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Spring brings new life to reform debate

While in the shadows of the Russian capital’s large apartment blocks last winter’s enormous amounts of snow slowly dwindle, the Muscovites take to the streets. Either in support of the beleaguered NTV television channel or to enjoy the first warm and sunny days of spring. Against events like these, news about the latest turn of the country’s long and winding road to pension reform will only rarely make it into the headlines. And yet, observers and practitioners alike watch developments with an emotional interest appropriate for the season – this time it may just be for real!
In his state of the nation address in the beginning of April, President Vladimir Putin highlighted yet again the weaknesses of Russia’s existing pension system. For too many pensioners the benefits are low and not sufficient to survive on. For the working population there is no incentive to disclose the full amount of their incomes. The rules and the reality of the system suggest that whatever the individual contributions paid, pension expectations can only be low.
On the fiscal side, the government has made some progress to remedy this situation. The introduction of a 13% flat rate income tax and the unified social tax with a regressive tariff structure peaking at 36.5% has brought down the tax burden as of January 2001. At the same time, the PFR and the other off-budget social security funds lost the responsibility to collect their own contributions. The new unified social tax is collected by the Tax Office.
As for the reform of the pension system proper, two different positions gained some prominence in the discussion, publicly represented by the first deputy minister of the economy, Mikhail Dmitriev, and the chairman of the Pension Fund of the Russian Federation (PFR), Mikhail Zurabov. The ministry seemed to focus on the macroeconomic impact of the pension system, aiming to keep the present and future burden on the economy under control. It stressed the likely positive effects on capital markets of the introduction of funded elements into the pension system, and the necessity to involve private actors in the management of a provident fund type arrangement. Perhaps not surprisingly, with an eye to keeping its own central position in the workings of the pension system, the PFR suggested that its database of contributor records, built up over the past five years, be used to administer truly individual accounts of a new funded element, which should be very close to the PFR organisationally. It argued that public opinion was in favour of strong state involvement in the provision of pensions.
To help the reform discussion and its eventual outcome gain public legitimacy, Putin established the National Council on Pension Reform. It comprises government ministers, the governors of some of Russia’s 89 regions, parliamentarians, trade union and industry representatives. In its first meeting on March 19, the council discussed what had emerged as the government position.
The proposals foresee a flat rate basic pension financed through a 14% social tax rate. This base amount would be topped up by an individual labour pension calculated in accordance with lifetime contributions as recorded in a notional account. Current workers’ accounts would be credited with an initial balance to recognise rights accrued under the old pension system. A second 14% contribution rate would be split between these personal notional accounts and fully funded accounts to which contributions may be as low as 2% initially.
Many details of the proposals still need to be clarified. However, what has emerged so far has positive sides and very weak points, too. The intended strong link between contributions and future pensions is a positive development, and should be a further incentive to declare incomes. In a country where it is not unusual for companies to declare as little as 10% of an employee’s earnings, this would help to improve the financial position of the PFR and to cover the shortfall caused by the diversion of part of the contributions into the funded accounts. As yet, the formulae suggested for the accumulation and conversion of the notional account balances do not explicitly take into account the foreseeable demographic impact on the pay-as-you-go system. Setting out rules or principles early, would help to create discipline and transparency.
The creation of a funded pillar will improve pension security by spreading the risk associated with Russia’s difficult demographic situation. Over time, pensions from the funded system should reach levels that will also allow the PFR to reduce the benefits from the paygo-system once the size of the working population begins to shrink dramatically. To achieve this, it may be wise to quickly increase the share of the contribution rate destined for the funded element as 2% may neither be efficient nor sufficiently effective.
The real challenge however, will not be in the design of the new system but in the management of its introduction. Russia’s capital markets are still fragile, the standards of corporate governance low and the protection of shareholder rights weak. The institutions for regulation and supervision of the funded system will have to be built up quickly and be given the necessary powers. Expanding the PFR’s recording system to cope with tracking individual contributions and assets will be a huge task.
And this vast country’s diversity is a challenge in itself. The new pension system must be better fitted to the big economic variance between the different regions. Today, in economically strong regions like Moscow or the affluent Siberian oil and mining towns with a high cost of living, the PFR’s pensions are not enough to survive, while in 39 regions the average pension is actually higher than the average salary.
But as the soothing spring sun suggests, this time it may well happen!
Matthias Zeeb is with Callund Consulting

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