II pillar

July was notably more eventful on the securities markets than the monthly returns of stock indices and bonds might suggest. The first half of the month saw an upward trend on global stock markets, with the final days of the month yielding back some of that growth.

This year, stock markets have been supported by the expectation that, following a short break, central banks will once again open the money taps. Only last December, the Federal Reserve raised the interest rate by 25 bp and was forecasting two more hikes for this year; yet, only a few months later, the expectation had become that interest rates will be lowered instead.

On 31 July, the US Federal Reserve did lower the interest rate range of overnight lending rate offered to financial institutions to a target range of 2.00% to 2.25%. Even though the Supervisory Board of the European Central Bank left interest rates unchanged at its July meeting, it was implied to the markets that these could drop in the future, and that it is also investigating the possibility of resuming the bond purchasing programme, which ended in December 2018.

Central banks are being forced to ease their monetary policy as economic growth has slowed in many parts of the world and darkening clouds are gathering on the horizon in the escalating trade war. Against the backdrop of the economic slowdown and modest profit growth expectations of undertakings, this year’s rise in share prices demonstrates that investors are seeing the relaxed monetary policy and lower interest rates as an elixir capable of solving every problem.

There are more than two asset classes

The amendment of the Investment Funds Act, which was adopted at the end of the last year and enters into force on 2 September, has received minimal attention despite its radical nature; although the topics relating to pension funds have been on the agenda for a long time, and those opposing the pension funds have started to draft another legislative amendment.

Basically, concerning the amendments set out in the Investment Funds Act, the press has mainly mentioned the increase in the percentage of shares permitted in the funds of up to 100% of the assets of the pension fund. However, the more important updates have been neglected. Most likely this focus on the percentage of shares arises from the fact that since 2002, the strategies of pension funds have been defined through the percentage of shares in the pension funds (balanced – 25%, progressive – 50% and aggressive – 75%).

However, the law entering into force in September is so fundamental that, in essence, it makes describing the classification of investment strategies through the percentage of shares irrelevant. Dividing the investment universe into shares and bonds is as general and shallow as dividing investment strategies into active and passive. I can’t say that it is wrong, but for me, this is almost irrelevant.

There are far more asset classes than merely bonds and shares. For example, the investment firm managing donations to Yale University divides their managed investment portfolio (USD 30 billion) into eight asset classes.

Distribution of investments by Yale University at the end of 2018. Source: http://investments.yale.edu/reports.

As we can see, the percentage of domestic equity (the US) as an asset class in the portfolio of Yale University is just 3.5%, despite the fact that the US is the world’s largest stock market. While absolute return strategies, private equity funds, venture capital, natural resources and real estate investments may be generally classified as investments similar to equities, the investment team from Yale University treats them as independent asset classes; as their risk and return characteristics are clearly different and they behave differently in different phases of the economic cycle.

Allowing a higher percentage of shares in pension funds is to be welcomed; however, the new law will bring about much more important changes. The Investment Funds Act, entering into force from 2 September, notably expands the investment opportunities of Estonian pension funds into real assets and OTC securities, including into private equity and venture capital funds, whose long-term expected rate of return is higher than that of the listed shares. LHV pension funds have, for some time, focussed on OTC investments and the forthcoming new law will broaden our investment opportunities even more.

The new law also stipulates the return expectations to be set for the pension funds through the introduction of a success fee. If the pension funds grow the money of pension savers faster than the salaries rise, the fund will be entitled to a success fee. At the same time, the management fees of pension funds are lowered radically. Setting Estonia’s salary growth as the benchmark index for pension funds should also focus the attention of fund managers towards searching and creating local investment opportunities, as the correlation between Estonian salaries and the cost of Estonian assets should be high over the long term.

Reshaping the investment strategies of pension funds and finding and realising new investment opportunities is a lengthy process, and it is regrettable if amendments of Acts are initiated faster than the previous ones are able to enter into force.

I suspect that such hasty actions also prevent politicians from understanding the very essence of what they are voting for, and what is relevant may be completely forgotten and pushed aside in the process of political extortion and compromises.

Disservice to future pensioners

When an Estonian citizen retires, their income compared to their final salary (this ratio is called the replacement rate of pension) will drop more than in any other European country (also in those that are poorer than us).

Slide 12 of the presentation by Lauri Leppik: Theoretical replacement rate of net salary and net pension of a person paid an average salary for 40 years and thereafter retired among the European Union countries. European Commission data for 2018.

The politicians of the Pro Patria Party believe that future pensions being even lower than those of today is not a problem, and it is the children who should support their parents during retirement. It is in this way that they are trying to push through an erroneous vision that the future decrease in pensions will support the rise in birth rates. I suspect that the logic of the politicians of the Pro Patria Party is flawed, and poor pensions in the future will mean increasing wealth inequalities in society, resulting in political instability, which in turn will start inhibiting the growth of population as well as wealth.

To make sure that the focus is maintained, we need to find a solution to the problems that is as direct as possible. Decreasing pensions in order to raise the birth rate is not only too indirect of a method to be efficient, but is frankly the wrong solution.

All changes to the pension system should be assessed based on whether pensions will increase or decrease in the future in comparison with salaries. But before that, politicians should adopt a position on whether today’s pensions in Estonia are too high or too low. Today, I am left with the feeling that even though there are discussions about a possible one-off pension increase, then there are still amendments being drafted which will lead to a big drop in pensions in the future and force elderly people to live below the poverty line.