Pensions reforms back on track
Few countries need pension reforms as badly as Russia. The majority of the country’s 40m pensioners live in dire poverty, and this population is increasing as a result of increasing longevity. Pensions reforms, however, have had a mixed response, from both the public and providers. Their complexity has raised questions about the government’s commitment to enacting any significant changes, while Russia’s post-communist financial scandals and crises have left many with a lingering distrust of anything connected with financial markets.
Private pensions have been available in Russia since the mid-1990s via corporate schemes established by large state monopolies. There was a stab at reforming the state system in 1995, and again in 1997, with the World Bank lending $800m (e629m) to strengthen the pension fund of the Russian Federation (PFR). The government itself made some progress on a three-pillar system but the following year’s financial crisis after the rouble collapsed suspended the project.
Pension reforms restarted in earnest in 2000, largely to stave off the bankruptcy of the PFR, the state pensions provider: they were finally implemented in 2002. Until that time the PFR received the full 28% payroll tax paid by all employers, while pensions were paid out on the basis of the last two years of employment. The comparatively low retirement age (at most 60 years for men, 55 years for women), as well as a falling birth rate put further strains on the system. By EU standards Russia has a very unfavourable demographic situation. Men over the retirement age (60 years) account for 30% of the population; this is projected to rise to 40% by 2020 and 60% by 2040.
The key change in 2002 was the replacement of the old-pay-as-you-go (PAYG) system with a mixed system of flat basic (PAYG) pension, a PAYG notionally defined contribution scheme based on newly formed individual accounts - the so-called insured portion - and a fully funded defined contribution (DC) scheme, the so-called cumulative portion or second pillar. The latter was the privately managed component, restricted to men born no later than 1952 and women born after 1957.Under the reforms, the 14 percentage points of the 28% tax contribution went to the basic pension, between 10-14 percentage points to the insured portion and the rest to the accumulative scheme.
In 2003, those entitled to the accumulative, second pillar component had the option to either have that portion of savings managed by the state-owned Vnesheconombank (VEB) or by one of the 55 asset management companies (AMCs) that received pensions licences that year. The choice of VEB was controversial: as the bank also manages Russia’s foreign debt, it faces an obvious conflict between maximising the value of government securities for its pensions clients and reducing the value of the debt.
For various reasons, less than 2% of entitled workers chose an AMC, the rest either opting or defaulting to VEB. “There was relatively little money going into the second pillar, so the incentive was not large,” explains Alex Bertolotti, partner and head of the insurance and pensions department at PricewaterhouseCoopers Russia. “The system was not particularly well publicised in terms of its mechanics, and there is still a lack of trust in financial institutions.” The applications procedure was also complicated. “Unlike Kazakhstan, where workers can set up second pillar schemes through their employers, Russians had to organise it themselves through a pension fund or bank, which is very inconvenient,” adds Karina Khudenko, senior tax manager at PricewaterhouseCoopers Russia. Alex Bertolotti warns that unless these areas are addressed, the shift from public to private provision will not be successful.
The many legislative changes in 2003 resulted in the AMCs only receiving their licences in September of that year, another factor contributing to VEB ending up as default asset manager. The following year 40-odd non-state pension funds (NSPFs) received second pillar pensions licences, giving workers the additional burden of deciding between two types of financial institutions that would in any case be working in contractual partnership. The same year the capitalisation criteria for new applicant AMCs were raised, as a result of which no new companies applied.
An NSPF licensed for second-pillar provision provides full-scale servicing in terms of governing second-pillar pensions savings, including administration and payment of non-state pensions. Under Russian legislation, the asset management of second-pillar pensions has to be performed by a licensed AMC, so NSPFs outsource the asset management of pension savings. “Thus these two entities do not substitute each other: they render complementary services,” notes Evgeniy Yakushev, managing director, NPF Raiffeisen in Moscow.
As Yakushev explains, NPF Raiffeisen is licensed for second and third-party activity, and being an open fund provides services for individuals and corporates. In 2004 it had received around 1,000 applications for the second pillar.
Russia’s AMC market is, nevertheless, highly concentrated, with a handful of managers, including Troika Dialog, Alfa Capital and NikOil, managing most of the assets in the third pillar and those not handled by VEB in the second. Typically, a large third-pillar pension fund will outsource to several AMCs. For instance, Troika Dialog currently has 48 NSPF clients, including virtually all those of the natural resource and utility companies. “There are not that many benchmarks [in Russian pension fund_management], so a pension fund would use around three AMCs with identical mandates to provide that,” notes Pavel Teplukhin, president of Troika Dialog.
Many financial groups have nevertheless stayed out of the second pillar market, preferring to concentrate their resources on the third pillar. As one spokesperson for a foreign group explained: “The legal environment is too unpredictable, there is no working business model, the margins are very thin and there is no retail distribution.”
More changes came into effect in 2005. Firstly, in a bid to reduce the high tax burden on companies, the rate of unified social tax - the employer tax funding pensions, social security and compulsory medical insurance - has been reduced from 35.6% to 26%, and the pensions component from 28% to 20%. The financing of the basic first pillar pension falls from 14% to 10%, that of pensions insurance from 10% to 6%, while the accumulative savings portion remains unchanged at 4%.
Because of the inevitable increase in the state pension fund deficit, citizens born before 1967 will no longer be able to participate in the second pillar scheme – their savings to date will remain in their personal account until retirement. “One of the reasons is that there is not enough time for these workers to accumulate an adequate pension, although they can still participate in third pillar pensions,” explains Yakushev.
This measure has nevertheless been widely criticised. As the International Monetary Fund noted in
a recent report, the funded, DC
system will lose a substantial portion of contributions in order to
finance the defined benefits pay-as-you-go system following the transference of between a third and half
of employees. As the report
comments: “This is a sharp reversal of an ambitious pension reform, which was launched in late 2001 with the aim to develop financial markets and ensure long-term financial viability of the public pension system.”
Secondly, there have been significant changes in the taxation regime for second and third pillar contributions. The tax changes have been more positively received. They included clarification of second pillar contributions and benefits, which are now fully exempt for participants and exempt on contributions and returns, but with the benefits taxed for those that inherit a participant’s pensions.
In the case of third pillar pensions, contributions to solidarity accounts (collective company pension schemes) are no longer tax deductible for profit tax purposes, while returns are subject to full profit tax. In the case of individual accounts in company and other third pillar schemes, contributions are tax exempt up to a limit of 12% of the payroll cost.
Opinion remains divided over the impact of these changes. “The third pillar tax changes will hopefully provide a stimulus for employers to set up pension schemes,” notes Bertolotti. Teplukhin disagrees: ”Those corporate funds that exist are largely concentrated in companies with 100% or significant state ownership, mostly natural monopolies. They are not widely spread among private companies, because pensions represent a financial burden and it would be more efficient for them to raise current salaries rather than help individual employees save.” In the future it may happen, Teplukhin adds, when companies start competing for labour.
Even despite the relatively small proportion of wages transferred to the accumulative portion, the sheer size of Russia’s population - 144m - implies a massive fund growth. In 2003, RUR50bn (e1.4bn) of second pillar pensions were transferred into privately managed funds and an estimated RUR80bn the following year. According to recent projections from the ministry of finance, these funds will rise to RUR100bn by 2006, RUR250bn by 2010 and a massive RUR400bn by 2014.
These projections raise interesting investment questions. Currently second pillar funds can only invest in domestically registered securities, including domestic sovereign bonds (up to 100% with a 35% limit on any single issue), domestic regional and municipal bonds (40% limit), corporate bonds (50%), unit investment funds invested in foreign assets (15% managed by one firm), mortgage-backed securities (40%), foreign currency (20%) and cash deposits (20% with a 10% limit on a single bank).
While the greater amount remains invested in government securities, the pace at which pension assets are set to grow more than outstrips the government’s plans for issuing debt. The ministry of finance expects the surplus of pensions assets over public debt issuance between 2006 and 2014 to total $35bn. The inevitable consequence is that second pillar investment limits have to change, including a significant overseas component.