The Estonian parliamentary elections are coming up in March, and the campaign promise season has just geared up with the first policy point worth talking about: the shutdown of the mandatory retirement savings scheme and the return of the money to the citizens – to invest privately or do with as they please.
The idea comes from Helir Valdor Seeder, the chairman of the former IRL (Union of Pro Patria and Res Publica), now rebranded back to just Isamaa – the same party that was behind the personal business account scheme. It touches upon two other peculiarities of how Estonians handle their money: the second pillar of the old-age pension system and the investment account (investeerimiskonto) scheme.
According to Seeder’s proposal, Estonians would be allowed to take the money in their second pillar funds and, if they wish, transfer them to an investment account – where they can make broader choices on how to invest the money or even withdraw it.
What is the second pillar?
The Estonian old-age pension system notionally consists of three pillars. The first is the basic state pension, provided to anyone upon reaching retirement age (currently 63 but rising to 65 by 2026), as long as they have been employed and paid taxes for at least 15 years. The monthly pay-out for this pension – which is somewhat variable – remains, unsurprisingly, not enough to have a respectable life as a retiree.
The second pillar is supposed to rectify this problem by introducing an element of mandatory savings for each individual person, to be paid out only upon their retirement. Two per cent of your gross salary (of the number in your employment contract) is paid into a special pension fund; this is matched by an extra 4% from the state, paid out of the social tax that your employer pays on your behalf (this is on top of the salary figure in your contract). These 6% of your monthly wages are then collected and invested, over your entire working life, by a commercial investment fund, usually run by one of the big Estonian banks. You can move the money between different pension funds, but you can’t take it out until you retire (or die, in which case your next of kin inherits the money – it doesn’t just go to the bank).
There is also a third pillar, a completely voluntary scheme where you can pay more money into your pension fund on top of the 2%+4%. Third pillar contributions are tax-deductible (up to a certain limit), but since you still can’t take the money out until you retire, it’s not popular.
What is the investment account?
It’s a special bank account (which, unlike the personal business account, actually exists and is offered by retail banks). It is designed to give private citizens the same advantage that corporations enjoy with Estonia’s zero corporate tax on reinvested profits.
Just as Estonian companies only pay income tax when they pay out the money in dividends, individuals can put money into an investment account and use it to buy stocks, bonds, shares in investment funds etc. When you sell those shares at a profit, the money goes back into your investment account and is not taxed – you can use all of it to buy more shares. When you withdraw money from the investment account into your regular bank account – only then do you have to pay income tax and only on the difference between what you put in and what you took out.
What is the problem with the second pillar?
There is competition between providers of second pillar pension funds (between banks), and each provider offers funds with different risk levels. They are run by professionals and they have fairly high administrative costs (taken out of the value of your savings). Still, most of them are actually quite bad at the job of investing.
The Estonian pension index shows the increase in the value of a share in second pillar funds of different categories – from EPI-00 (the average of conservative funds that do not invest in risky stock markets at all) to EPI-75 (the average of aggressive funds that can put up to 75% of their money into the stock market), we can see the return on investment is between 40% and 85%.
Over the same period, the consumer price index has grown by 63%. If you started saving money when the scheme was introduced (and it was mandatory for anyone born after 1983), then unless you were very lucky in choosing your pension fund – it’s not the highest-risk ones that have shown the best returns! – then your current second pillar savings are, in real terms, worth less than what you paid in.
Discounting the boom-and-bust of the 2008 financial crisis paints a slightly better picture – even the worst-performing index shows an increase of almost 27% since April 2009, while consumer prices have increased only 25% since then – but the average Estonian is still left with a very legitimate question: why am I giving my money to bankers who aren’t increasing its value?
In the last couple of years, this criticism has even resulted in a new non-bank player in the second pillar market: Tuleva fund, whose pension funds have smaller administrative charges and just follow the decisions of major market players, instead of paying the salaries of independent stock traders who aren’t good at their jobs. This, however, is largely cosmetic: Tuleva’s pension funds have also struggled to grow more than inflation in Estonia.
Is the investment account better?
Not necessarily. The most obvious way to use your investment account is to buy shares in the funds provided by the same bank that handles the account. The range of available funds is much broader than with the second pillar, you can choose funds other than your bank’s and you can even buy and sell individual stocks. You can buy and sell shares in Facebook or Ford.
But non-pension investment funds have also struggled to show growth that’s higher than inflation. And investing directly in stocks, you are at risk of actually losing your money. It’s certainly possible to make a profit in the stock market – but you have to pay a lot of attention, do a lot of research and treat it as a job. Which is a very different proposition from a passive investment to increase the size of your pension when you get old.
Is Seeder’s proposition a good idea?
It’s certainly a populist move, but in this case, it will be popular because it genuinely makes sense. Everything comes down to effectiveness: the second pillar simply does not work. When it was introduced as a new payroll tax around 2003, it was supposed to be a way to make your pension big enough to live on comfortably when you retire – but this promise was always implausible and, fifteen years later, it looks just about impossible.
What happens if Isamaa gets enough votes to stay in government after the next elections and gets the coalition to make the second pillar conversion happen? It’s unlikely that a large proportion of Estonians will immediately become active investors, with stock tickers on the main screen of their smartphones. Most of them will probably go straight for withdrawing the full amount from their investment accounts (and paying income tax, presumably).
For the Estonian economy, it will be an instant and major stimulus in spending. For Estonian households, it could mean sudden access to a lump sum sufficient to, for example, make a down payment on a mortgage or reduce the outstanding loan by a significant amount. (Going from renting an apartment to paying down a mortgage on a home whose value is likely to grow? That sounds like a much better investment decision than a mediocre pension fund.) And once Estonians get active investment accounts, they are likely to pay at least some attention to active investing.
What will it mean for Estonia? On the one hand, it will prop up the real estate market, which has certainly recovered from the 2008 crisis and looks increasingly like another bubble – but mortgage interest rates are expected to start growing in the next few years, which is certainly a threat to Estonian homebuyers. On the other hand, a sudden influx of disposable income is likely to make inflation and consumer prices increase further – but Estonia is part of the eurozone and a bit of inflation is acceptable as long as salaries grow faster.
Furthermore, Seeder’s proposal is not just a one-time deal. The 2%+4% will still be collected – and can be converted and withdrawn in the future – making it a sneaky opportunity to increase take-home pay and reduce Estonia’s payroll tax burden, something that’s been a big subject of discussion lately.
The downside, of course, is that retirees will not have the benefit of additional pension pay-outs. How much of a difference will it make? Using NASDAQ’s pension calculator, we can take the example of a 30-year-old making Estonia’s average salary (€1,354, as of writing). Discounting both inflation and wage growth, over a 45-year working life this person will contribute around €44,000 to a pension fund. Assuming the investment banker will increase this to €60,000, it will give them €266 per month in extra pension pay-outs for 10 years after retirement. That’s not insignificant – but if it makes the difference between renting or owning a home, the trade-off could certainly be worth it.
Will it get Isamaa elected?
It just might.
Isamaa, Estonia’s moderate nationalist party, is currently a junior coalition partner with very modest ratings among voters. Elections are still many months away, but Seeder’s proposal is the only campaign promise so far – among any party – that is a meaningful policy proposition. The leftist Centre Party of the current prime minister, Jüri Ratas, has achieved little in two years in office; the economic-liberal Reform Party has a photogenic new chairperson but no ideas beyond criticising anything the Centrists do; the Social Democrats are saddled with the legacy of a highly unpopular increase in alcohol taxes. Isamaa’s main competitor for the conservative vote is the populist neo-Nazi EKRE.
It’s a long way to March of 2019, but by promising something genuinely new and helpful (as opposed to hateful), Isamaa is easily taking the lead.
The opinions in this article are those of the author. The cover image is illustrative (Pexels).