Russian pension reform goes on
As the main achievement, the new three-pillar system incorporating the mandatory funded pillar was launched in 1 January 2002. Now 2% out of 28% of pension contributions calculated from the payroll are used for investment purposes. In 2002, all contributions to the funded system go to the public Pension Fund of Russia (PFR). Over the first four months, the PFR received nearly Rb11bn* in contributions (this amount is expected to reach nearly E1.7bn over the year).
Meanwhile, the pension asset investment law only passed the first reading at the State Duma. The discussion was how to ensure efficiency and security of investment, only to delay preparation of amendments for the second reading which was successfully completed last month, with the third reading due as IPE went to press. It is worth remembering the basic idea of the funded pension system built into this law.
In 2002 funding contributions will be received by the PFR, to be collectively invested into eligible instruments. Before 1 July 2003 the PFR will distribute accumulations by individual accounts while account holders will receive statements of account and blank applications to choose between the PFR and one of several asset managers selected in advance on a tender basis. Thus, individuals can choose a private asset manager offering an investment portfolio different from the PFR strategies. Industry experts believe that the share of ‘enterprising’ individuals will be approximately 15%. Many would like to maintain a status quo while others will not be able to make a choice between different companies and their investment strategies. Therefore, the number of ‘defaults’ who simply will not respond is expected to be larger. These resources will follow an auxiliary path of investment via a special authorised (most likely public) asset manager.
The PFR made its first investment in April this year. Since the investment law had not yet been discussed, the government issued a special ordinance which established a provisional investment procedure for the maximum period of six months until the law was adopted. Under the provisional procedure, pension assets could be invested into government securities of Russia denominated in roubles and foreign currencies, including Russian eurobonds.
As of the end of first quarter of 2002, the Pension Fund reported Rb7bn (E233m) of funded pensions in its accounts with the Treasury (Rb0.2bn in January, Rb3.2bn in February and Rb3.6bn in March). As we reported, PFR was looking for investments and specific plans were not disclosed until the first investments were made on April 3. The Pension Fund invested Rb3bn into fixed coupon federal bonds (OFZ) of two series (27,014 and 27,015) with average return of 17.28% (for ruble-denominated bonds). Bonds were purchased at the auction. These issues were additionally placed by the Ministry of Finance. Moreover, apart from the Pension Fund, there were very few participants in the auction, and return turned out to be high. With a view to forecasted inflation, this would mean approximately 2–2.5% above the annual inflation rate.
However, some experts discovered a negative side in the 17% return on government securities. They believe, firstly, that this high interest will be compensated by taxpayers anyway. Secondly, that the high interest rate and growing amount of investment into the public debt are both dangerous and irrelevant for the country.
As a result, PFR will probably continue investing into rouble-denominated securities. This is something that will require a change in the public borrowing plan since the Ministry of Finance planned to borrow Rb38bn over the next five months. The return is likely to decline. It is possible that PFR will purchase dollar-denominated securities (domestic bonds denominated in dollars or eurobonds). Other categories of assets are not available to the Pension Fund until the pension asset investment law is passed.
The pension reform stakeholders believe that investments into shares and corporate bonds will become a reality as asset managers join the system next year followed by private pension funds (PPF) in 2004. Then individuals will be able to choose not only an asset manager but also transfer their pension assets to PPFs. The focal point of discussion around the investment law was precisely the arrangements for participation of PPFs in the system. As a result of these discussions, it was decided to describe these arrangements not in this law but in the form of amendments to the effective PPF law.
The text of amendments to the Law of Private Pension Funds (PPF) is subject to heated debates in the pension community. The government submitted its version of these amendments to the State Duma at the beginning of June for further consideration. The old law of private pension funds will be almost completely changed, with up to 80% of old provisions to be amended. Below we provide some of the possible changes to the law.
According to the amendments, there will be new licensing requirements for PPFs: in order to be registered, PPFs will be required to have the minimum authorised capital of Rb3m (as compared to the current Rb1.5m) while starting from 2005 this requirement will be increased to Rb30m.
Licensed funds may be accredited for operations under mandatory pension insurance. For this, funds will have to comply with a number of tougher requirements: minimum relevant business experience of five years, payment of pension during at least one year, simultaneous maintenance of more than 5,000 nominal accounts for more than one year, absence of actuarial deficit for more than three years. In addition, funds will have to comply with requirements relating to the value of authorised capital and pension assets.
Amendments make a distinction between pension assets and pension accumulations. The former are raised by PPFs under private pension insurance and the latter under mandatory pension insurance. This distinction requirement means that PPFs will essentially have to set up ‘a fund within a fund’ to account for individuals insured under the public system. Moreover, the amendments require that pension accumulations should be placed only under trust management contracts with asset managers selected on a basis of tender for placement of pension assets of the public fund.
The discussion of possible participation of PPFs in the mandatory pension system attracted more attention to funds themselves. The question was whether they were better or worse than the public pension fund. A poll conducted by PensionLine.ru to discuss whether PPFs could be more competitive than the PFR showed the following result: reliability = 22%, yield = 19%, transparency = 44%, and quality of service = 15%. Thus, the main issue is on transparency.
Meanwhile, the PPF inspection agency published data on investments made by PPFs as of the end of the first quarter of 2002. This resulted in a scandal when it showed that a number of pension funds violated required investment ratios (limits) and enjoyed special permissions of the inspectorate. Let us dwell upon the published data in more detail since they can partially show to what extent PPFs are profitable and transparent. PPFs place their pension assets as defined by the government and the PPF inspection agency. Under this procedure, they arrange their investment portfolio on the basis of the following guidelines: maximum 20% per single investment, maximum 20% for unquoted securities, maximum 30% for securities issued by PPF founders and depositors, maximum 50% for federal securities and securities issued by constituent territories, maximum 50% for company shares and bonds, maximum 50% for bills, bank deposits and real estate. Moreover, PPFs may refer to the PPF inspectorate for a permission to use a different procedure of investment. Approximately 10% of funds operating in the market enjoyed this permission.
Indicators reported by the majority of PPFs revealed non-compliance with investment principles such as diversification of risk and higher security of investment. A number of funds invested up to 100% of assets into one class. Some PPFs overburdened their portfolio with government securities, others invested their assets into bank deposits while the third used bills (by the way, this class of assets was not even included into the list of eligible instruments for investing mandatory pension accumulations). Private funds were also violating the ratios of investment into shares. Moreover, they often failed to diversify them by issuers and would prefer shares of the parent corporation.
In the last year, Russian PPF assets doubled from Rb17.5bn to Rb34bn which is 94% growth. However, this growth is attributable to just Gazfond which later last year revalued its holdings of approximately 5% of Gazprom shares purchased in 1996. This resulted in Gazfond assets growing Rb11.5bn (from Rb8.5bn to Rb20bn) in the fourth quarter of 2001 (about 60% market share).
According to statistics, up to 90% of pension assets were invested into short-term instruments maturing in less than one year. Some PPFs, far from waiting until bonds they purchased were repaid, engaged in speculation. But active operations do not significantly affect profitability. In 2001 this figure fell to 5.2%. Leaving aside non-operating PPFs, the average yield is only a little more than 18%. It means that PPFs failed even to compensate for inflation which amounted to 18.6% last year.
But even if PPFs achieve equality in terms of legislative provisions for their operations within the mandatory funded pension system, they will not necessarily become more competitive as compared to the Pension Fund of Russia and private asset managers. We believe that in the short term, the funded pension system is unlikely to attract more contributions to private pension funds without efforts on their part to improve marketing, investment, accounting and payment systems. Industry experts believe that nearly 15% of individuals will transfer their accumulations from the Pension Fund of Russia to asset managers during the first three years (2003–05). We believe that only 20% out of these 15% (or only 3% of the total amount of approximately $4bn (E4.1bn)) will transfer their accumulations to PPFs. This will make up $120m. This amount could probably be increased two to three times through ‘administrative marketing’ of corporate and regional pension funds. Anyway, we believe that PPF representatives dream of other figures. If so, they should work on improvements right now.
We coined the term ‘Russia’s new pension industry’ to identify new trends and designate those agents and processes that are emerging in the Russian financial market in relation to the pension reform.
Private pension funds have been existing in Russia since 1991, their number reaching 1,000 by 1993. As tougher requirements were introduced, the PPF community shrank to 270 in the first quarter of this year. PPFs use the services of asset managers and specialised depositaries (since last year). Many things are now expected to change as the market is on the verge of new segmentation caused by new possibilities and new requirements.
Mikhail Dmitriev, deputy minister of economic development, declared that 90% of the existing PPFs might as well be closed. He believes that a vast majority of Russian PPFs fall short of international requirements and need to be additionally licensed before they are allowed to invest the funded part of public pensions. This declaration offended some PPF managers (“We don’t care for these standards, we live in Russia,” said the head of a large PPF). But most industry experts are more realistic and believe that Russian PPFs need to be improved along a number of parameters. Discussions of what might be the form of access of PPFs to this market still continue.
PPFs themselves have started to reorganise. Towards the end of last year and into the early part of this, a number of large domestic and international banks started the process of registration and acquisition of PPFs. While some prefer to do it secretly, others rush to announce their intentions in the press.
The Siberian Aluminium Group announced its first and at the same time major merger of PPFs. PPF “GAZ” (Nizhni Novgorod) ranks 11th by the amount of its pension reserves (Rb335.4m), “Socium” (Moscow) 42nd (Rb46.1m), “KGES-Penfo” (Krasnoyarsk Region) – 59th (Rb30.1m) and “Energia” (Irkutsk Region) – 151st (Rb2.5m). The consolidated assets of the four funds covering 213.000 participants are expected to exceed Rb1bn. This consolidated fund will rank seventh among Russia’s PPFs by the amount of pension reserves. Pension fund representatives believe consolidation of PPFs to be the major trend of the year. The procedure of fund reorganisation is currently under consideration with the PPF inspection office under the Ministry of Labour. If everything goes smoothly, the first consolidated NPF will be registered in June.
The market of asset managers (48 companies are currently licensed by the Federal Securities Commission to manage assets of investment, unit investment and pension funds in Russia) is also pension-biased. Under the reform project it was envisaged that asset managing companies should undertake public pension assets from 1 July 2003. The selection procedure details are yet to be discussed and approved but the potential range of participants could be considered now.
From this forecast scenario, the pension reform developments should eventually lead to final adoption of the investment law by the State Duma and endorsement by the President this summer. Discussion of details of the PPF law will continue. Another point of discussion will be the arrangements for launching the occupational pension system on 1 January 2003.
On 20 May, Prime Minister Mikhail Kasianov sent a letter to the State Duma specifying a list of 31 draft laws (including ‘pension’ drafts) which the government asked the Duma to approve before the end of the spring session in July. The list includes the pension asset investment law (meaning a request for both the second and the third reading). The set of draft laws for the first reading includes the draft law on mandatory occupational pension systems and insurance contributions for financing these systems (already submitted by the government) and the law on private pension funds (approved by the government and officially submitted to the State Duma in June).
Thus, the new pension system is operating, with details to be further refined along the way. One can be certain that by next year Russia’s pension industry will be actively transformed and during the year adapted to new progressive mechanisms.
Vadim Loginov is a pension reform expert based in Moscow