The Bank of Latvia has prepared proposals for the improvement of the state-funded pension system

The Bank of Latvia once played an important role in advising the responsible ministries on increasing the return on VFPS contributions and achieving a significant reduction in management costs, while not threatening the entry of new managers into the VFPS market. This time too, the Central Bank responded to the call of the responsible ministries to help review the regulation in this area.

Prepared amendments to the State Funded Pensions Law and the Cabinet of Ministers’ regulations of December 19, 2017 “Procedure in which the asset manager of the state funded pension scheme calculates the payment for the management of the investment plan, and the procedure in which the said payment is recorded and withheld”.

Amendments to both legal acts have been developed in accordance with the joint position reached by the heads of the Ministry of Finance, the Ministry of Welfare and the Bank of Latvia at the March 28, 2024 meeting. According to it, the State Funded Pensions Law plans to gradually reduce the permanent part of the payment to VFPS fund managers, expressed as a percentage of the managed assets, depending on the size of the managed assets. Thus, the amount of funds under management, which is constantly growing as a result of contributions, will be taken into account to a greater extent. Risk and conflict of interest management requirements for VFPS asset managers for investing in registered alternative investment funds will also be determined.

On the other hand, in the mentioned regulations of the Cabinet of Ministers, it is planned to revise the variable part of the payment to VFPS asset managers, by equating its reference value more closely to the proportion of investments in capital instruments provided for in the prospectus of the VFPS plan. This will allow the variable portion of the payment to be more closely tied to the performance of the VFPS plan, consistently outperforming the performance of a passively managed neutral investment portfolio.

The estimates of the Bank of Latvia show that as a result of the amendments, the savings for VFPS participants will exceed 100 million over the next 10 years. euro. Amendments to the law still need to be considered by the Cabinet of Ministers and adopted by the Saeima, while the regulations need to be adopted by the Cabinet of Ministers.

For more than 20 years, VFPS members have consistently paid and continue to allocate 6% of their salary to save for retirement. This process is mandatory and ensures the functioning and development of the pension system established by the state. More than 80% of the 7 bln. total VFPS assets worth EUR at the end of 2023 consisted of the cumulative net contributions of their members. Contributions are the main reason why VFPS savings are growing so rapidly – over the past 10 years, VFPS assets grew by about 15% per year.

VFPS managers apply the permanent part of the payment to the total amount of pension savings, which is expressed as an annual percentage of the amount of managed assets (in 2023, on average, approximately 0.45% of VFPS assets). Managers of mutual funds generally use the statutory maximum value or cap of the permanent part of the payment, with the exception of some passively managed investment plans.

Based on the information provided by the Organization for Economic Cooperation and Development (OECD), total management costs in Latvia in 2022 were 0.1 percentage points higher than the average in OECD countries. Without changing the method of calculating the permanent part of the payment, under the influence of the increase in the amount of accumulated VFPS capital, they could no longer decrease and stop at the 0.4% limit, and at the same time, the remuneration for managing the total assets under management would increase, not creating sufficient motivation for managers to achieve a higher return on pension assets and increase the pension of future retirees.

Taking into account that all the investment risk is assumed by the VFPS members, as well as the net contributions of their members make up more than 80% of the accumulated VFPS capital, the principle of regressivity should be strengthened in the maximum value of the permanent part of the payment – the larger the assets, the lower the ceiling of the permanent part of the payment. In the assessment of the Bank of Latvia, the permanent part of the maximum payment should be set at 0.6% for the first 100 million. euros in management and can be reduced by 7.5% for each next 100 million. in euro management, until the threshold value of 0.20% is reached. Along with the lower ceiling of the permanent part of the payment, the variable part of the payment will be more important. The variable part of the payment provides managers with the opportunity to earn additional income from the management of VFPS investment plans, if they are able to consistently increase the pension savings of VFPS members above the general market trend.

The amendments also affect other aspects. In order for VFPS asset managers to be able to more fully implement the legal obligation from July 1, 2024, to evaluate the investment plan chosen by the VFPS participant and to inform him or her of whether the person has chosen the plan that best suits their age and needs, the Bank of Latvia proposes to impose an obligation on VFPS asset managers to disclose information , how VFPS members can familiarize themselves with the prospectus of the investment plan and the basic information document intended for participants, and how and where VFPS members can receive advice on the investment plan.