Ukraine, the second biggest country in the Commonwealth of Independent States (CIS) after Russia, is the latest in implementing a World Bank-style three-pillar pensions system. A long-term strategy for pensions reform was developed back in 1998 by PADCO, a contractor for USAID; the company subsequently won USAID’s tender for a stand-alone pensions project.
With key legislation passed last year, Ukraine has grasped the nettle in reforming the first (state-run) pillar and augmenting them with mandatory and voluntary private systems. The demographic pressures behind pensions reforms are particularly intense. The population has shrunk from more than 50m in Soviet times to around 48m, and even allowing for a recent rise in life expectancy, Ukraine has a net loss of 500,000 a year due a declining birth-rate and migration, including a high rate of trafficking. “Ukraine is in a classic pincer movement of declining numbers of workers, increasing numbers of pensioners, declining benefits and high contributions,” notes Greg McTaggart, head of the PADCO/USAID Pension Reform Implementation Project.
Currently the number of contributors, at around 23m, outnumbers the 14.5m-15m pensioners receiving benefits, but the dependency ratio has been forecast to deteriorate to 11 pensioners per 10 workers by 2020 if the system had remained unreformed.
The state system was overhauled under the Law on Mandatory State Pension Insurance passed last year and which took effect at the beginning of 2004. The key changes include switching the benefit from final wages to a calculation based on 1% of career average earnings. The law also introduces an Accumulation Fund, Ukraine’s version of the compulsory second pillar, which is expected to start operating in 2007, and will be compulsory for all workers with 20 years’ remaining service and voluntary for those with 10-20 years to go. At that point the coefficient will fall to 0.8% for those who join the mandatory pension system.
A new Swiss-type pensions indexation, based partially on the previous year’s inflation rate but with a government-determined portion of not less than 20% tied to real wages growth, takes effect at the beginning of 2005.
The provision of so-called privileged pensions, for miners and others in hazardous occupations who were entitled to higher benefits and earlier retirement, has been shifted to their employers. However, raising the retirement age, currently 60 years for men and 55 for women, proved too sensitive politically and was left unchanged in order not to derail the entire pension reform project.
Ukraine’s second pillar is being established as a compulsory accumulation system, funded through a 7% wage contribution, with the existing Pension Fund of Ukraine acting as administrator and record keeper, a task it already performs in the state system. Once up and running, it will accumulate an estimated $500m (E404m) a year. Unlike other central and east European countries, Ukraine will operate only one fund. The reasoning behind this is that multi-fund manager schemes operating elsewhere have seen a significant portion of assets dispersed to the financial services industry.
According to McTaggart, the Ukrainian system bears some similarities to Singapore’s Central Provident pooled fund, and will be run as a private pension fund with its own trustees, investment adviser and asset managers. Under the law there will be a tender for at least three private asset managers, most probably towards the end of 2005, as well as a custodian bank, to manage the components of the fund.
The criteria established for asset managers has been one focus of controversy. Initially the management companies were expected to have a minimum capitalisation of E10m and US$10bn of assets under management, which would have excluded all Ukrainian and most Russian contenders. This has since been diluted to the obtaining of an operating licence from the Securities and Stock Market Commission, which requires a minimum capitalisation of E1m for the Ukrainian branch. McTaggart says the original proposal could have resulted in asset managers with plenty of international experience but little in the domestic market, while an exclusively Ukrainian-run system would lack international asset management expertise.
The trustee and investment adviser will determine the overall limits for the asset managers themselves, while the custodian bank will monitor compliance. The board of trustees will comprise seven presidential appointees and seven individuals chosen by parliament, including one representing employers and one the trade union movement. In today’s political system – a strong president alongside a parliament where pro-presidential parties command the majority – the proposed system leaves itself open to charges that it will not be independent. However, the incumbent Leonid Kuchma is not running again in the election later this year, and his departure is expected to usher in a new political era.
Finally, the third-pillar schemes under the Law on Non-State Pensions came into effect at the beginning of this year. McTaggart regards the legislation as the best in the region, in that only defined contributions schemes are permitted and all have to be fully funded.
The law permits three types of schemes: corporate pension funds run by single employers or holding companies with numerous subsidiaries; professional schemes established by trade unions and employers; and funds run by the financial services industry such as banks and insurance companies. Trustees will appoint the asset managers, who require a special pensions licence from the securities commission, and a separate custodian. Either entity can act as administrator, or the task can be sub-contracted. With the financial services industry currently more interested in acting as asset managers, one potential problem that McTaggart foresees is a lack of experienced custodian banks. In addition, the trustees must by law pass the relevant examination, and PADCO is in the process of establishing certification courses for interested parties.
The voluntary funds are seen as critical to supplementing the scaled-down first pillar. Both the corporate and professional schemes require compulsory employer contributions, of up to 15% of wages exempt from tax. Employers can only vary contributions for individual employees according to age or service length, not status. Ukraine’s high social tax –34.5% of wages – makes it more advantageous for employers to reward their employees with higher pensions contributions than pay rises.
According to McTaggart, on the basis of inquiries, the professional schemes are generating the most interest. “The interest is extraordinarily high. If every employer who has indicated a willingness to establish a scheme does so, we will see 20-25% of the workforce in a pension scheme within two years of operations,” he adds. The first schemes should be in place by the summer, with the possibility of some open schemes, for either public or private sector employers, getting technical assistance from USAID to act as pilot schemes.
In Ukraine’s politically charged climate, pensions reform has not gone unchallenged, particularly where investment regulations are concerned. In the second pillar they include limits of 50% on bank deposits, 50% on Ukrainian government bonds, 10% municipal government bonds, 20% in Ukrainian corporate bonds, 40% in Ukrainian equities, 20% in international government bonds with a minimum Moody’s A rating, 20% in shares and corporate bonds of international companies, 5% apiece in mortgage bonds, real estate, precious metals, and a 10% limit on any one company.
By regional standards, the regulations are heavily geared towards private sector securities, with the non-state funds allowed to invest an even greater proportion of their assets here. In contrast, most central European private pensions systems have no cap on domestic government investment, and generally the bulk of assets get invested in government bonds - some 80% in the case of countries such as Hungary. As McTaggart points out, this recycles private pensions into government borrowing. However, the limitations of the Ukrainian markets have raised concerns about the ultimate safety of pensions assets. In 1998 Bank Ukraina, one of the country’s largest, went bankrupt, while a number of the country’s 150-odd banks are offering above-market deposit rates to attract funds.
The private pensions industry will nonetheless make its impact on the capital markets. “The private pension funds will become the first corporate investors in Ukraine and it will be interesting to see how the market responds to their introduction,” says McTaggart.
Tomas Fiala, managing director of Dragon Capital, the country’s largest brokerage, predicts that the pensions will initially channel assets into bank deposits and corporate bonds, similar to the local insurance companies’ investment strategies. Local currency (hryvnia) bank deposits currently offer returns of 9-10% against 5-7% for US dollar denominated ones, while corporate bonds from the better rated companies yield around 12% on two-year issues.
The corporate bond market, with some $500m outstanding, is developing rapidly according to Fiala, with recent issues by major utilities such as the railways. In contrast the government has issued relatively little hryvnia-denominated debt recently. The stock market, meanwhile has picked up. The KP-Dragon Index of top 10 stocks, with a total capitalisation of $3.4bn, rose by 50% last year and by 57% year-to-date as of early March. “It has benefited from foreign institutional investor interest, although liquidity is still not very high because there have been no privatisations through the stock market for the last five years,” adds Fiala. “We expect some IPOs after the presidential elections later this year, which should boost liquidity.”
He foresees the pension funds becoming significant players in the debt market in two to three years’ time, and in equities a couple of years’ later. “The debt market is currently dominated by local banks and stocks by foreign institutional investors, so it will be good to have more local institutional investors.”