees. As expected under these conditions, employers use legal and other means to evade contributions to ZUS. The taxable wage base for social insurance has no upper limit. However, the social insurance taxable wage base excludes certain forms of compensation, such as life insurance premiums paid by the employer on behalf of the employee. Tax issues are considered later in this paper. Trust Funds Overview Trust funds are the Polish equivalent of American mutual funds. The Act on the Public Trading of Securities of March 1991 regulates these open-ended funds which must be licensed by the Polish Securities Commission, referred to as the Commission. The trust fund sponsor is required by law to act in participants' best interests, although the law does not define this concept. We treat this issue and fiduciary concepts on pages 21-23 of the report. In addition, the trust fund sponsor also must be licensed by the Commission. Trust funds sell participation units to investors via brokerage houses, although theoretically they may use other distribution channels. Trust fund participation units are more closely related to bank accounts than to. securities: Investors can redeem participation units, but cannot sell the units to third parties. Ownership of a participation unit gives the investor a claim against the trust fund assets: the trust fund manager holds title to the fund assets. The trust fund manager invests the assets in according to the fund's investment philosophy. Trust fund bylaws disclose not only the investment policy, but also sales charges, net asset value computation, and other important information for investors. Notably, that although Polish law does not require trust funds to maintain separate accounting for sponsor and investor assets, both Pioneer and Korona do so. Market Two companies currently offer trust funds in Poland: the Pioneer group out of Boston, and Korona, a Polish/Austrian joint venture. These two companies manage a total of four funds and have approximately $400 million under management. A number of foreign companies may be preparing to enter the Polish trust fund market, including CS First Boston, Franklin Templeton, Kleinwort Benson, and ING Bank. The Polish Securities Commission denied a third fund management company, Fidelia, the right to offer participation units. We received conflicting explanations of the Commission's decision. The Pioneer Funds The Pioneer group of funds, based in Boston, launched the first Polish mutual fund in July 1992. The manager and underwriter of the fund is Pioneer First Polish Trust Funds JSC, 100% owned by Pioneer International Corporation. Pioneer sells participation units at more than 500 outlets belonging to banks and private brokerage houses. The minimum investment is 100 Polish zlotys (PLN 100). The fund charges a 5.5 % load on investments up to PLN 25,000, which is reduced to 2.5 % for investments over PLN 500,000. The fund also charges a 2 % management fee based on the value of the average monthly assets under management. As of the middle of 1995, the fund had PLN 835,580,000 under management or about US$334 million, down from PLN 1.43 billion or roughly US$572 million at the end of 1994 and PLN 911 million or about US$364 million at the end of 1993. As of the middle of 1995, the fund had about 37 % of its portfolio invested in Polish equities, 62 % in Polish debt and the rest in foreign securities. Besides the Pioneer First Polish Trust Fund, Pioneer has a debt fund, the Pioneer Debt Securities Fund and plans to offer an aggressive growth fund that will target Polish equities. In addition, Pioneer markets a retirement plan. This product, which uses the trust funds for investment, is sold primarily to employees of companies with over 50 employees as well as to individual investors. The initial investment is PLN 100 but subsequent investments can be as .low as PLN 50. Approximately 400 companies participate in Pioneer's retirement program. The program is individually tailored to meet company needs, so fund contributions may come from employees, the employer, or both. The investment funds are portable for the employee. Employer contributions are taxable to the employee and increase the employer's wage base for calculation of payroll taxes. Information on the number of employees participating in this plan was not available to the consulting team. Pioneer management characterized the retirement plan as giving Pioneer a chance to market their investment funds to a company's employees. This characterization suggests that participation is not high. According to Pioneer, the lack of fiscal or tax incentives is an issue for employee participation in their retirement plans. However, this pension program is not really a retirement plan because investors do not have to keep money in the plan until retirement. Rather, this program is akin to a savings account as employees may withdraw funds at any time at their discretion. The Korona Fund The Korona fund, a joint-venture between Creditanstalt of Austria and Bank Gospodarki Zywnosciowej, began operations of August 7, 1995 with a balanced fund investing in Polish debt and equities. Creditanstalt Securities was the first foreign brokerage house to operate in Poland while BGZ is one of Poland's leading banks and was the first brokerage house in Poland to obtain a licnese to provide investment advisory services. Like Pioneer, Korona has a sales commission of up to 5.5% depending in the amount invested and a management fee of 2% of the fund’s average daily assets. Korona’s portfolio is invested 40% in equities and 60% in debt. The company does not offer a retirement plan, but expects to do so in the future. Other Forms of Collective Investment Vehicles Largely due to Poland’s tax laws, at present the only form of collective investment vehicles is the open ended fund regulated by the Act on Securities. Because closed end funds are not subject to any special regulation, unlike open ended funds, they would be organized either as joint stock companies or limited liabilities. Both of these organizational forms are defined and subject to the Polish Civil Code. Neither form, however, is practicable for the development of investment vehicles. An investment company in the form of a joint stock company subjects participants to double taxation, as profits are taxed both at level of the corporation and the individual. This double taxation occurs because corporations pay tax on profits, then pay dividends. Individuals must pay taxes on dividend income, even though the corporation has already paid a profit tax. As such, joint stock companies are a less attractive collective investment vehicle. Although limited partnerships do not suffer from that requirement, the cumbersome process of establishing such entities make them unsuitable as investment vehicles. Although recommendations have been made to the Government that would eliminate double taxation, these recommendations have not been enacted. Tax law is complex and rapidly changing in Poland, as the Government struggles with competing needs to reduce budget deficits and create conditions to foster economic growth. Tax considerations are treated more fully later in this section. Insurance Companies Overview In August 1995, Poland adopted a new insurance law which modifies previous legislation. Insurance companies must comply with capital adequacy requirements, submit to examinations, distribute products via licensed brokers and agents, and contribute to a guarantee fund. The Ministry of Finance issues and revokes licenses to insurers, while the new regulator licenses brokers and agents. The new insurance regulatory agency, referred to by its Polish acronym, PUNU, had not been established when the project field work took place. The law embodies the philosophy of regulation through solvency requirements. As a consequence, insurance products are not subject to any regulatory approval. But because the regulator sets capital requirements for specific products, the Government regulates the products sold. As mentioned, consumers are protected by an insurance guarantee find. Insurers pay 1.9% of gross premiums to the fund. The Ministry of Finance sets the premium. The new law reduces coverage for life insurance claims, which are generally voluntary coverages, from 100% to 50% of the claim up to a maximum of 30,000 european currency units (ecu). Market Polish law requires the separation of life insurers and property and casualty insurers. These companies are separately capitalized, although cross-shareholdings are permitted. Of the 40 licensed insurance companies in Poland as of May 1995, 12 were life insurers, although data is available for only 11 of these companies. Information published by Reczpospolita on March 4, 1996 shows that life insurance premiums increased sharply in Poland in 1995. At the approximate year-end exchange rate of 2.5 Polish zlotys per US$, 1995 life insurance premiums totaled nearly $740 million. ESTIMATED POLAND INSURANCE MARKET (in millions of Polish zlotys) Premiums Equity Capital   1994 1995 1994 1995 PZU Life S.A. 1,216.34 1,615.05 110.00 145.00 Commercial Union Life, S.A. 36.53 119.50 11.55 11.55 AMPLICO Life, S.A. 25.82 84.68 2.00 2.00 Heros Life, S.A. (Founded 1994) NA 8.61 NA 14.00 Nationale Nederlanden (Founded 1994)         AGF Life Insurance, S.A. 5.29 7.07 4.75 4.75 Gryf Life, S.A. (Founded 1994) 0.10 NA 2.00 NA Benefit, S.A. (Insurance Company of Cooperative Saving and Credit Bank)         Polisa Life NA 0.77 NA 6.20 Petrus, S.A. (Founded 1994) 0.00 0.02 4.51 4.51 Azur Life, S.A. (Founded 1994) 0.00 0.01 2.50 3.75 TOTAL 1,284.36 1,849.65 144.31 196.76 Key: NA means information not available. Poland demographically is an attractive market for life insurers. With a population of over 40 million, per capita premiums are about US$ 18.50 in Poland. This level of penetration is low compared to Western European countries. The potential market is at least 5 times these levels, according to conservative estimates from the insurance industry. Successful macroeconomic growth and stability could as much as double these estimates. This market potential has attracted a number of new insurance companies to the Poland insurance market. Despite or perhaps because of increased competition, life insurance premiums grew by 44% in 1995 alone. Robust growth is likely to continue for the foreseeable future. Estimated life insurance market shares are shown in the table below. ESTIMATED MARKET SHARE – POLAND INSURANCE MARKET Market Share (%)   1994 1995 PZU Life S.A. 94.7 87.3 Commercial Union Life, S.A. 2.8 6.5 AMPLICO Life, S.A. 2.0 4.6 Heros Life, S.A. (Founded 1994) 0.0 0.7 Nationale Nederlanden (Founded 1994) NA 0.5 AGF Life Insurance, S.A. 0.4 0.4 Gryf Life, S.A. (Founded 1994) 0.0 NA Benefit, S.A. (Insurance Company of Cooperative Saving and Credit Bank) 0.0 0.1 Polisa Life NA 0.0 Petrus, S.A. (Founded 1994) 0.0 0.0 Azur Life, S.A. (Founded 1994) 0.0 0.0 TOTAL 100.0% 100.0% Key: NA means information not available. Although the state-owned insurer, PZU Life retains its dominant position, its market share has declined from 94.7% to 87.3% over the last year. Such a decline is not unusual after a market has been opened to competition. Prior to 1991, PZU had a monopoly on the market. Competition, particularly from Commercial Union at the affluent end of the market, has led to new product introductions and more choice for consumers. c. Products This report concentrates life insurance products, particularly annuity and endowment products, because of their similarity to pension products. An annuity is a contract between the insured and an insurance company whereby the company agrees to pay a certain amount to the insured at regular intervals, typically monthly. These payments are like pension payments. Annuities are not commonly sold in Poland. A likely reason is because annuities in Poland typically have not kept pace with inflation. In fact, some annuity contracts do not provide for indexation. Although annuity products exist which allow policyholders to participate in the insurer’s investment performance, the policyholder still bears the risk if the investment returns do not exceed the inflation rate. Endowment policies are life insurance policies which mature when the person reaches a certain age, typically age 65. At maturity the policyholder receives a benefit as defines in the policy. Annuities and lump sum payments are the most common form of endowment benefit. If the policyholder dies before the policy matures, benefits are paid to the beneficiary. Because policyholders may receive an annuity as a payout from an endowment policy, insurance companies claim that these are pension products. However, endowment policies in Poland do not meet the criteria defined for private pension funds in two ways. First, an endowment policy does not necessarily provide retirement income. The policyholder can choose to cancel the policy at any point in time and receive a refund. This policy feature explains the second reason why endowment policies do not meet the pension funds: they are not necessarily long term investments. All the major life insurance companies in Poland offer an endowment product, although sales and market information on these policies was sketchy, conflicting, or considered sensitive. The consulting team requested policy sales, lapse, and cancellation, but did not succeed in obtaining it. Endowment and other similar life insurance policies are sold to individuals and groups in Poland. Insurance companies market certain group insurance policy as pension products. Employers piurchase these life insurance policies, typically endowment policies, on behalf of their employees. The employer pays the premium, which is considered an expense for corporate income tax purposes. The employee holds the policy and pays income tax on the amount of premium paid by the employer on his or her behalf. Analysis of such a policy offered by PZU Life suggests that these policies can also be canceled at the employee’s discretion after a moratorium of a few years. Prior to the moratorium period, steep penalties apply. After the moratorium period, premium payments plus interest would be refunded to the employee. The employee pays no income tax on the refund because taxes were paid on the premium amount. As such, these group life insurance policies in Poland are more like savings schemes than pension funds. Market participants imply that these policies are being used to increase employee wages but avoid the payroll tax. Although life insurance may be paid as annuities or as a lump sum, the latter is more popular. Many annuities, particularly for older policies, are not indexed to inflation. For this reason, PZU Life faces litigation from life insurance beneficiaries whose monthly annuity payments were severely eroded by inflation. Each beneficiary must file a lawsuit to request a one-time only adjustment of these benefits. Part of the rationale for the case-by-case approach is because each individual has a separate contract with PZU Life. This situation highlights a weakness of using contract law to protect individual pension interests. Some individuals will lack the resources to take PZU to court to obtain the adjustments to their pensions to which they are entitled. PZU now offers fixed or indexed annuity benefits. Indexed annuities participate in the insurer’s profits. Such indexation may be sufficient to prevent erosion of benefits by inflation. Indexed annuities only protect beneficiaries’ purchasing power if they keep pace with price inflation. In other words, the insurers’ investment portfolio returns must equal or exceed inflation. Indexed insurance policies are also starting to appear in the market, primarily in the form of foreign currency policies. Typically, foreign currency policy premiums are established in foreign currency, such as dollars. Policyholders can pay the premium in zlotys based on the current foreign currency exchange rate. Insurers are unlikely to offer policies indexed to inflation until they have investment alternatives which are fully adjusted for inflation. Tax Treatment of Private Pensions The Government of Poland currently grants no tax incentives to private pension funds. Financial sector participants repeatedly cited this policy as an obstacle to private pension fund development. The products marketed as pension products have different tax treatment. This section reviews the tax treatment of trust funds and insurance policies described above. 1. Trust Funds Both Pioneer and Korona pay no dividends, choosing instead to reinvest all trust fund income and realized gains in the funds. Investors realize gains when they redeem participation units. As such, investors earn capital gains or losses on trust fund investments. Under 1995 tax law, capital gains are not taxed, however, they are expected to be taxed in 1996. Under current law, investors place post-tax money in trust funds. Trust funds are also subject to inheritance tax. When a trust fund investment is used for pension fund purposes it receives no tax exemptions. Employee investments use post-tax income. Employer contributions in behalf of an employee not only raise the employee’s taxable income, but they also raise the taxable wage base for social insurance (ZUS) purposes. In other words, each 100 zlotys paid by the employer on behalf of the employee Pioneer’s retirement program raises the employer’s expenses by 148 zlotys. Under these circumstances, trust funds are at a competitive disadvantage compared to life insurers. One alternative for Polish trust funds might be to establish a pension program in conjunction with an insurer. This alternative would be viable only if the insurer can legally invest in trust funds. Trust funds might find this alternative attractive, giving them access to tax-sheltered savings. However, the trust funds would have to give insurers an incentive to combine forces. 2. Life Insurers Life insurance policies have four types of favorable tax treatment in Poland. First, although individuals purchase life insurance policies with post-tax monies, benefits are exempt from tax. Carrying this logic forward, premium refunds for canceled policies are also tax-exempt. Second, when companies can purchase life insurance policies for their employees, the premiums are tax-deductible expenses for the company. The employee thus includes the premium as part of his or her taxable income. Third, companies purchase group life insurance policies, the wage base for calculating payroll taxes to ZUS remains unchanged. So, an employer paying a 100 zloty premium for insurance increases his expenses by only 60 clotys assuming a corporate tax rate of 40%. Finally, insurance is not subject to inheritance tax. Capital Markets Private pension funds typically are important investors in the capital markets. For this reason, the PW team assessed Poland’s capital markets to determine if the structures can support development of private pensions. This section contains an overview of the capital markets in Poland. For further information on the legal and regulatory framework and market operations please refer to Appendix C. 1. Introduction Although at present, Poland has no private pension system, the country has many, though not all, of the necessary institutions in place. Private, publicly traded companies exist. Debt and equity is issued and traded on the Warsaw Stock Exchange. Basic legal, regulatory and market institutions function. Compared to many of the countries in the region, Poland’s capital markets have a relatively comprehensive and well-developed legal framework with an increasingly developed institutional and regulatory capability and relative transparency. While not as developed as many Western markets, Poland’s capital markets are certainly adequate to support the development of private pension reform. The primary law governing Poland’s capital markets is Act of the 22 March 1991 On Public Trading in Securities and Trust Funds referred to as the Act on Securities. This law establishes and regulates the Polish Security Commission, Brokerage and Advisory Activities, the National Securities Depository, and Trust Funds among other things related to capital markets. 2. The Warsaw Stock Exchange The Warsaw Stock Exchange (WSE) reopened in 1991, 52 years after it was closed. The WSE, Poland’s only stock exchange, is a self-regulated organization, the rules of which must be approved by the Polish Securities Commission. Parties to transactions on the exchange may only be broker shareholders of the exchange. There is no over the counter market in Poland at present, though one is scheduled to commence in February 1996. The WSE equities market is modeled on the French call market. The market consists of a main market and a parallel market, depending on the size of the listed company. When the WSE opened on April 12, 1991, seven brokerage houses traded shares in five companies with a total turnover of approximately $2,000. As of October 1995, 66 companies traded on the WSE. Approximately 49 issues were listed on the WSE’s main market and 20 issues were listed on the parallel market. At the end of the third quarter of 1995, the total capitalization of the listed companies on the Warsaw Stock Exchange was approximately $3.6 billion while the parallel market was capitalized at approximately $82 million. Equities The WSE’s trading system is order driven and dematerialized. Equities are traded five days a week with orders accepted from brokers up until 11:00 am on trading days. The main feature of the WSE is that a single price per share emerges at the end of each trading session as a result of the orders submitted. Investors place orders with the broker using either a limit or market order. Limit orders may vary from the previous price by no more than 10%, i.e., no more than either 10% higher or lower. Prices of individual securities are fixed by a specialist, an employee of a brokerage house under contract to the issuer. Price determination uses an algorithm based on two major criteria: maximizing turnover while minimizing the difference between demand and supply as well as the price in the current trading session and the previous one. Transactions are then executed at that price, known as the equilibrium price. In the event that the market is unbalanced, i.e., the difference between demand and supply exceeds the upper or lower limit, the specialist may either correct the imbalance or fail to conclude the transactions, depending on the circumstances. As of October 28, 1995, the WSE adopted new listing requirements. For the main market, securities may be admitted to trading following approval by the Commission if, among other things, (i) the value of the listed shares is not less than PLN 7 million (US$2.8 million); (ii) the company’s book value is not less than PLN 9 million (US$3.6 million) or in the case of banks or insurance companies not less than PLN 15 million (US$6 million); (iv) the company has pre-tax combined profits for the past three fiscal years of at least PLN 3 million (US$1.2 million); and (v) the company has disclosed audited financial statements for the last three years. The parallel market’s listing criteria are similar to the main market, but slightly less stringent. In addition to these quantitative criteria, the Exchange’s Supervisory Board must take certain qualitative criteria into account before listing a company. These criteria include profitability forecasts and creditworthiness, management quality, and safety of the market’s participants. The equity market has three market indices. Market indices are useful tools to benchmarking investment funds and pension fund performance. The existence of equity market indices as well as transparent equity markets bodes well for the development of private pension funds in Poland. Bonds Because there are no publicly traded fixed income securities issued by private companies in Poland at present, the WSE’s bond market is limited to government bonds. Treasury bills are not traded on the WSE but, rather, on the interbank market, run by the National Bank of Poland. Certain bonds are traded on the so-called single price market, which uses the same principles as the equities market. However, bond prices may vary by no more than 5% from the previous session compared to 10% for equities. Large investors, mostly banks, may trade large blocks of bonds on a system of continuous trading, also known as the block market. Quotations on the block market are performed using the continuous trading system where the opening price is determined according to the single-price quotation system. It is worth mentioning that Poland passed a corporate bond law in June 1995. The unfavorable interest rate environment, coupled with economic uncertainty, probably account for the absence of corporate bond issues to date. 3. The National Securities Depository Started five years as a subsidiary of the WSE and independent for little more than a year, the National Securities Depository is the only central facility for clearing and settlement of securities in Poland. All publicly traded securities, except Securities issued by the Government of Poland, must be deposited with the National Depository. These shares are fungible and trade on the WSE only in book-entry form. Clearing and settlement must occur within three days of the transaction. Thc National Depository records the nominee owners, rather than keep a record of the beneficial owners of the securities. The National Depository also opcrates a guarantee fund aimed at guaranteeing the mutual solvency of the parties to a trade. No claim has ever been made against the National Depository’s guarantee fund. This dematerialized trading system facilitates market activity, facilitating securities sales and purchases for all investors, particularly high volume institutional investors such as pension funds. 4. Brokers and Investment Advisors Brokers may buy and sell securities as a principal, i.e., dealer, or as an agent for their clients. A broker acting as a dealer must have a minimum capital of PLN I million (US$400,000). A broker operating solely in the capacity of a broker must have a minimum capital of not less than PLN 130,000 (US$52.000). A brokeragc firm offering investment management services must have a minimum capital of PLN 1.75 million (US$700,000). As of the end of 1995, there were 54 brokerage bonuses, including 32 non-banking brokerage houses and 22 banking brokerage houses with 708 customer service outlets. Pension Reform Plans 1. The Miller Plan a. Synopsis In December 1995, the Government of Poland announced its intent to reform pensions in Poland. The Miller Plan, named for the Minister of Labor, is the Government's blueprint for reform. Poland plans a three-pillar pension system as follows: First Pillar - Publicly managed, mandatory social insurance system (ZUS) providing a basic benefit for old age, disability, and survivorship. Second Pillar - Privately managed pension pillar allowing employer-based and independent pension funds. Tax incentives for participation are expected. These pensions will supplement public pensions. Although this pillar is supposed to be voluntary, some members of Government favor making this pillar mandatory. Third pillar – Individual, voluntary private pension funds. Tax incentives are likely for this pillar as well. The first pillar would be reformed to reduce its costs. Examples of reforms are increasing the retirement age for women and reducing preferential benefits for privileged groups. These changes are expected to be politically sensitive. For this reason, the Government plans to undertake simultaneous efforts to reform the first pillars and develop the other pillars. b. Status The Council of Ministers sent the Miller Plan to Parliament. They designated the Ministry of Privatization to work with the Institute of Labor and Social Studies on draft private pension funds legislation. However, a group in the Insurance Department of the Ministry of Finance is also working on draft legislation for private pension funds. This technical assistance is being funded by PHARE. The law firm, McKenna and Co., was retained by the Ministry of Finance to prepare this draft legislation. This law firm has a reputation for offering solutions which benefit the insurance industry. c. Analysis The Ministry of Finance observes that this plan is slow to address the financial problems of ZUS. Reservations from the Ministry of Finance are included in the version of the Miller Plan which was passed to Parliament. Other critics observe that ft Miller Plan does not go far enough. In our opinion, without a significant decrease in payroll taxes for the public pension system, the private system may only attract people with enough resources to benefit from pension tax incentives. But limited reform is better than the current situation of low pensions, high contributions, social insurance deficits, and no private pension system to help people save for their retirement. 2. The Mazur plan a. Synopsis The Mazur Plan proposes a Chilean-stylc reform of the Polish pension system. This reform creates a three tier pension system: a basic, minimum government pension; mandatory participation in the second tier, and a voluntary third tier. The second tier initially would consist of ZUS and privately managed, defined contribution based pension funds. While participants in ZUS would have the option to switch to the new system, workers newly entering the labor force would have to join the private system. The Mazur Plan was prepared and revised with the help of leading experts in the pensions field. Mazur and his team, who work in the Ministry of Finance, travelled to Latin America to study the Chilean-style reforms. The Foundation for the Development of Social Security was established to provide a mechanism for technical assistance. The Mazur plan includes financial projections and various simulations of different scenarios for the government budget and economic growth. b. Analysis Political feasibility and speed of reform make the Mazur plan a radical reform alternative for Poland. In comparison to the Miller Plan, it has high immediate costs. The Mazur Plan requires the Government of Poland to recognize pension obligations now that otherwise would not be payable for decades. But this reform alternative also would bring about a faster accumulation of savings and resolution to the pensions challenges in Poland. Such savings would likely be channeled into the capital markets in Poland, supporting domestic economic growth. For these reasons, in our opinion, the Mazur Plan is probably a technically better solution for Poland. But this plan may not be politically feasible according to some Government officials. Legislators may have access to the Mazur Plan to allow them to make comparisons to the Miller Plan. Widespread government support for the Mazur Plan was not evident to the consulting team. 3. Other Pension Proposals  One type of proposal discussed by the Government of Poland is using privatization assets for pension funds. The basic concept is to distribute assets which have not yet been privatized, such as bank shares, to capitalize pension funds. These assets might compensate public sector workers for past promises which the Government has not yet fulfilled or pay back pensions, for example. The primary advantage of linking privatization to pension funds is that the transaction does not require cash. However, many criticisms may apply. First, there is the question of what the shares are worth. If privatization does not also involve sale to external investors via the capital markets or a strategic investor, then the share value is open to debate. The book value may not reflect the true asset value. In the absence of a market for shares, how will they be valued in future? Can pension fund managers or pensioners sell them? If so, how and under what conditions? A second set of issues relate to the purpose of privatization. Ownership change and strategic partners are ways to improve operations, transfer technology, and increase profitability. Another privatization objective is to broaden share ownership. While the privatization via pension funds would broaden share ownership, the other objectives might not be achieved with this program. One way to link mass privatization and pension reform is to use the Bolivian model. A strategic investor acquires half of the shares of the company to be privatized and management control. A bidding process is used to select the strategic investor. The remaining shares am distributed to all adult Bolivians via newly created private pension funds. However, because many Bolivians are unlikely to make future contributions to the pension system, it is not clear how the private pension funds will cover their administrative costs. Shares cannot be sold until a person qualifies for retirement. But it is not clear how this share market will develop in Bolivia. The Government of Poland should consider these issues in any program design. Back to Top   ISSUES Private Pension Market Although Poland lacks both a legal and regulatory framework for private pensions and private pension products themselves, demand for these products exist. The potential market size for a voluntary pension market is limited without fundamental reform of ZUS. Tax incentives would increase the potential market size, however it is difficult to say by how much. The 48% contribution paid to ZUS leaves little room for contributions to a private, voluntary system. If pension contributions did not increase the taxable wage base for ZUS, employers would find these deferred compensation arrangements a less costly way to increase wages. However, interviews with Poles suggested that even though they are interested in pensions, many would prefer money in their pockets to money in a pension fund which they cannot access until retirement. Offsetting this desire is concern for a secure, adequate retirement income. We analyze the potential market size of a voluntary pension market using Polish labor statistics from year-end 1994. In December 1994, 141 million people contributed to social insurance: 12.6 million active workers in ZUS and 1.5 million agricultural workers in KRUS. Nevertheless, the potential market size is significantly less than this number for reasons explained below. Public Sector Workers – 7.9 million of the active workers participating in ZUS work in the public sector. Public sector workers are less likely to participate in private voluntary private pension funds for two reasons. First, their employer, the Government of Poland is not likely to contribute on their behalf in this area of fiscal restraint. Second, these workers tend to have lower salaries and so are not likely to finance private pensions themselves. Agricultural Sector – The agricultural sector is not organized in corporations, so workers would have to finance their own private pensions. As such, demand for voluntary private pension funds in this sector is expected to be low. Even with tax incentives, the high level of tax evasion among this group means that they will derive little benefit from such measures. Small enterprises – Small and medium-sized enterprises comprise a significant portion of private sector employment. These firms are not likely to sponsor private pension funds. As such, participation is likely to be low from this group. Of the 14.1 million active workers in Poland, we estimate that the market potential for voluntary private pension funds is only 4.5 million people. Assuming market penetration of 25% in the early years, the estimated voluntary private pension market is 1.1 million participants. This market size is sufficient to sustain an industry specialized in pension products. Although this small, supplementary pension market will not be sufficient to resolve the public pension crisis in Poland, it may be a step in the right direction. A small, voluntary, private pension system could be the foundation for a more profound reform of the overall pension system. Tax Incentives Tax incentives have played an important role in development of private pension funds in countries such as the United States, the United Kingdom, New Zealand, Hungary, the Czech Republic, Chile, Peru, and Argentina. Pension products have no tax incentives in Poland at present. The lack of fiscal incentives is a major obstacle to development of the private pension market in Poland. Since employer contributions are not tax deductible, there is little incentive for any employer to establish a pension plan for its employees. Regulatory Framework The existing legal and regulatory framework does little to encourage the development of private pension funds. Polish law does not contain the basic concepts necessary for the development of a private pension system, such as the concepts of the trust, the fiduciary, the prudent man and so on. Finally, Poland currently lacks the institutional capability to regulate private pension plans. Legal issues related to the development of private pension funds in Poland are described below. 1. Fiduciary Concepts Unlike common law countries such as the United Kingdom, the United States, Canada, Australia, India and New Zealand, for example, Poland’s Civil Law system does not recognize certain concepts necessary for the development of private pension plans, including the concepts of trust, the fiduciary, the sole benefit rule and the prudent man investment standard. These concepts underlie the Employee Retirement Income Security Act (ERISA), the basic federal regulation of U.S. pension plans, and require that one entrusted with the standard of care that the archetypal prudent man would in investing money for another. Rather than relying on the common law and federal statutes, as in the U.S., Poland, as a Civil Law country, addresses these issues through contractual doctrines regulating the relationship between the fund and the investor. This situation is an obstacle to pension reform but is not insurmountable. One way to deal with the absence of these concepts would be to draft comprehensive regulations, patterned after those in the United States. This process would be very time consuming and be subject to vast political uncertainties. In the end, such regulations might prove unworkable since Poland’s legal system is very different from ours. One Polish legal expert believes that these matters can be addressed contractually. The standard of care would have to be set precisely enough to achieve what common law achieves through the concept of fiduciary, for example. Only minor adjustments would be needed to existing legislation and the development of a form contract. This contract could be approved and mandated by the Securities Commission or an appropriate regulatory body that holds the pension fund manager to the obligations of a fiduciary. However, contract law has certain weaknesses which are addressed in the next sections. 2. Trust Concepts Description of Polish Situation Existing Polish law for trust funds is not well suited for pension funds because of a weakness in the trust concept. According to Dr. Andrzej Kawecki, a leading Polish legal authority, the trust concept requiring pension funds to act in the best interests of investors, similar to the fiduciary concept, has no intrinsic meaning in Poland. The concept was grafted from common law; no precedent exists for it in Polish law or civil code. Common law states general principles and allows case law to decide application of these principles. Under civil law, by contrast, judges refer to the law or code and apply it to the fact. What this means for trust funds is that the law does not provide specific provisions to protect investors from certain forms of fraud. The trust fund by-laws, which are basically contracts, govern the relationship between the investor and the trust fund. Contract law is a weaker form of law. Disputes are decided by judges with limited experience in financial markets cases given Poland’s relatively recent experience in this area. According to Dr. Kawecki, the risk is that the participants may not be adequately protected. For example, unless trust fund by-laws forbid it, trust funds could pledge investors’ assets as security for their own loans. This situation is possible because assets are in the name of the trust fund itself. If the trust fund could not meet its obligations, such assets could be seized by creditors. Further, allowing pension fund assets to be pledged as collateral for loans conflicts with the goal of long term capital accumulation. Pension fund investments should strive to balance safety of principal with high rates of return. Another weakness is that trust funds do not have to maintain separate accounts for their own and trust fund assets. Commingling of funds creates the conditions for conflicts of interest, at a minimum, and facilitates fraud or embezzlement at worst. Lessons Learned from Other Countries Historical experience in the United States and United Kingdom indicate that trust law does not always adequately protect participants. Prior to the passage of the Employee Retirement Income Security Act (ERISA) in 1974, pension fund investment abuses were all too common. Funds were lost and people were left without pensions. In the recent Maxwell pension scandal in the U.S., the Maxwells diverted pension monies to other corporate purposes, effectively draining assets from the pension fund. The political ramifications of a similar pension scandal in an emerging market could be extraordinary. Conclusions We conclude that additional refinement of the concept of conflict of interest is needed to support healthy development of a private pension fund industry in Poland. Specific measures to deal with these potential weaknesses are: Define what it means for trust funds or pension funds to act in the best interests of others. The Employee Retirement Income Security Act (1974) and U.S. Department of Labor regulations define such standards and might serve as a guide. Require trust funds and pension funds to keep participant assets separate from the fund manager’s assets. In other words, do not allow commingling of participant and fund manager assets. Similar standards should apply for fund administrators and other service providers in the industry. Establish investment limits or guidelines for pension funds to assure that participant assets are invested appropriately. Further study is needed to determine what safeguards would be required in Poland. 3. Insurance Regulation The new legal and regulatory framework for insurance is being implemented at present. The new regulatory body had not yet been established as of December 1995, although legislation was passed several months earlier. It is too soon to evaluate insurance regulation in Poland. However, we observe that although insurance products have similar features to pension funds, they are not necessarily the same. In general, insurers assume risk when they sell products. For pensions, the list of risks includes mortality, investment, interest rate, default, and even political risk. However, with private pension funds either the employer or the individual bears some or all of these risks. Pensions, therefore, require different legislation from that of insurance. Some of the basic principles, such as protection of participants’ rights, may be the same, but they require different application because they serve different purposes in pensions and insurance. Capital Markets The Polish equities market is characterized by thin trading and extreme volatility. Most professional participants in the market attribute this to the absence of institutional investors and the prevalence of small investors who view the WSE more as a casino than a place for long term investments. Although WSE statistics do not reveal much about its investor profile, the exchange’s representative was of the opinion that the bulk of the trades were made by small investors. This view was seconded by the brokers we interviewed. The one relevant statistic maintained by the WSE shows that: 92% of WSE transactions are for $1,000 or less 4% are between $1,000 and $4,000 4% are over $4,000 The total value of transactions breaks down as follows: 21% of the transactions are for $1,000 or less 11% are for $1,000 to $4,000 68% are for over $4,000 While these statistics are not definitive, they suggest that the bulk of activity on the WSE is very small trades by individual investors. The Polish market is deeper than some emerging markets, but not as deep as others. For example, in U.S. dollars, the monthly value of stocks traded in the three month period between July and September 1995, averaged approximately US$249 million. By contrast, during the same time period, the Hungarian and Turkish markets averaged monthly trading values of approximately US$45 million and US$4.3 billion, respectively. In the same three months, the market’s capitalization, averaged about US$4.1 billion. By contrast, the Hungarian market, during the same period, was capitalized at approximately US$29 billion. Converted into US dollars, for the period November 1994 through October 1995, the smallest average value of a buy order on the main market was approximately US$3,000 in March 1995 and the largest average value of a buy order was approximately US$8,000 in October 1995. Measured on a quarterly basis, the equity market was characterized by dramatic swings in price: for example, returns in Polish zlotys on the WIG Index were a positive 17.9% for the third quarter of 1994 followed by a return of a positive 40.9% for the second quarter of 1995. The lack of indexed investment instruments is another area of concern for the development of private pension funds. The few indexed securities available in Poland tend to vary only the interest rates paid and not the principal amount. In addition, private pension funds seeking to invest outside of Poland would probably face low limits such as the 5% of assets that Pioneer is allowed to invest abroad. Real estate investments, normally an effective hedge against inflation, are risky in Poland due to problems with the property registry system. Secret tax liens against property allow the Ministry of Finance to claim property unwittingly purchased from a debtor. The Polish capital markets thus offer investors few ways to protect capital against the effects of inflation at present. Back to Top   BACKGROUND ON MINIMUM LEGAL AND REGULATORY REQUIREMENTS Rationale The case for private pension fund regulation serves to prevent market failures, assure equity, or both. The three primary financial market weaknesses which may affect private pension funds are: Asymmetrical information Externalities Monopolies Government regulation also may be used to enhance equity, adequacy, or security of pension arrangements. When pension tax benefits are granted, governments often want to assure that the system can provide adequate pensions and that participants are treated fairly. Although the industry may form self-regulatory organizations to help assure compliance, these are unlikely to be sufficient to protect the interests of participants. Governments thus play an essential role in private pension fund regulation. Asymmetrical Information Description Information asymmetries occur when the purchaser of financial services finds it difficult or expensive to obtain sufficient information about the quality of service. In this instance, pension fund participants, those individuals associated with the pension system, may not be able to evaluate the quality of the pension fund or fund manager due to lack of information or inability to obtain information. At a minimum, these asymmetries expose pension fund participants to possible investment losses or mismanagement; at worst, to failure of the pension fund. Because pension fund investments comprise a significant portion of participants’ savings accumulated over a long period of time, such losses can financially devastate individual participants. Corporate or group participants presumably have more purchasing power than the individual participant. This purchasing power gives corporations more bargaining power, hence access to better information. The information asymmetry is thus more a weakness of the individual than of the corporate private pension market. Nevertheless, corporations benefit from government measures to prevent these asymmetries in the pension market by assuring that certain minimum information will be available from all providers. Potential Government Measures At a minimum, the government and the pension fund industry have an interest in assuring that information asymmetries do not undermine faith in private pension funds. At best, such government measures promote development of a health pension funds industry. The legal and regulatory framework for private pensions in Poland should address these information c through disclosure and reporting requirements, which are discussed later in this report. Externalities Description Externalities occur when actions by certain agents have consequences for others in the sector. The risk of contagious bank runs is a typical example provided in this case. This risk may also hold for the pension sector, particularly in emerging markets where confidence in the financial markets is still shaky. Some may argue that pension funds are at less risk because they tend to offset long run assets with long run liabilities; the collapse of pension funds in Russia and Ukraine in 1995 proves otherwise. Both the Aurora pension fund in Russia and the Oberig pension fund in Ukraine operated more like pyramid schemes than long term savings vehicles. In other words, these pension funds promised outrageously high short term rates of return to investors in the funds. Early investors achieved those returns, not from actual investment results, but with funds coming from other investors. When the growth rate of new participants slowed, these pension funds could no longer fulfill their promises. Investors tried to recover their deposits, creating a run which caused the pension funds to collapse. Because the private pension fund markets in both countries were completely unregulated, investors had not protection and little recourse against these fund managers. Potential Government Measures Governments might best deal with externalities in private pension fund markets by establishing a sound legal and regulatory framework for private pension funds. However, specific measures to deal with these externalities present other risks. Solvency requirements and minimal capital requirement for pension funds or fund managers may help reduce or limit externalities. A guarantee is another commonly used measure to protect pension fund participants from failure of a pension fund. However, whether government-sponsored or privately organized, guarantees introduce moral hazard. That is to say, pension funds at risk of failure have little incentive to reduce risks because if they fail, the guarantee will take care of participants. In fact, a guarantee may encourage pension funds to take more risks, raising the cost of the guarantee. The experience of the Pension Benefit Guaranty Corporation in the United States suggests that private pension funds or fund sponsors behave this way. Monopolies Description Monopolies occur when there is only one provider of a good or service. The monopolist usually looks after its own interests first, charging maximum fees while providing goods and services as required. Monopolies are often characterized by inefficient management, high costs, high fees, and poor service. For example, social security systems often have a monopoly on state pension provision. The costs have continued to rise, but service quality is notoriously low in many social security systems. Monopolies also may exist in private pension funds under at least two conditions: compulsory participation and limited association. Compulsory participation in an employer-sponsored pension plan may tempt the employer to structure plans favoring the employer or certain special groups, such as management. Pension funds may not be portable, pensions may be low, or other rules may be used to keep pension costs low and look after the employer’s interests. Some pension fund sin the United States demonstrated these characteristics prior to the adoption of the Employee Retirement Income Security Act (ERISA) of 1974. Similarly, if pension fund association is limited, then participants may not be able to "vote with their feet", making the pension fund market less efficient. Potential Government Measures Different approaches exist to prevent monopolies. In the case of compulsory participation, allowing pension fund participants to switch from one pension fund manager to another is essential to curb monopoly abuses. Pension fund managers then will be motivated to compete for business. Limited association, regardless of whether the pension system is voluntary or mandatory, requires measures to protect participant rights. Such government-mandated measures include: Vesting requirements determining how and when participants are entitled to pensions or pension assets Portability requirements assuring that participants may be able to prepare pension fund assets Non-discrimination requirements assuring that participants are treated equitably Funding requirements Investment limits or guidelines Objectives The nature of pension plans, especially if these enjoy tax exemptions, requires a legal and regulatory framework that protects both the contributors’ and the State’s interests. The legal and regulatory framework for private, voluntary pensions in Poland would benefit from achieving these objectives: Increase the safety of the pension system by reducing the probability of capital losses by participants. Capital losses often lead investors to ask for assistance from the State to bail them out. A sounder approach is to encourage development of a healthy private pension industry which does not need bailouts. Grant fiscal incentives only for true pension savings. Create an industry which could serve as a basis for a future private pension system which integrates social security. To assure that these objectives are met, the legal and regulatory framework must be designed exclusively for the interest of the pension industry. No matter how attractive using pension fund legislation to promote other economic or political objectives might be, we strongly recommend against such linkage. In particular, the Government should not try to make legislation fit the needs of industry hobbies or the privatization process. If a mandatory private pension system were to be introduced, the legal and regulatory requirements would be stringent. Because the Government of Poland is not currently considering that alternative, we focus more on the voluntary requirements in our recommendations, pointing out where mandatory requirements would differ from these. Minimum Legal Requirements The legal requirements for private pension funds address the same topics regardless of whether the private pension system is mandatory or voluntary. A mandatory privately managed pension system needs stricter legal requirements to protect the interests of individual participants whose position is weak relative to the private pension fund manager. Although a private, voluntary pension system requires safeguards to protect participants, its very nature gives pension fund managers a greater incentive to follow sound business practices. Participants may leave the system if its benefits do not outweigh its costs. 1. Licensing or qualification of pension funds Private pension funds licensing or qualification serves two purposes. First, licensing assures that pension funds are established to help participants save for their future retirement. By so doing, the Government helps bestow credibility on the new industry from the onset. Second, licensing allows the Government of Poland to assure pension funds meet the requirements to receive fiscal incentives. Fiscal incentives are addressed later in this section. The Government also retains the ultimate sanction of revoking a private pension fund license or qualification due to flagrant violations of the legal and regulatory framework. Licensing requirements may include minimum capital requirements for pension fund managers, qualification of fund sponsors or managers, e.g., they are not convicted felons, establishment of a board of directors or trustees for the fund, legal organization, and/or approval of the pension fund itself. The first two requirements help discourage or bar dishonest players from entry to the industry. The legal form will depend on decisions made during the private pension system design process in Poland. As explained earlier in this report, each of the legal forms has weaknesses which make them inappropriate to be used for private pension funds at present. These weaknesses, such as double taxation and permitted commingling of participant and fund manager assets, need to be addressed as part of private pension system design process. The pension plan, if the system is voluntary, also must be reviewed to assure that it meets the criteria to qualify for tax benefits. The pension plan defines the terms and conditions of pension fund participation. Many of these terms, such as vesting and portability, are defined below. Mandatory systems typically mandate the pension fund terms, participation, and benefits. As such, the pension plan is embodied in the legal and regulatory framework. Licensing of pension funds may have more stringent requirements for a mandatory system that for voluntary system. The Government may wish to set higher minimum capital requirements to assure that private pension fund managers are serious about the pension fund business. For a mandatory pension fund system, particularly in an emerging market, we also suggest considering separation of the pension fund management industry from other segments of the financial sector. The reason why is to remove the temptation for banks or even insurers to shift poor risks to the private pension fund. For example, a bank client seeks a loan for a risky project, but the bank board declines the loan. Bank management, wishing to keep their client happy, arranges for the client to issue bonds which will be purchased by the pension fund. One way to prevent this sort of conflict of interest is to separate the financial services industries, at least during the early years of private pension fund development. Investment limits, which are discussed below, are a second way to address this conflict of interest. 2. Protection of Participants’ Rights "Participants" refer to the individual workers associated with the pension system. For both mandatory and voluntary private pension systems to operate effectively, the participants’ rights must be clearly defined and protected. We treat key areas of pension rights, such as vesting and disclosure, as separate topic below. In the case of mandatory private pension systems, the law typically defines the participants’ rights, while regulations cover implementation details. In the case of voluntary private pension systems, the law and regulations generally set the parameters within which private pension funds must operate. For example, the participant has the right to a pension upon reaching a certain age or meeting certain conditions such as permanent disability. In the mandatory system, the rules for determining the pension amount are likely to be stated in the law or regulations. However, in the voluntary private pension system, the legal and regulatory framework may merely state that a person has right to tax-deferred savings. 3. Portability and Vesting For both mandatory and voluntary private pension systems, participants should always be vested in their own contributions. Vesting periods should be reasonable for employer or sponsor contributions. We suggest a period of 5 years for vesting, after which participants would be entitled to the employer’s contribution. There are various ways to apply the principle. Cliff vesting gives the participant no claim prior to a certain cut-off date. As such, cliff vesting can be abused by employers who intentionally discharge employees just prior to the vesting date. Gradual or rolling vesting also may be used, allowing participants 20% per year. Portability of private pension funds is a minimum requirement as well. Portability eases labor mobility, which may enhance economic efficiency. Participants should be able to transfer vested assets to another pension fund. 4. Disclosure Under both voluntary and mandatory private pension systems, pension funds should be required to disclose financial information to participants. Investment fund value, investment performance, and the funded status of pension funds should be required to be disclosed at regular intervals. In addition, pension fund managers should disclose information about their operating expenses and administrative costs regularly. Consistent standards should be used to prepare these statements and pension fund managers should be required to prepare information on a consistent basis applying generally accepted accounting principles. Pension fund financial statements must be audited and certified annually. While disclosure requirements may be similar for voluntary and mandatory pension funds, the latter should mandate more disclosure and impose stiffer penalties for failure to comply with the law. 5. Reporting Requirements Closely related to disclosure are the reporting requirements. Pension funds should be required to report to participants, sponsor(s), and the government regulator. Participant reports typically communicate contribution history, account values, fund performance, and information about the fund manager. Communicating the funding situation and investment results are often the purposes of reports for the sponsor. Finally, government regulators seek to protect participants and assure that pension funds are eligible for tax exemptions. 6. Conflicts of Interest Private pension fund regulation is designed to avoid conflicts of interest. Such conflicts arise from investments with parties related to the pension fund, investments in assets of the fund sponsor or fund management, contracts with parties related to the pension fund, and so forth. To prevent abuse of discretionary power in contracting services and making fund investment decisions which harm pension participants, conflicts of interest should be clearly defined and prohibited. Self-improvement should be severely restricted or prohibited as well. 7. Investment Guidelines or Limits Investment guidelines or limits aim to protect pension fund participants. Such limits should consider the delicate balance between the need for higher investment returns and the need for security of principal. Another consideration is the need for flexibility on the part of investment managers. a. Mandatory and Voluntary Systems Voluntary private pension systems rely more on guidelines, such as the prudent man rule in the United States. This rule requires pension fund managers to invest as a prudent man would. The courts have interpreted this rule to require sensible portfolio diversification. Pension fund investments should generate reasonable investment returns. Mandatory private pension systems tend to use stricter investment limits than voluntary systems. The reason is the same as for many other areas of regulation: participants need greater protection because of externalities and information asymmetries. Also, investment limits may reduce the possibility of pension fund failure, which is an even bigger concern for mandatory than for voluntary private pension systems. The political fallout from such failures could be disastrous for elected government officials. b. Types of Investment Limits Private pension systems use several types of investment limits: Asset class or type of instrument, e.g., equities, corporate bonds. Issuer, e.g., the company or organization backing the investment. Issue, e.g., not more than 10% of the bond offering. Investment risk, i.e., based on investment ratings. Sector, e.g., not more than x% invested in the financial sector or abroad. These investment limits may be an absolute or relative measure, applied independently or in tandem. An example of an absolute measure would be allowing pension funds to invest only is securities rated "A" or better by Standard and Poor’s. Relative limits are often some expressed as a percentage of the pension fund portfolio. Pension fund investment limits may be expressed as a minimum or a maximum. Minimum limits require investment in certain assets, often government securities.14 Such requirements artificially inflate the demand for certain types of investments, effectively lowering their yields. Maximum investment limits allow pension funds to invest up to a certain amount in specific assets. Pension fund managers thus may allocate assets to maximize returns and assure security of principal. We prefer the latter approach because it allows the market to set investment rates competitively and with fewer distortions than minimum investment limits. In Poland the decision on investment limits will depend on whether the private pension system is to be voluntary or mandatory. A voluntary system may use guidelines, rather than limits. However, we would recommend investment limits for a mandatory, privately managed pension system. 8. Fund Valuation The purpose of fund valuation requirements is to assure that pension fund asset values are reported fairly. Fund valuation requirements typically follow generally accepted accounting principles, although certain assets have special valuation for pension funds. As a result, for publicly traded assets, pension funds typically use market values. However, for less liquid assets, such as thinly traded bonds, methodologies are specified to assure that these values are not manipulated. 9. Funding Requirements Funding requirements generally refer to pension fund solvency. Governments often impose funding requirements to assure that pension funds have adequate resources to fulfill pension promises to participants. For defined benefits schemes, the obligation is based on a formula including salary and years of service. Pension obligations change constantly as new participants join, staff retire, salaries change, and years of experience increase. Funding standards require pension funds to value assets and perform actuarial calculations of liabilities at regular intervals. The asset value is compared to the liability value to determine the funded status. Regulators can set a minimum funded standard. For example, defined benefit pension fund might have to have assets greater than or equal to 80% of pension obligations. Under defined contribution pension schemes, the pension amount depends on the value of funds accumulated at retirement. As such, defined contribution pensions are always funded. The Government of Poland is leaning toward defined contribution type private pensions. As a result, this area of private pension regulation is not expected to be necessary in Poland. 10. Requirements for Fund Managers For both mandatory and voluntary systems, requirements for pension fund managers are similar. Typically, individuals who will work in the industry must have no criminal record. This requirement is common in other segments of the financial sector dealing with other people’s money, such as the securities markets. Individuals who are to act as investment managers are generally required to be registered investment counselors or managers and are subject to securities markets regulation as well. 11. Regulatory Body The government must decide who will regulate pension funds. In many countries with voluntary systems, such as the United States, the tax authorities play a key regulatory role. The tax authorities’ role is linked to tax incentives for pension funds, thus it gives the government both a carrot and a stick to assure compliance. However, the Department of Labor also has an important role in private pension fund regulation in the U.S., while the Securities and Exchange Commission may get involved on the investment side of pension regulation. In Hungary, which also uses a voluntary system, the private pension funds regulator is a department of the Ministry of Finance. Countries with mandatory pension systems tend to establish independent regulators. In Chile, Argentina, and Peru, a separate regulatory body exists to oversee pension funds. The pension fund regulator has a significant degree of independence from other parts of government, although they work closely with other government bodies, such as the securities commission, insurance regulators, and finance ministries of their countries. The decision on what government body should regulate private pension fund in Poland will depend on the nature of the system. A mandatory reform calls for a strong, independent regulator who would work closely with other regulatory bodies like the Securities Commission, the new insurance regulator (PUNO), the Ministry of Finance, and the Ministry of Labor. A voluntary system probably does not require the establishment of a separate, independent regulator. The regulator could be housed in an existing ministry or regulator. However, the design of the regulator needs to encourage cooperation with other relevant government bodies mentioned earlier. 12. Role and Responsibilities of the Regulator The role and responsibilities of the regulator also depend on the nature of the private pension system. At a minimum, the regulator is likely to authorize pension funds, develop rules and regulations, review reports, assure that minimum capital is maintained, conduct inspections, enforce compliance with pension law and regulations, and impose sanctions on those that violate the law. The regulator might also oversee a pension guarantee program, propose new legislation, or serve as an ombudsman for participants. Back to Top   RECOMMENDATIONS In our opinion, although the Government of Poland’s objective in the development of a pension industry is perfectly valid, a private voluntary pension scheme cannot be a substitute for mandatory systems. In other words, creation of voluntary, supplemental pension funds will not solve the problems of social security (ZUS) in Poland unless it serves as an impulse to more ambitious reform of ZUS at a later date. To create the conditions for a healthy, efficient private pension fund industry in Poland that might serve as the basis for eventual reform of social security in Poland, we recommend the actions described below. 1. Create a legal and regulatory framework for private pension funds As discussed previously, the minimum legal and regulatory framework depends on the nature of the private pension system. In general, mandatory systems have more stringent requirements to protect individual participants. Strict government supervision is necessary for mandatory pension systems. Voluntary private pension systems also need government supervision. The rationale and areas of regulation are discussed in greater detail in the previous section of the report. At a minimum, the Polish legal and regulatory framework should address the following areas: 1. Licensing or qualification of pension funds – Pension funds should be authorized or licensed by the government based on stated criteria. 2. Protection of participants’ rights - Set parameters within which pension funds,employers, and/or pension fund sponsors must operate. 3. Portability and vesting – Require pension funds to be portable. Set reasonable standards for vesting of pension fund contributions. 4. Disclosure – Require pension funds to disclose fund financial, investment, and fund manager operating and financial information to participants. 5. Reporting Requirements – Establish the frequency of reporting information to participants, sponsors, and regulators. 6. Conflicts of Interest – Prohibit investments in or transactions between parties related to the pension fund and/or sponsor. Define related parties in the law. 7. Investment guidelines or limits – Establish investment limit or guidelines which are appropriate for the nature of the private pension system in Poland. A voluntary system may use guidelines, rather than limits. We recommend investment limits for a mandatory, privately managed pension system. 8. Fund Valuation – Set standards and methods for fund valuation. Require annual audits of pension funds by certified public accountants. 9. Requirements for fund managers – Set objective criteria for fund managers. 10. Definition of regulatory body – Decide whether to establish a separate, independent regulator or one within an existing regulator. The former approach is more appropriate for a mandatory private pension system, while the latter approach is more commonly used for voluntary private pensions. 11. Roles and responsibilities of the regulator – Establish the role and responsibilities of the private pension funds regulator to safeguard participants’ interests and assure compliance with the law. In some of these areas, private pension fund law probably will dovetail with other legislation governing the capital markets, insurance, or labor. For example, pension fund managers may have to be qualified investment advisors. The Polish Securities Commission licenses investment advisors and has jurisdiction in this area. 2. Offer fiscal incentives for pension fund contributions Fiscal incentives for private pension funds are justified to the extent that the State believes that demand for future government expenditures to pay pensions will decrease and that pension savings will promote economic development in the country. We suggest designing fiscal incentives applying the following principles: Offer exemptions to pension fund contributions. Collect taxes on pension benefits when these are received. Establish maximum amounts for exemptions. Offer exemptions only to regulated plans complying with legal requirements. Assure that the exemption would be lost and/or a penalty would apply if the participant withdraws funds from the pension plan early. This approach is consistent with practice in the U.S., U.K., Chile, Hungary, and many other countries around the world. An alternative approach would be to offer tax credits for pension contributions, up to a certain amount. This approach is less regressive than the first approach as it benefits lower wage earners more than high wage earners. The Czech Republic uses that tax credit approach for private pension funds. Pension contributions are not tax deductible expenses to employers. Instead, the Government provides a credit or allowance up to a maximum of 120 Czech korunas based on the contribution amount.15 3. Establish a maximum wage base for contributions to ZUS. The reason for a maximum wage base for the payroll tax is to make space for the private pension system. This change also could affect ZUS contributions significantly, given that earnings are under-declared and evasion is high. Furthermore, the concept of a maximum taxable wage base is consistent with the Government’s desire to assure that each person has access to an adequate retirement income to meet basic needs and maintain some portion of historic consumption. To meet this objective it is not necessary to tax the full wage base of all workers. 4. Revise capital markets legislation, particularly with respect to conflicts of interest The Polish capital markets are well regulated. However, certain types of conflicts of interest are of potential concern and may need adaptation to support private pension funds. Areas of potentially needing attention are: Related party transactions Simultaneous investment of own and third party portfolios. Use of privileged information (insider training). Intentional negligence, active and passive. Sales of services to the fund under management. Back to Top   NEXT STEPS These steps are alternatives presented for consideration by USAID and the Government of Poland to support private pension development in Poland. USAID should consider coordinating with the relevant Polish Government authorities to support development of a private pension system. During our field work, the Council of Ministers informed us that a group comprised of Ministry of Privatization and Institute of Labor and Social Studies officials have been assigned responsibility for this task. While this group may be the primary counterparts, other representatives of the Government of Poland are also involved in development of the private pension system. For example, the Ministry of Finance is working on a draft private pension fund legislation for the second pillar with the support of EU-PHARE. Finally, the Chilean-style reform championed by Marek Mazur of the Ministry of Finance could emerge as the pension reform model. USAID should consider keeping dialogue open with all parties involved, perhaps even serving as an objective intermediary. Regardless of which group becomes the primary counterpart, all appear to be stakeholders in pension reform. The Ministry of Finance has a stake in proposal which offers fiscal incentives, so they need to be involved in these efforts. Because of possible linkage of privatization with pension reform, the Ministry of Privatization may be a part of the process. Finally, the Ministry of Labor, on its own or through the Institute of Labor and Social Studies has a stake in the social insurance and worker rights aspects of pension reform. USAID may choose to work with a primary designated counterpart, extending the olive branch to other groups. The Government of Poland, presumably via the Council of Ministers, would designate the counterpart. The second alternative would be to work with all parties, supporting different efforts led by different counterparts. This second approach is inherently complex, difficult to implement, and may be inconsistent with USAID rules for technical assistance. Although we are uncertain as the current status of the Government’s plans for private pension funds, in the short term we recommend the following activities: Coordinate with other donors on technical assistance for private pension fund development in Poland. This step is designed to target resources effectively to support the Government of Poland. EU-PHARE is already active in private pension fund development. The World Bank, British Know-How Fund and other donors might also be interested in supporting projects in this area. USAID should consider leading efforts to coordinate donor-funded technical assistance for private pension fund development. Discrete projects could be supported at different donor organizations. Support development of the legal and regulatory framework for private pension funds, be it through helping to draft the project or offering object expert reviews of the proposed legislation. We understand that more than 20 laws and regulations must be modified to implement the proposed pension reform in Poland. Such a project represents a monumental effort in the area where Polish Government has limited experience. One alternative for USAID consideration is to make experts available throughout the process. Another alternative is to offer the Polish Government ready access to international experts for targeted needs. The legal and regulatory framework for private pensions in Poland should address the following areas: Licensing or qualification of pension funds (for fiscal incentives) Protection of participants’ rights Portability and vesting Disclosure Reporting requirements Conflicts of interest Investment guidelines or limits Fund valuation Requirements for fund managers Definition of regulatory body Role and responsibilities of the regulator. Perform technical studies to resolve specific issues related to private pension system design. Another potential area for donor-funded technical assistance is that of technical studies. Issues such as fiscal incentives are likely to require further study to support policy decisions. Fiscal incentives may be analyzed by developing financial models to simulate the effects of different alternative tax structures using different assumptions and under various scenarios. Hungary and the Czech Republic demonstrate two different, but equally valid approaches to fiscal incentives. The former grants a tax exemption while the latter uses a subsidy. Also, different tax treatment may be used during the three stages of the pension fund life cycle: contribution, capital accumulation, and retirement. Other potential topics for technical studies are fund valuation, development of the regulator, and commission or administrative expenses of pension fund managers. Consider organizing seminars for Government officials to familiarize themselves with international experience with private pension fund regulation and supervision. Such seminars would serve two purposes. Officials designing the legal and regulatory framework would broaden and deepen their knowledge of the subject, helping them to achieve their goal. But perhaps more importantly, seminars and workshops may help to familiarize legislators and functionaries with the rationale and characteristics of healthy, efficient private pension systems. Seminar attendees may help increase public awareness as they are potential spokespeople who will support private pension system development. The seminars could be one part of a broader program to build public awareness and support for private pension funds. Design and develop support training of officials involved with designing the new legal and regulatory framework via study tours, seminars, or obtaining educational materials on private pension funds regulation. Consider sending Government of Poland officials to an upcoming seminar on the Hungarian private pension system in Hungary. Organized by the World Bank and taking place in April or May, this seminar could be a useful learning opportunity for Government of Poland officials involved in private pension development. The Hungarian private pension system supplements the social security system. As in Poland, the Hungarian social security has high contribution rates, high evasion, and financial deficits. The Hungarian Government is now said to be considering allowing workers to opt out of social security, at least in part, and eventually receive the bulk of pensions from the private system. Polish policy-makers would likely benefit from speaking with Hungarian Government officials and private sector pension funds about the Hungarian private pension system, policy decisions taken there, and those now being considered by Hungarian policy-makers. Another seminar taking place in Santiago, Chile from May 1-3, 1996 could be a useful learning opportunity. The private pension systems of Chile, Argentina, Peru, and Colombia will be addressed at the seminar. The seminar, organized by the Chilean Association of Pension Fund Administrators, will offer simultaneous translation to English, but not to Polish, for participants. Offer assistance to establish the regulatory body for private pension funds in Poland. This step will take place later in the process, once draft legislation has taken shape. The nature of the system will influence the role, functions, and attendant organization of the private pension regulator in Poland. For example, a voluntary system needs less strict oversight than a mandatory system. In the latter, the Government has an important role in safeguarding the rights of pension participants. USAID or some other donor such as the World Bank may wish to fund this effort. Assist with the development or revision of draft legislation for closed end funds. Some experts argue that closed end funds are a safer form of investment vehicles for pension funds. This option will not be available for private pension funds until legislation is passed. However, in our opinion, lack of such legislation should not hinder the development of private pension funds in Poland. Back to Top

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