The new Russian pension system, based on the Swedish funded system, was launched on 1 January 2002 when the new pension legislation was enacted. Originally, males born before 1952 and females born before 1956, did not get the right to participate in the funded pension pillar. For everyone else, employers began to transfer 2% of pay to the funded pension pillar at the state pension fund of Russia (PFR).
In 2002 more than 33bn rubles (€1bn) was contributed. ‘Vnesheconombank’ 1 was designated to serve as the State Asset Manager (SAM) for the PFR’s reserves. These reserves were temporarily invested in Russian government securities denominated in rubles and hard currencies.
In 2003 the funded pillar was strengthened with new operational mechanisms. For the first time ever the PFR assigned personal data to the individual pension accounts of citizens in its record keeping system.2 Each eligible citizen received his first ‘letter of happiness’ – an envelope containing the information about the size of his personal pension account. In order to cope with this size mailing, the PFR purchased a powerful printing facility and negotiated special arrangements with the Russian postal service, and despite some technical problems the progress of reform was not interrupted.
The same year private asset managers joined the system. In the summer of 2003 the first competition among private asset managers took place, and 55 companies were selected to manage the funded pillar’s pension reserves. In the fourth quarter, the government conducted the first ‘pension elections’ during which eligible Russian citizens could file a petition to transfer their pension savings from the SAM to one of the 55 private asset managers. The savings of people who did not make a choice (the so-called ‘silent’ citizens) automatically remained under the SAM’s management. Private asset managers embarked on their own advertising campaigns, while the government provided little or no help in promoting the reform and explaining its meaning to the population. As a result only 2% of eligible citizens (slightly more than 700,000) transferred to the private system. By the end of 2003 the PFR’s funded portfolio already had more than 100bn rubles.
Investing this money yielded two positive results almost immediately: a very high investment return and a sizable contribution to lowering the country’s public foreign debt.3 The high return was possible because much of the money was invested in Russian Eurobonds, which at that time traded at an enormous discount. Very soon, however, Russia’s economy improved dramatically through positive trends on international energy and commodity markets, which in turn raised the price of the Eurobonds. So, the ‘pure financial result’4 on contributions of 2002-03 was approximately 40%. In other words, the total invested amount increased by 1.4 times during this period. A period of disappointments and pessimism came in 2004. The beginning of the year is marked by a massive government/administrative reform and many of the ‘ideologists’ of the pension reform changed jobs.
At the same time the accelerating tax reform lowered the unified social tax, which provides funding for the PFR (mainly for the pay-as-you-go part of the system). As a result supporters of a more conservative pensions reform path prevailed. Decisions were made to, firstly, exclude everyone born after 1967 from the funded pillar of the pension system, and, secondly, to cancel the originally planned increase in contributions to 6% of the paycheck.
All this provoked a wave of criticism and pessimism.
At the beginning of the second quarter of 2004, the money of those people who had chosen private asset managers was transferred to these companies, and the private investment had began. The list of investment assets allowed for private asset managers is broader than that of the SAM – in addition to government securities they can invest in stock and corporate bonds. Unfortunately, during the first nine months the market performed poorly causing bad investment results across the board, on average below inflation.
The results ranged from 10% to -6% depending on the portfolio and professionalism of a particular asset manager.
Opponents of allowing private asset managers access to the pension savings became very vocal in the media. As a consequence, 2004’s ‘pension elections’ failed. The number of eligible citizens who for the first time selected a private asset manager dwindled by almost 50% compared to 2003 (only 375,000). The only positive development in 2004 was that non-state/private pension funds (NPFs) joined the funded pillar. Now, eligible citizens could chose among 55 private asset managers and more than 80 funds.
By the end of 2004, the funded pillar already had 200bn rubles; out of this amount only 3bn rubles were managed by private companies. At that time parent companies (particularly banks) of some private asset managers and NPFs decided to put the pensions side of their business on hold.
However, 2005 brought positive news. The initiative in executing the pension reform moved to the ministry of finance and the Federal Service for Financial Markets of Russia (FSFM),5 that are run by fairly progressive teams of young pro-market officials. Also, private asset managers demonstrated a dramatic improvement in their investment results (see table 1).
The results of 2005’s ‘pension elections’ are markedly better: this time about 750,000 new petitions were filed. This is twice the number of the previous year and higher than the number of the first ever pension elections of 2003. Today, the total number of citizens whose funded pension savings are managed by the private sector companies is about 1.5m.6
It is important to understand, however, that most of these transfers occurred because a number of large employers strongly encouraged their workers to make a choice. Naturally, corporate and regional funds are leading the pack in terms of the number of attracted votes. Among private asset managers the best election results belong to companies that are owned by large investment groups and banks.
At the start of 2006, Russia’s funded pillar included 55 private asset managers and 99 NPFs. In order to join the system they have to meet a number of official criteria. Private asset managers also have to go competition.
The current 55 companies were selected in 2003 and received the right to sign five-year agreements with the PFR. In 2004 and 2005 there were no new asset managers willing to join the system, and therefore the competitions did not take place. And NPF’s joining procedure is easier. If a fund meets the required criteria, all it has to do is to file a request with the FSFM. In this category there are many willing entrants and their number is constantly growing.
There is one principal difference in the way pension savings are accounted for during transfer to private asset managers and to NPFs. When a citizen chooses a private asset manager, his savings are transferred there anonymously, ie, the company receives a lump sum transfer from the PFR not knowing whose savings constitute this lump sum. In contrast, when a citizen chooses a non-state pension fund, he does not only have to file a petition, but also sign an agreement with a particular fund regarding the transfer and management of his pension savings.
Any eligible citizen can make a new choice (or change their previous choice) once a year during a three-month period.
Below is a summary of the 2005 pension elections results: 730,000 new petitions were filed, of which 600,000 people chose to transfer their pension savings to private pension funds (NPFs) and 130,000 to private asset managers. The highest number of votes went to large corporate pension funds: roughly 160,000 people chose NPF Blagosostoyaniye (affiliated with transportation giant JSC Russian Railways), 100,000 chose NPF Lukoil-Garant (affiliated with oil company Lukoil), 50,000 chose NPF Elektroenergetiki (affiliated with RAO UES of Russia). Among asset managers, Rosbank’s subsidiary (affiliated with Vladimir Potanin’s Interros holding) is expected to have the best result – about 40,000 votes.
As instructed by citizens’ petitions the PFR transfers their savings to the selected private asset managers or NPFs, which then do the investment.
Notice that NPFs do not invest these reserves directly, but through agreements with private asset managers. In other words, the savings attracted from individual citizens by NPFs also end up under the management of private asset managers. Many asset managers understood this situation and now prefer to spend their advertising budgets on targeting particular funds instead of individual citizens. The market of managing the funded pension pillar reserves remains extremely attractive due to its high growth potential.
Today the funded pillar incorporates about 54.6m accounts of insured citizens7 (although 40-year-olds have only three years worth of savings: 2002-2004). It has almost 300bn rubles and is forecast to reach 1.8trn rubles by 2012, with annual contributions of about 400bn rubles – in seven years the funded pillar is expected to grow six-fold in terms of absolute monetary value.
Now the funded pillar equals 1.7% of the GDP. Even if the goal of doubling the GDP within 10 years is achieved, by 2012 the funded pillar will constitute 7.5%. Will the government be able to use such a powerful investment resource effectively, ensure high investment results and security without distorting the financial markets?
This remains to be seen. Do not forget that today private asset managers and pension funds have only about 6bn rubles of the funded pillar reserves under their management. The rest is in the hands of the state asset management company, Vnesheconombank, which invests mainly in ruble-denominated government securities. Now, however, the federal budget has practically no need for and is well balanced without borrowed funds.
The forecast growth rate of the funded pillar reserves is considerably higher than the planned growth rate of the Russian national debt, therefore the market of government securities will soon be too small to accommodate the savings of all ‘silent’ citizens. Besides, investment returns on government securities have dropped dramatically.
Thus, if the list of assets allowed for the investment of silent citizens’ savings is not broadened today, investors will face dire consequences tomorrow.
In order to liberalise this market the Russian government is planning to amend the law on investment of pension reserves. It is proposed to broaden the list of assets permitted for the investment of pension reserves and eliminate the monopoly of Vnesheconombank, which is currently the only asset management company investing the money of silent citizens.
One promising investment asset is mortgage-backed securities. However, due to flawed legislation this type of securities has not yet developed in Russia.
It is also proposed to invest pension reserves in various infrastructure development projects through bonds issued by development banks. – in this respect Russia is paying close attention to the experience of Kazakhstan.
A discussion is under way about the possibility of investing the silent citizens’ pension savings into Russian and foreign corporate bonds and stocks. Legally, private asset managers (unlike Vnesheconombank) are already allowed to invest in foreign assets, but the government has temporarily limited their ability to do so in practice. It is hard to promote the idea of investing in foreign assets due to the demagogy of certain politicians who oppose “financing foreign economies with Russian money”. But there is a more balanced and constructive view of this matter among state financial officials.
Investing everything in the Russian market alone is, of course, limited by fears of an asset bubble and monopolisation of the market by the pension reserves. As a consequence, some experts suggest allowing private asset managers to manage the silent citizens’ savings.8 How to achieve it technically speaking remains a question – most likely special competitions will be conducted to select managers for certain mandates (amounts of money with specified investment criteria). Some argue that these mandates should relate to various market segments (eg, only stock, only bonds, etc.); others insist that each mandate should be diversified into several groups of assets.
Supposedly there will be no limit to the number of asset managers that can compete for the money of silent citizens.
At the same time, there will be strict requirements regarding an asset manager’s portfolio size and experience of working in the market of pension reserves.
The government also wants to boost the citizens’ interest toward pension savings. A bill on voluntary funded pension pillar has been drafted. Its authors believe that it will be important for those who are currently excluded from the mandatory funded pillar. According to this bill, citizens will be offered to contribute 4% of their salary into this voluntary system while the state will provide a matching contribution.
Today, it is fair to conclude that the Russian pension system is not stagnating, and that its funded pillar is developing and growing. In future issues of IPE, we will discuss the development of Russia’s private pension funds in terms of voluntary savings, and also the growth of the asset management industry where investment portfolios and professionalism are reaching new heights.
Alexander Kupriyanov and Vadim Loginov, FundsHub.Ru
1 A large state-owned financial institution/bank.
2 The breakdown of new pension contributions by individual accounts for a particular calendar year always takes place in the first quarter of the next year after employers report all personalised data to the PFR. For example, the contributions made during 2002 were broken down by individual accounts only in the beginning of 2003.
3 Through investing this money in government securities a significant part of foreign public debt was converted into domestic debt.
4 A term created by the government to designate return on investment of all contributions made in 2002 and 2003 as if they were made as a lump sum and not as regular installments over time.
5 Formerly known as the Federal Commission for Securities Market.
6 Adjusted for the number of petitions filed to switch among private asset managers, among NPFs, or between private asset managers and NPFs.
7 The pension system is officially called ‘the system of pension insurance’.
8 The idea is that involving multiple asset managers will (a) disperse investment decision-making among many different players and (b) ensure investment of pension savings into a broader group of assets (including securities issued by 2nd and 3rd tier companies).