One could hardly have imagined that such a complex issue as reform of the pension system, which has been discussed in Russia since 1995 and failed to be launched three times, would proceed at such an incredible pace in 2001, with practical operation of the new system expected already in 2002. The working concepts and legislative framework of the new system of public pensions were developed over a year, backed by President Putin’s political will and supported by intense government efforts employing extensive expertise from the international and domestic expert community and private sector.
Pay-as-you-go (PAYG) is to be replaced by a combined option including, apart from the old PAYG pillar, a differentiated notional funded system and a second pillar. Moreover, the second pillar will incorporate both the funded public system and occupational pensions, with pension assets of the second pillar to be invested in financial markets with the participation of private financial entities. Different classes of assets and types of private entities will be integrated into the system in line with the time schedule.
A line of argument often heard before the start of pension reform in Russia argued that funded principles could not be implemented because of the weaknesses of domestic financial markets – lack of financial instruments, unreliable market institutions, low market capacity etc. In their turn the reform advocates argued that these were the reasons to undertake the reform (just like demographic problems and low efficiency of the old system) rather than to delay it. As, according to market theory, demand results in supply, so, vice versa, supply may bring about demand. Emergence in the market of a sizeable long-term passive portfolio pension capital is a powerful incentive for development of financial markets in a variety of directions, which is badly needed for economic growth.
This will also result in the general stabilisation of markets in terms of price volatility, liquidity, level of yield and risks. It will encourage certain categories of investors (including private investments and international capital) to seek more stable markets in parallel with pension assets. There may be other factors too, but we will focus on two.
q First, it is the influence of various classes of financial assets on markets.
q Second, the influence on the activities of market participants.
Calculations show that receipts of the funded pillar in 2002 will amount to approximately e1.2bn. Before 2012, when first benefits from the funded pillar are envisaged, total assets of the funded pillar will amount to approximately e30bn–35bn, as adjusted for growth of annual contributions, plus contributions to occupational pension schemes (rates are under discussion but the figures will be comparable). For the Russian capital market these figures are fairly impressive, with a variety of expert assessments around. Pessimists argue that with the current lack of quality instruments the stock market will be overheated because of its inadequate capacity. Optimists envisage a positive scenario due to the incremental growth of these assets and the current situation in the markets.
Let us discuss these forecasts. Classes of assets that are expected to be eligible for investment include government securities, securities of constituent members of the federation, corporate shares and bonds, real estate collateralised (mortgage) bonds, and international shares and bonds (maximum 20% of the total assets). In the first year of ‘transition’ investments will be made primarily into short-maturity rouble-denominated government bonds, with a wider range of instruments to be made available from 2003 onward. Undoubtedly, government securities will account for a sizeable share of the portfolio, but it is expected that they will be long-term maturity bonds including those denominated in foreign currencies (and, possibly, Russian eurobonds). As a matter of reference, the market of Russian government bonds amounts to approximately e40bn (external debt) and e8bn (domestic debt).
Considerable hopes are pinned on the corporate bond market, which is relatively small today (up to e3bn). The veksel (IOU) market is more developed (up to e40bn), as companies find it simpler and cheaper to issue IOUs. But in 2002 it is envisaged to abolish the emission charge, something which together with inflow of pension assets can encourage corporations to issue bonds (it is forbidden to invest pension assets in IOUs).
Shares are more problematic. Undoubtedly, they are needed for the portfolio to ensure a better yield. But pros and cons are yet too many. The current market capitalisation is approximately e70bn, with 500 tradable shares. Many analysts believe it to be undervalued and point out the possibility of implementing a ‘potential yield’. But since it is expected that pension assets will be invested in shares that comply with certain criteria (the corporate governance rating is proposed as a criteria, possibly, for the first time ever, with a pilot project managed by Standard & Poor’s already under way in Russia), there may simply be a shortage of ‘blue chips’. Nobody will be anxious to purchase them at higher prices. Actually, it is a case for investment into shares of international companies. Many argue that investments abroad are needed to diversify risks of the portfolio. But they can also serve as a ‘valve’ to reduce pressure on domestic markets, once they cannot cope with the inflow of money.
A class of securities tied to real estate is regarded as promising. While this market is quite young in Russia, it is expected that the pension reform will provide a considerable incentive for its development.
Thus, we have a situation that could see a certain amount of competition between classes of instruments for pension assets. However, competition between financial organisations is expected to be just as tough. First, the pension reform envisages consistent and extensive involvement of the private sector, including asset managers, non-government pension funds, insurance companies, banks, depositaries, rating agencies and consultants.
Private asset managers will handle public pension assets from 1 July 2003. By this time the government will have arranged a specific tender to select five or more asset managers that will propose their investment strategies to place these assets. Then a future pension beneficiary may choose to transfer his pension assets from the pension fund to a particular asset manager. There are 40 companies (the ‘oldest’ has been in operation for five years) specifically licensed by the Federal Securities Commission to manage the assets of investment, mutual and pension funds. These are essentially small companies, with active operations performed by only a half of them.
Russian investment groups with developed businesses, which include asset management, and have been operational for 10 years, hold strong positions. The top five include Troika Dialog, Aton, Nikoil and UFG, possibly complemented by Alfa-Group. Several active companies operate on the regional level.
International players are also interesting. World branded companies managing mutual and pension funds with a presence in the Russian market include State Street Global Advisors (Pallada Asset Management) and Franklin-Templeton, which has been operating local asset managers since 1996. Credit Suisse had a local asset management company until last year but the business has been passed over to Pioneer, with CS retaining for itself only a bank and custody operations. The joint venture of Fleming and Guta Bank of Russia has an asset manager but it has not been active so far. Dresdner Bank recently set up an operating asset manager with Deutsche Investment Trust (DIT). In principle, a number of other international banks and investment bankers have a presence in Russia, with some having only a representative office and others developing business (banking, brokerage, corporate finance, insurance) including asset management – though in sectors other than pensions.
Of those yet to come, some large companies are on the horizon, with a view to possible access to the pension market. The situation is likely to develop quite dramatically but we believe that only five to six international companies will offer a competitive edge over the next two to three years. Others will simply be unable to catch up, as there will be little time left to set up a local company and the low availability of local staff for specific pension operations. A possible option may be to purchase already operational domestic companies (including regional), or joint market expansion supported by a local partner. Non-resident international companies may also look into a possibility of winning the tender to manage the international assets of the pension fund.
Understandably, asset managers will actively seek a share of the market for pension asset management. In combination with a need to propose financial instruments of adequate quality this will encourage generally more intensive, dynamic and stabilising development of the financial market in Russia and of the pension industry in particular. Once it is achieved, the exponents of the pension reform will be in a position to assert that, apart from the social objectives, they have managed to contribute to the development of the domestic financial market.
Vadim Loginov is a Moscow-based pensions and investment expert.