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Russia gets to grip with ailing system

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Russia's government is aware that the pension system needs greater funding and better long-term planning, says James Johnson

Of all the stakeholders in Russian society since the collapse of communism, pensioners have arguably been left worse off than the rest. The welfare system that protected them during the Soviet Union underwent massive reform. The collapse of the Russian financial system in 1998 wiped out many people's life savings. Inflation has forced the price of goods and services upwards for the elderly. Benefit reform attempted earlier this decade by liberal government factions met with fierce social unrest.

Outside observers might have expected the recent stockmarket collapse to have dealt an even greater blow to people's hopes for their retirement. But very few would-be pensioners hold Russian equities directly. Even the Russian government's pooled pension assets have little equity exposure.

The downside was previously that the interest rates earned by the Russian government on most of its assets until now had struggled to keep pace with inflation. The local equity market soared from the late 1990s until the middle of last year, and government bonds could not keep pace with the returns.

The upside is that now equity markets have crashed, Russian government pension funds and others are left with a buying opportunity. With Gazprom trading at between one and two times earnings, for instance, the temptation to put money back into equities is greater.

The government has also recognised that the stockmarket fell so far because it had little long-term support from domestic institutions. When foreign investors withdrew money during the financial crisis and the Russian state closed the national exchanges, it used short-term cash to support the currency that could previously have been invested long term to make the market more stable.

By investing more in equities, the government can help stabilise the financial system as well as winning more money for its elderly citizens. By lending to cash-strapped oligarchs and buying stakes in their companies, it can also ensure the private sector does not slide into chaos.

But the reform is unlikely to stop at asset allocation. The government has seen the pension and financial systems not only require a new type of investment, but larger quantities of funding and better long-term planning. Latest figures from pensionfunds.ru show that at $39bn (€31bn) in the first half of 2008, Russian pension assets per capita are two-fifths those of Kazakhstan, a sixth those of Poland, less than 4% those of Chile and under one hundredth those of the US. Kazakhstan and Poland have been operating with reformed systems for roughly a decade. Russia's received the same treatment in 2002, but without the same general success.

As a result, the government will levy national insurance contributions in addition to ordinary taxation and set up the equivalent of a national insurance scheme to help meet pension liabilities and social security needs more generally. And under the latest proposals, 0.6% of GDP will be paid from the National Welfare fund, one of Russia's two sovereign wealth vehicles, into the state pension fund system each year until 2023. This will help the government meet its pension liabilities.

Just when this will happen is unclear; the intention has been announced but previous experience suggests that Russian government reform deadlines are pretty elastic. However, following a healthy period for the oil price, Russia now looks in a stronger position to do both.

Arkady Dvorkovich, a presidential aide responsible for socioeconomic issues, points to the improvement in Russia's financial position between 1998 and 2008, although in the latest turmoil even more foreign capital flowed out of the country.

"If you look at where Russia was 10 years after the financial crisis, most Russian people were poor in the direct sense of this world, below subsistence level," he says. "We had no foreign exchange reserves; external debt was 150% of GDP. Now GDP has doubled in 10 years and foreign exchange reserves are more than $500bn. The government has financial resources to compensate any change in the oil price. [Even] if oil is below $70 a barrel the budget will be OK for a long time."

He points out the government has to use some of this wealth to address the funding gap in the pension system. "When people born now go to the labour market, there will be fewer problems but there will be a gap of many years in between."

Bob Foresman, deputy chairman of Renaissance Capital, observes that Russia has also been keen to throw money at parents in an effort to improve the country's woeful demographics. "Until recently, the male life expectancy was 57 years," he says. "That's largely because of alcohol, tobacco, diet, medical care, stress and the climate. Russia is trending towards a low population because it has low birth rates. If you have two kids, that's above the average."

One focus of pension reform that has yet to fulfil its potential is encouraging the private sector to play a greater role. As Alexander Lorenz, (pictured right) chairman of the council at the Raiffeisen Pension Fund, observes, the government set up defined contribution accounts for anyone born after 1967. As a result of reform, 21% of the salary of employees born after 1967 is paid into a second pillar fund. But only 12% of the potential workforce chose to join the system .

State financial institution Vneshecon-ombank runs the rest of the assets in a gigantic pool that is invested predominantly in fixed income, with only a little in equities.

A major reason why so little of this money has flowed into the private sector is that fee income has depended solely on the performance of the assets, rather than on the quantity that a pension provider attracts to its books, says Lorenz.

"Although the reform was implemented quite well, one major problem is that we lack private investment in this sector," he says. "In Poland, you had reform and you had massive investment by local and international players in this sector; 5-6% could be taken off any contribution as it came into the account. The problem in Russia is that the fee structure is dependent on returns rather than contributions. You can charge 15% of positive investment income per annum. If the market is not convinced this is a fantastic opportunity, it will not put money into this and convince individuals to outsource." 

There are also ambiguities as to where private pension schemes for individuals are allowed to invest, Lorenz says. "Now 20% of assets can be invested overseas, but there has been no feedback or instructions from the government about precisely how to structure these investments on a practical level."

Lorenz describes Raiffeisen's asset allocation as very conservative: "We have some exposure to stocks and we have invested in property in the past, but mostly it's fixed income, municipal debt, state paper, corporate bonds and bank deposits with highly rated banks." Hedge funds and private equity have not featured on Lorenz's shopping list so far.

However, even before the next round of reform, Lorenz says positive steps have been made to incentivise Russians to invest more of their money for their retirement. "On 1 January 2008, they introduced a tax deduction of up to RUB100,000 [€2,800] for private social security contributions. Then there's co-financing, which means the state will match contributions made by individuals by up to RUB12,000 a year. The pick-up in the market has been quite strong."

But for now, the majority of Raiffeisen's Russian pension business is in corporate pension funds. All the major Russian corporates and multinationals have funds, and the fee situation for asset managers is far more attractive. "With voluntary pensions - retail and corporate - the situation is much better," Lorenz says. "You can charge up to 3% of contributions and participate in the investment income."

However, corporate schemes do not cover the entire population. Russians who do not work for one of their country's industry majors or for a multinational desperately need solutions for their retirement. In the coming years, it remains to be seen whether the private sector, with flexibility and international expertise, will play a part in encouraging Russians to save for an uncertain future. The Russian government, for once, seems to have its petrodollars behind them.

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