Radical pension reform is underway in Russia designed to stave off a potential future funding crisis and which will trigger the investment of billions of dollars into the country’s debt and equity markets.
The reforms will gradually replace the current ‘pay-as-you-go’ scheme with a mainly funded contribution system in which individuals save on personal accounts.
The changes will also stimulate competition in the financial industry because from 2004, workers can choose who invests their money between designated asset management companies and the current state monopoly, the Russian Pension Fund (RPF).
The need for reform is urgent, though not yet critical. In stark contrast to other European countries, Russia’s male life expectancy has dropped to 57 during the last decade.
That has eased the immediate pressure on the pension fund; as one morbid commentator noted recently, ‘dead men don’t collect pensions’ and in 2001 the RPF ran a surplus of $3.67bn (E3.4bn). But finances are set to worsen.
“Russia has an army of pensioners from the soviet era but the real demographic problem is that the birth rate has collapsed and that mortality rates are rising among people of working age so the number of contributors is declining,” says Matthias Zeeb of Callund Consulting which has advised on the reforms.
It’s not just the mathematics that are unsustainable; pensions are simply too small. Once promised life-long support by the Communist welfare state, most pensioners now eke out a grim existence on monthly payments of $50, $10 less than the government’s own official poverty level.
And life is set to get even more difficult. Inflation is running at 15% a year in Russia and vital economic reforms underway will see household bills for housing and energy rise even faster in coming years. In response the government was forced to raise payments by 32% last year and in January this year it announced a further 6% rise for the first half of 2003.
Pensions in Russia are funded directly from the state budget and by a 35.6% payroll tax, the Unified Social Tax, paid by employers. Of that tax revenue, 28% is used to pay pensions, the rest to fund other social services. Half goes directly to the state budget to cover the basic flat rate pension payments that everybody will continue to receive under the new system.
Out of the remaining 14%, which is paid to the PFR, some finances an ‘insured labour pension component’, a continued form of pay-as you-go provision where the pension amount is calculated using a system of ‘notional defined contributions’.
Most significantly however is that the balance of this 14% is now being paid directly into new individual saving accounts to prepare for the introduction of a funded labour pension component to the system for the first time in 2004.
This is pay-as-you-go, too, in the sense that today’s contributions pay for today’s pensions. However, the ‘notional defined contribution character’ means that the pension amount is calculated in a particular way. All contributions are recorded in individual accounts and revalued each year with a notional rate of return. This notional rate of return is the lower of either the growth rate of the national average salary or the growth rate of the ratio of revenues for the insured component received by the PFR to the number of pensioners. This should guarantee that even when the demographic situation turns really difficult the PFR finances are not overburdened.
The effect of all this is that on retirement an individual has a certain notional pension capital recorded in their account – notional because there are no assets to back it. This capital is then divided by a factor that relates to the average life expectancy at retirement, which gives you the monthly pension amount. In effect, this component is a pay-as-you-go (‘social insurance’) system that uses some of the logic of a funded system to determine who gets how much in eventual pay outs.
The accumulation of capital for this funded component began in 2002 when the government allocated every worker in Russia, (except those with less than five years to retirement), some 57m people, individual saving accounts, currently held by the PFR.
The division of the 14% paid between the two components (funded or insurance) depends on an individual’s age and sex; the younger the worker the greater the proportion of the tax that will be directed to the funded component reaching a maximum of 6% by 2006.
The next significant stage of reform begins in 2004 when every account holder will be given the choice to opt out of the PFR and have these funds managed by one of a number of mandated private asset management companies.
As yet, no private asset managers have been appointed but the Russian State Pension Board must mandate at least three companies to invest these funds before July.
Anyone not satisfied with the performance of their fund can switch to another provider. Those who fail to nominate a manager will have their pension accounts automatically allocated to the least risky fund, invested in cash deposits and government debt.
Still to be hammered out is how to fund the early retirement. Still defined in long soviet era classification lists, hundreds of thousands of workers from miners to public transport drivers are entitled to end their working careers early.
Proposals to require employers to make mandatory pension contributions to fund bridging pensions until normal pension payments kick in have been rejected by employers, particularly those in the most hazardous industries where workers can retire as much as 15 years early, as too costly.
All this is good news for Russia’s debt and equity markets and asset managers in Moscow are looking forward to significant new capital inflows that the reform will stimulate with enormous interest.
“Some $6bn will have been collected by the end of 2003,” believes Adam Payne, vice president of sales and marketing at Moscow based at Troika Dialog bank. “If 10% of account holders opt out from the PFR fund during the first year as we expect that means an extra $600m will come under private management in 2004.”
The fund management companies eventually chosen will either be paid a management fee of up to 0.9% of the value of the fund value or a performance fee of as much as 10%, the exact details being negotiated individually.
Recent Russian media reports suggest the Federal Securities Commission plans to allow a generous 80% of the value of pensions to be invested in equities, though in the immediate future it is likely that most would be channelled into more stable sovereign and corporate bonds.
That will give the stock market, currently capitalised at just $17-20bn, a welcome liquidity boost but it also raises the risks of an asset price bubble. Without new equity issues to broaden the pool of assets to invest in, it may lead to increased volatility and risky overpricing.
The eventual success of the reforms is still not certain. Ahead lies a critical transition phase and finance-squeeze that will last as long as 20 years as revenues that previously paid for the pay-as-you-go system are siphoned off to the funded accounts.
The first funded pension payments will be made in 2012 and any deficits in the system before then will be met by direct subsidies from the state budget. That poses little problem in the immediate future; Russia has enjoyed impressive budget surpluses in recent years thanks to high global energy prices. But there’s no guarantee how long that will last.
The future role of the Russian Pension Fund is also unclear. While it will remain responsible for actually paying pensions its participation in managing a significant proportion of funds in the long-term will depend on the success of the other asset management funds at attracting and keeping clients.
That process is likely to take some time and distribution and education will remain the two biggest hurdles for those funds.
“I do not expect significant changes over the next two to three years,” says Florian Fenner, chief financial analyst for United Financial Group (UFG) in Moscow. “After all, let’s face it, a Russian steel worker is going to do whatever his director is telling him.”
Russian authorities are also operating in the dark without detailed demographic information or financial modelling which makes it impossible to predict how the finances will develop in the future.
Though a database established in 1997 has now registered everyone in the pension system, masses of personal information remains unconsolidated across Russia’s vast 89 regions and tracking the population will prove enormously difficult. The situation however is improving. “Things are being done and I don’t think the government can be criticised too severely,” says Zeeb of Callund Consulting. “The soviet system where pensions were calculated locally made sense under a system where no one had to worry about where the money came from.
“Given the difficulties they face in changing the administrative procedures in such an enormous territory I think they are doing quite well.”