When Croatia became independent in the early 1990s following the collapse of the former Yugoslavia, it was in a sorry state. A devastating war with its neighbour left the country deeply in debt and nursing the wounds caused by the five-year conflict - hundreds of thousands of homeless refugees, tens of thousands dead or missing, and a severely depleted infrastructure.
When Croatia became independent in the early 1990s following the collapse of the former Yugoslavia, it was in a sorry state. A devastating war with its neighbour left the country deeply in debt and nursing the wounds caused by the five-year conflict - hundreds of thousands of homeless refugees, tens of thousands dead or missing, and a severely depleted infrastructure.
Less than two decades later, however, and it’s hard to see any damage at all. The country has patched up its damaged buildings, restored national confidence and rebuilt its economy. It punches above its weight in sport, with success in football, tennis and skiing, and has become one of Europe’s most popular tourist destinations. It’s on the fast track to join the European Union and plays a major role in international affairs.
Although the newly independent government began fiscal reforms at the start, little was done immediately as the war became the priority. Real financial changes began at the turn of the millennium, when companies were privatised and foreign investors started to build their confidence in the ravaged land. Unlike many former communist countries, there was little in the way of corruption leading to the creation of an oligarchy - although no-one will say the transition was perfect, there were opportunities for everyone, both local and international.
Finance
Croatia didn’t do too badly during the downturn - some of its exports were hit and tourism fell slightly, but compared to some of its neighbours, it remained fairly stable. That doesn’t mean all is rosy in the garden, though. It still has a high trade deficit and still carries significant debts. As part of its accession pathway for the EU, due to be completed in the next few months, the Government still has some work to do, much of which will not be popular with the local populace.
The country’s banking industry is in good shape, however. International firms snapped up some of the local players to create a trans-continental network and institutional provision is on a par with that on the rest of continental Europe. Custody fees are comparable with those in Italy, and the infrastructure means that settlement rates are high.
There isn’t a huge amount of fund activity, however. Mutual funds have not made much of a mark, and while international investors will often have a Croatian aspect to their portfolio, the country is not a major investment hub. Where the business thrives, though, is from its domestic pension funds.
In the 1990s, the Croatian pension system underwent similar types of reforms to those of most other former communist states. The war had one major consequence for the country’s pension provision - a dramatic increase in the number of pensioners and a drop in the size of the active workforce.
The PAYG system in place until 1998 was not able to deal with these shocks due to low retirement age, a weak link between contributions and benefits, and generous benefits. This is why major pension reforms were initiated in a gradual, step-by-step manner. The Croatian government implemented parametric reforms of the PAYG system in 1999 and introduced mandatory and voluntary pension funds in 2002.
Demographic development in Croatia is comparable to that in the rest of the region. The old-age dependency ratio is projected to rise from 25.6 per cent today to 49.6 per cent in 2050. This means that Croatia will be doing only slightly better than the forecasted EU-25 average of 52 per cent. According to a study from the Institute of Economics in Zagreb, public pension expenditure will fall (in the baseline scenario) from currently 13.1 per cent of GDP to 6.3 per cent in 2050. The EU-25 average will increase from 10.6 per cent of GDP to 12.8 per cent over the same period.
Pension assets in Croatia currently add up to EUR 2.2 billion in the second and EUR 54 million in the third pillar. Until 2015, we expect to see annual growth of 19 per cent for second pillar and 24 per cent for third pillar pension assets.
Public pensions
The pre-1998 system was purely PAYG. It was organised in three different funds for workers, the self-employed and farmers; benefits differed for each group. What’s more, certain groups, among them World War II veterans, former political prisoners, academics, police and military personnel, enjoyed a privileged status; their benefits were determined by a special law. In the late 1990s, almost 200,000 people belonged to these privileged groups. Retirement age was low at 60 for men and 55 for women. Early retirement was fairly easy and there were various supplements for years without contribution.
In 1999, Croatia reformed the public pillar and aimed at financial sustainability and cost containment. The retirement age has gradually been increased, reaching 65 for men and 60 for women. The minimum early retirement age has also been raised, as have benefit deductions for early retirement.
The current contribution rate is 20 per cent of gross salary, paid by employees alone. Minimum earnings for contributions are HRK 2,270 (EUR 309), maximum HRK 37,194 (5,066). For people who joined the mandatory pillar, 5 per cent of contributions are directed into their individual accounts. For those who had to or chose to stay in the old system, the full contribution is used for first pillar pensions. Initially, 10 per cent of contributions were to be re-directed into the mandatory pillar, but the amount was reduced to five per cent due to fiscal problems.
Just like in most other CEE countries, Croatia applies investment limits and a minimum rate of return to the mandatory pension funds. A special characteristic of Croatian regulation is that a minimum of 50 per cent of assets has to be invested in Croatian government bonds. Maximum investment limits include the following:
30 per cent for Croatian shares; for shares of domestic open investment funds; for Croatian municipal bonds, for Croatian corporate bonds traded on organised exchanges in Croatia 15 per cent for foreign securities issued in OECD countries and for bonds issued by OECD countries
10 per cent for corporate bonds and shares issued in OECD countries
five per cent for shares of open domestic investment funds or foreign investment funds that are primarily invested in bonds issued by governments of OECD countries, and for cash and bank deposits
Investing in real estate and derivatives, self-investment (investing in the pension fund management company) and investing in related companies of the pension fund management company is prohibited. Croatia has a limit for international investments: 15 per cent of pension fund assets can be invested abroad.
Pension fund management companies must credit a minimum rate of return to the individual accounts. The reference rate of return is defined as a weighted arithmetic mean of all mandatory pension fund average rates of return in the previous three years, reduced by two percentage points. Each mandatory pension fund member is guaranteed the rate of return that equals one third of the reference rate of return, if the reference rate is positive. If the reference rate of return is negative, each pension fund member is guaranteed a rate of return that equals a triple reference rate of return for the last three years. To offset losses if the pension fund falls below the minimum rate of return, it must have a guarantee fund, which is funded with part of the “success” fee.
If the fund’s actual rate of return falls below the minimum rate, the shortfall must be covered with assets from the guarantee fund. If these assets are insufficient, up to 20 per cent of the pension fund management company’s own capital must be used. If both sources are insufficient to compensate for the low rate of return, the state guarantees the remainder.
Asset management
and allocation
The initial take-up rate of the mandatory scheme was very high. Between November 2001 and the end of 2002, nearly one million people joined the mandatory system. By the end of 2006, the system had 1.3 million participants and assets worth EUR 2.2 billion. The mandatory pillar now covers 83 per cent of persons in employment.
Four mandatory pension funds are operating on the Croatian market, and all of them are linked to international financial institutions. In terms of members, the two biggest funds share 71 per cent of all members between them.
Assets are allocated in a fairly conservative way, even considering the restrictive investment limits. 91 per cent of assets are invested domestically. Of these, over 70 per cent are invested in domestic government bonds, seven per cent in open-end investment funds, five per cent in domestic shares and three per cent in corporate bonds. Foreign shares amount only to 1.4 per cent of assets. Croatian pension funds do not exploit the 15 per cent limit on foreign assets; only nine per cent are invested outside Croatia.
Taxation
Taxation of the mandatory pension scheme is of the EET type. Contributions and investment income are tax-exempt, whereas benefits are taxed. The tax allowance for pensioners is 1.7 times higher than for employees, meaning that pensions are only modestly taxed.
The third pillar – voluntary pension funds
Voluntary pension funds were also introduced in 2002 and complete the three-pillar system. These schemes are DC plans based on voluntary pension savings. Voluntary pension schemes are either offered by voluntary pension funds, or can be set up by trade unions and employers, making open and closed funds possible. Voluntary pension funds need to have at least 2,000 members two years after being established.
Participants in voluntary schemes benefit greatly from tax incentives. The state provides an annual subsidy of up to HRK 1,250 (EUR 171) and allows a tax deduction of up to HRK 1,050 (EUR 151) per month. Employer contributions are not subject to tax breaks; they are treated like salary payments. Benefits are paid as annuities or as periodic payments. Contrary to the mandatory pillar, voluntary pension fund companies can offer more than one fund.
There are currently six open pension funds on the market, provided by four pension companies. Voluntary pension companies overlap strongly with the mandatory pillar; three of the four pension companies offering mandatory funds also provide voluntary funds. 65,300 members participate in voluntary pension funds, which have assets of EUR 54 million under management. The two biggest voluntary funds have a market share of 80 per cent; the biggest fund alone has a share of 53 per cent. Investment regulation of voluntary pension funds is very similar to that of mandatory funds, but slightly more liberal. For example, the limit for international investments is 20 per cent rather than 15 per cent.
In geographical terms, voluntary pension fund asset allocation is slightly more conservative than that of mandatory funds: 94.5 per cent of assets are invested domestically. Investments in domestic bonds are lower (51 per cent of assets) than in the mandatory pillar, corporate bonds and open-end funds account for 12 per cent, deposits for six per cent. Foreign assets (5.5 per cent) are almost exclusively invested in open-end funds.
Closed voluntary funds are offered by three companies, which are also active in the mandatory and/or open voluntary pension fund market. There are currently 10 closed pension funds with 10,700 members and HRK 60.3 million (EUR 8.2 million) in net assets.
In terms of market attractiveness, Croatia has the biggest pension market among the smaller CEE markets, and the fourth largest pension market in the region. It will therefore remain an attractive market with considerable growth potential.
