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Russian pension reform: reloaded

Recently there has been a lot of talk in Russia that the pension reform of 2001, which created the second (funded) pillar, did not bring the expected results. Around 97% of eligible citizens still have not used the opportunity to transfer their second pillar pension savings from the Pension Fund of Russia (PFR) to private asset management companies and non-state pension funds (NSPF). The money of these so-called "silent" citizens does not work in the economy but instead is invested in government securities with returns below inflation.

The two non-funded components (pay-as-you-go and pension insurance) of the pension system keep increasing their payment obligations and are slowly drifting back to the old socialist system where everything depended on the state budget.

Legislatively corporate and personal private pension plans of NSPFs have already been around for 14 years, but citizens at large have not yet learned to make pension savings on their own.

There is no pension system crisis yet, but there are no impressive results either. Multiple problems remain unsolved. Before the State Duma elections at the end of 2007 and the presidential election of 2008 nobody wants to tackle such a serious problem as the pension reform. Effective solutions may have to be highly unpopular and it is very risky to violate the status quo. Now, however, it looks that the "fallen banner" of the Russian pension reform will be picked up and carried forward again.

Who would do this and how? The ‘father' of the Russian funded pension system à la the Swedish model Mikhail Dimtriev was squeezed out of the government and now works as an expert on Russia's trade with China and India. His ideological opponent - ex-head of the PFR Mikhail Zurabov - has become the head of the Ministry of Health and Social Development to which the PFR now reports. He has been far from focused on the development of the ‘out of favour' funded pension principles. One of the recent pension conferences produced a witty analogy that the Russian funded pension system has become a complete ‘orphan'.

It looks, however, that there are new ‘homes' opening up for adoption. One is the Russian Union of Industrialists and Entrepreneurs (RSPP) and, to be exact, Leonid Fedun - vice president of Lukoil oil company and the head of the RSPP's special working group on the development of pension systems. This group, created in May, started to collect and analyse proposals regarding the advancement of the pension reform. In the beginning of October Russia's central Black Sea resort city of Sochi hosted a major high-level pension conference where the RSPP presented a list of concrete proposals.

It is recommended:

q To introduce a flexible retirement age so that people could chose to retire before or after the official threshold;

q To allow the previously ‘disqualified' citizens born between 1953-1966 back into the funded pillar;

q To introduce tax incentives for voluntary pension savings.

The RSPP's goal here is to build a functioning trilateral partnership "state - employer - citizen" each member of which would be interested in and responsible for the formation of future pensions. Leonid Fedun said that "it is necessary to teach people a "saving instinct". All these proposals will be detailed and fine-tuned, and then the head of the RSPP Alexander Shokhin will present them personally to President Putin.

The RSPP is not alone in this game. Understanding that the pension reform will definitely come into the spot light before the elections, Mikhail Zurabov ordered his Ministry to accelerate the work on several new draft pension bills. One law would create better incentives for joining the second pillar. If a citizen contributes 4% of his salary into this system, the government will make a matching contribution equal to 50% of this amount (but not above the general limit of RUB5,100 (€151). To make this work, a citizen would have to file an official application with his employer and the 4% would be transferred monthly into his account with the PFR. Soon this bill will be considered by the government and then by the State Duma. There is a lot of hope but not a lot of confidence that this law would have a real impact - the average population remains extremely inert and cautious in its mentality.

At the same time, the Federal Service for Financial Markets is promoting its own idea of introducing equivalents of American 401k and IRA personal pension plans. Currently they are drafting a concept of the bill but due to numerous legal obstacles (many related laws will have to be amended) this approach may take a very long time.

Also, ex-Prime Minister and current head of the Russian Accounts Chamber (equivalent of the US General Accounting Office) Sergei Stepashin is looking for a shorter route. According to our information, his agency is preparing a letter to President Putin, which would express concern regarding the low returns on pension savings and will contain improvement recommendations. Sergei Stepashin will most likely present this letter to the President during their upcoming personal meeting. Most people of importance clearly believe that only the sitting President can give the necessary impulse to further development of the national pension system (it is true that the credit for political will to start the pension reform in 2001 belongs personally to President Putin).

Are there other alternatives? Our answer is yes. Several interesting projects with a ‘national priority' status are currently growing in Russia: healthcare, education and affordable housing. They are spearheaded by the First Deputy Prime Minister and Russia's top presidential candidate Dmitry Medvedev (the second candidate is Defense Minister Sergey Ivanov).

Just like the pension reform, the affordable housing project is moving very slowly - housing prices in large
cities have climbed sky high. Today a square meter of residential housing in Moscow costs on average $4,000 (€3,196). A regular Russian citizen is utterly unable to pay $200,000-250,000 for an apartment. The existing incentives from the government and the lowering of mortgage rates are not helping much. People are not taking out mortgages because they fear not being able to pay them back at the current level of prices and salaries. The solution is to significantly increase the supply of housing through more investment and more construction. Such investment may come from the pension savings that are currently just a dead weight in the economy.

The idea is to jointly develop the pension reform and the affordable housing project. It would make sense to invest in housing construction the pension money from the State Asset Management Company that currently managers all the savings of the ‘silent' citizens. It might also make sense to stimulate similar investments from the NSPFs. The first successful examples of this business model are already available in Russia's regions.

This August in Khanty-Mansiysk autonomous region (Siberia), for instance, three new apartment blocks were constructed by the joint project of the Region asset management company and Khanty-Mansiysk NSPF. This NSPF created two closed-end mutual funds (ZPIFs) one of which invests in real estate and the other helps refinance mortgages. These funds' current investment portfolios together exceed RUB1,3bn. Khanty-Mansiysk has become the first Russian region to implement this mechanism of using pension savings to finance residential housing construction. The region's governor Alexander Filippenko said: "This gives us an opportunity to solve two critical problems simultaneously: build housing and increase pensions." Although this project was commercially driven, the price of resulting housing was not allowed to exceed 35,000 rubles/m2, which was significantly below the market.

So, this is just the first step - only three apartment buildings or 560 apartments, but already 25% of the total annual residential construction in the city of Surgut! The same approach of using pension money to finance housing was chosen by Peter Pyankov from the city of Perm. With the trust and support of the population he managed to create the first ever independent (ie non-corporate) NSPF with reserves larger than RUB1bn - NSPF Strategy. The pension industry's leading internet resource FundsHub.RU is actively promoting this approach and according to our information another NSPF - NSPF Stalfond of the metallurgical concern Severstal belonging to multibillionaire Alexei Mordashov - is getting ready to invest in construction in Vologda region. We hope that these positive experiences will be noticed and replicated across Russia, eg, in Norilsk, Novosibirsk, St. Petersburg and Moscow.

The accumulated pension reserves are high enough to take part in construction projects. The construction's return on investment even if selling well below the market will dwarf the return on government securities and inflation. The synergy of the pension reform with building affordable housing creates not only an economic but also very large social impact. When the population sees and owns tangible results, it will be more willing to start saving in the second and third pillars.

We hope that these ideas and experiences will be objectively evaluated and incorporated in the proposals of the RSPP, and also noticed by the federal government.

Alexander Kupriyanov, is at Kellogg School of Management, Northwestern University and Vadim Loginov with FundsHub.RU

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