Retirement Savings and Capital Markets: the Case of Romania

Retirement savings are the "fuel "of capital markets. Only a well-functioning capital markets system can provide effective retirement finance. Working together, both sustain the compound interest process that creates financial wealth

Romania, with its aging population and emigration challenge and the threat of a retirement crisis in the future, must understand these simple yet profound lessons fully.

• The challenge of retirement finance

We all get old and eventually retire.... Who will pay our pensions?

Retirement finance stands on the famous Three Pillars.

Pillar 1 - National "social security" pensions. Active workers make contributions which are paid out as pensions to retirees. Financial viability depends on having enough young contributors. With aging populations (and emigration in Romania's case) this is not sustainable.

Pillar 2 - Employer pension funds, professionally managed

Pillar 3 - Individual pension funds or insurance products, professionally managed

Pillars 2 and 3, are "funded" retirement schemes.

Every month, an automatic flow of contributions comes into the fund. The contributions typically benefit from favorable tax treatment ("pre-tax money"). The money gets invested in a diversified portfolio of stocks, bonds and "alternative assets". Within the pension plan, money compounds tax-free. The mechanism of compound interest generates growth in "Assets-under-Management" (AuM). From the principal plus the return on investment, the fund pays pensions to the beneficiaries. Constant actuarial and financial analysis ensure pension funds are solvent.

How much money must be saved for retirement? A lot!

Saving money is difficult. Keeping it and growing it is even more challenging: investments fluctuate and markets may crash. Inflation, taxes and the fees of financial intermediaries insidiously erode the value of savings.

"Real" investment returns, i.e. net after inflation, taxes, fees of financial intermediaries, are small, perhaps in the range of 1-2 % per annum, on average. They may even be negative in unfavorable market conditions.

For an individual, the "rule of thumb" is that you need, at retirement age, say 65, total retirement savings of at least 10-15 X your final salary on a fully funded basis. (would be less if you benefit from a generous "social security" pension)

What about a country? We estimate that, on a fully funded basis i.e. excluding the "social security" pensions, a country with European demographics would need to accumulate long term savings of at least 3-4X GDP on a steady state basis. As real investment returns are small, it takes time to accumulate such savings.

Some countries, in particular the "Anglo-Saxons" (US, UK, Canada, Australia, New Zealand, Singapore etc.) are relatively advanced on the road of accumulating financial assets. In these countries, the mechanism of automatic savings through pension funds and professional investment in securities, especially equities, has been at work for a long time.

Other countries, especially the post-Communist Eastern European nations, are far from this target.

• The US Model: a "capitalist success story"

The United States is perhaps the best example of a "capitalist success story" as illustrated below.

In the above chart, Household Financial Assets are the financial assets owned by the population: cash, bank deposits, stocks and bonds directly held, mutual funds, life insurance reserves and pension funds.

Not surprisingly, the overall assets by country (size of bubbles) correlate with GDP/Capita and the population size. The ratio Household Financial Assets /GDP, on the vertical axis ,also correlates with GDP/capita.

How did the US get to its enviable position?

It has been a long process as illustrated by the 1948-2021 historical perspective below.

The charts below are "movies" of the US Household Financial Assets (adjusted for inflation) during the period 1948-2022. Note how the assets have grown and how the mix has evolved.

As of 2022, Household Financial Assets (HHFA) had reached US$207,000 per capita or 358% of GDP. In inflation-adjusted 2022 dollars, assets have approximately doubled over the last 20 years, which represents an average annualized growth rate of around 3.6%/year

Two key events during this period: ERISA (Employee Retirement Security Act of 1974) which regulates employer pension funds and 401k act of 1980 (which regulates individual retirement plans) helped stimulate growth.

Over time , the asset mix has evolved. Growth has come mostly from securities (stocks and bonds held directly) and "professionally managed assets" (defined as mutual funds + life insurance reserves + pension funds). As of 2022, these professionally managed assets represented 46% and directly-held securities represented 34% for a total of 80% of the total. Cash and bank deposits represented only 20%. This is a favorable mix.

As "safe investments", bank deposits usually pay a tiny premium relative to treasury bills. Interest income is taxable. Inflation and taxes are constantly eroding the value of the investment.

Directly-held bonds are a little better since they pay a higher interest rate. Although more volatile, equities are a much better investment, since they enjoy the equity premium and companies reinvest a portion of their profits in the business, which guarantees compounding.

The table below shows the long term performance of these asset classes in the U.S.

Note: Bank deposits (not shown) pay a very small premium over T-Bills.

So, if you want to make money, you are better off taking some risk and investing in equities for the long term. The US (like the other Anglo-Saxon countries) has benefitted from a strong "equity culture".

The other development which has stimulated investment has been the increasing penetration of "professionally - managed assets". These include mutual funds, pension funds and savings-oriented life insurance products.

Professionally-managed assets perform better than direct investments in securities: they offer diversification, professional management/lower transaction costs and, in many cases (e.g. pensions and life insurance endowment products) a "tax-shelter" since assets compound tax-free until distribution time.

• What is the "moral of the US story"?

To build up financial assets, you need "fuel" - regular, automatic savings that compound. To achieve good investment performance, you need to move from T-bills and bank deposits which offer low, taxable returns to securities, in particular equities, and to professionally-managed assets.

Countries that embrace this philosophy become wealthier. Countries such as the Western Europeans (e.g. France, Germany, Spain, Italy) have not yet fully accepted the equity culture and funded pensions and lag behind.

Eastern European countries, which have suffered through the Communist regimes are even further behind.

• The Case of Romania: still "early days"

Romania's Household Financial Assets/GDP, which were at 15% in 1998 have advanced to 43% by 2022.

This ratio is lagging behind a peer such as Poland (76%), behind the Western European "benchmarks" (160-190%) such as France, Germany, Italy and Spain and way behind the US (358%)

The Household Financial Asset "movie" for Romania is shown below, in inflation-adjusted US$ terms for the period 1998-2022.

What is striking in Romania is the historical evolution of the asset mix.

In 1998-2000, cash and deposits represented close to 90% of the "consumer wallet". In 2000-2006, Romania experienced a strong bull market in stocks and many investors presumably drew down on bank deposits to buy equities. The stock market then crashed during the 2007-2008 financial crisis. Cash and bank deposits recovered their share-of-wallet and today represent 67% of the overall Household Financial Assets. Directly held securities remain a tiny 8% of the "wallet". However, professionally managed assets (driven mostly by Pillar 2 pensions) are capturing an increasing share and in 2022 reached 25%.

The good news is that Romania is making progress, but not fast enough. The historical experience has left sequels and a relative lack of trust in capital markets. Romania thus remains a "bank-centric" rather than a "market-centric" economy.

• Suggested priorities for Romania

The Romanian economy has performed reasonably well in the last few years, which presents a good opportunity to address the longer-term retirement challenges and the quality of capital markets.

For Romania, the suggested overall priorities are:

accelerate the growth of professionally-managed assets and

increase the role of capital markets intermediation vs. bank intermediation.

The country needs a more efficient way to generate savings and put them to work to address the retirement challenge.

There are some major hurdles to overcome:

• The Romanian population is not well-informed about financial matters.

Various studies show that the level of financial literacy in Romania is just about the lowest in Europe.

In particular, it is striking that the profession of financial advisor is embryonic: the few people who exercise it are in fact "tied" salespeople for banks and insurance companies; they are not well trained, and they are certainly not independent. Independent financial advisors are practically inexistent.

The independent financial advisor can only function with "open architecture" asset management. In other words, asset managers (banks, insurance companies and other asset management firms) distribute their products both through their own salesforces and the independent advisors. This forces them to compete, which is good for the ultimate investor.

The regulator, ASF, should facilitate the emergence of a professional, independent financial advisor corps to help educate the Romanian population about securities, mutual funds, life insurance and retirement savings products as well as promote "open architecture" and more competition in the asset management industry.

The media industry should also play a major role in educating the Romanian public about finance and investment. There should be a financial television channel active in Romania.

• The Romanian population does not trust the capital markets.

Romania has unfortunately experienced a history of financial uncertainty and/or financial scandals during the 30+ year post-Communist transition.

There has been some uncertainty in "plain vanilla" occupational pension funds which concerns millions of individuals. At one point, there was even a failed attempt to nationalize Pillar 2. Pension fund regulations and fees have been modified repeatedly.

The mutual fund industry has experienced a couple of major scandals, including a Ponzi scheme in its early years. Several hundred thousand investors lost their savings.

The insurance industry has had a few major scandals in recent years: RCA, City Insurance and Euroins.

There are suspicions of market manipulation by the SIFs.

Not surprisingly, the average Romanian does not trust the capital markets and prefers bank deposits....

Establishing and maintaining trust in the capital markets should be top priority for the regulator, ASF, the key market institution, BVB and the brokerage industry.

• Narrow product offering and insufficient diversification

The range of financial instruments available to the Romanian active investor today is still fairly narrow - stocks, government bonds primarily . Only 15-20 stocks on BVB are reasonably liquid. There are few mutual funds.

A rational investor needs diversification, international and asset class diversification. Today in Romania, there are only a few thousand active investors and for these, international diversification means simply buying Apple or Google stocks. There should be more opportunities to diversify internationally both in developed markets and in the Central and East European region.

There should be more opportunities to invest in asset classes such as real estate and infrastructure bonds which would appeal to Romanian investors.

To sum up, Romania still has a lot of work to do to strengthen its retirement security and its capital markets.