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The Actuary The magazine of the Institute & Faculty of Actuaries

Russia’s pensions reform loses time

T he Russian government has just passed a ruling delaying the implementation of the latest part of its ambitious pension reforms. The issue? Less than two million of the 40m required benefit statements had been produced by the deadline. The only real surprise is that the government had been insisting as recently as the previous month that things would run to schedule. This was despite the latest World Bank economic report prepared for the Russian government, which highlighted concerns about sustainability and the capacity of Russia’s financial markets and social security administrative systems.
Progress has, however, been made. The majority of the framework legislation is now in place, although many of the details are still to be fleshed out. This article discusses the background to the reforms and why they were needed, the fundamental changes that are happening, and the changes that are still needed if the reforms are to succeed.

Traditional pension provision
The Russian Federation, with a population of some 145m people, spans ten time zones covering 89 member states, each with its own legislature and budget. Each state has its own industry, climate, and culture. Yet, despite this diversity, pension provision has been the same for all, with normal retirement ages of 60 for men and 55 for women and a target pension of 75% of earnings. A full pension is payable after 20 or 25 years of service, which can include periods of higher education, military service, and maternity leave.
Under the communist regime, it was illegal to be unemployed. Pensions delivered post-retirement living standards matching those pre-retirement. Post-communist Russia in the early to mid-1990s tried the sink-or-swim approach to transition to a free market economy. It hit a rock in 1998 with the government debt payment default. The resulting hyperinflation led, in many cases, to a total loss of savings and the population’s mistrust of both state and private financial institutions. This is stalling the growth of Russia’s economy, as there is currently very little private investment. Income (in roubles) is routinely converted to dollars and stored under the bed rather than in banks. Russia is in fact the world’s second-largest dollar economy.
Hyperinflation caused a swift and dramatic erosion in the purchasing power of pensions. Many pensioners suddenly found themselves with incomes below subsistence levels. New laws were introduced in 1998 to try to address this, but without much success. The majority of Russian pensioners live at or below subsistence levels, with the state pension amounting to around $20 per month.

A new system
Government projections showed that the system inherited in the 1990s was rapidly becoming unaffordable. Either social taxes would have to climb to 6070% of pay, or benefits would be cut to levels that would put the majority of pensioners below the poverty line.
The government therefore wanted to encourage a move away from total reliance on state benefit provision. Legislation passed in late 2001 introduced major reforms to the state pension system effective from 1 January 2002, including a funded element. The government is in the process of legislating for the involvement of the private sector. Figure 1 left shows the components of pension provision under the reforms. Those shown shaded in yellow are the state elements; those in white are the elements provided by employers.
As in the previous system, the Pension Fund of Russia is at the centre of formal provision for old age and, for now, remains responsible for the administration and payment of all pensions under the reformed system. Pensions are financed through the unified social tax, a payroll tax levied on employers and collected by the tax office. Of the total 35.6% social tax rate, 28% is used for pension purposes. Of this, 14% is allocated to finance the basic pension and other social pensions on a pay-as-you go basis, and 14% finances the notional (also pay-as-you go) and funded elements.
The government is aiming to introduce legislation making it mandatory for employers in certain industries to fund early retirement pensions. It is currently envisaged that this funding will be done in a way similar to that of the funded state defined contribution pension. Currently more than 20% of employees (including public sector workers, workers in hazardous and arduous conditions, and workers in the far north) have at least some right to early retirement, the cost of which is met by the Pension Fund of Russia via the unified social tax. However, this is a contentious issue that is unlikely to be addressed before the Duma elections later this year.
Finally, the government wants to encourage non-state provision by creating opportunities for the long-term tax-efficient reward of employees, and encouraging employees and employers to make further provision for retirement. In the longer term this is envisaged in two ways.
n Voluntary provision There are currently fewer than 250 non-state pension funds in Russia, many of which are not operational. A handful of these, mostly associated with the industrial conglomerates (such as Lukoil and Gazprom), offer defined benefit pensions.
n The state-funded element It is hoped that eventually employees will choose to invest the funded element of the state pension with private investment managers and/or non-state pension funds.

Investment and regulation
Russia employs Europe’s biggest workforce and is the home to Europe’s largest army of pensioners. Hence the reformed pension system will command substantial financial flows: the first quarter contributions deposited on individual pension accounts totalled circa $250m. It is estimated that the accounts will accumulate more than $1 bn within a year, and then a further $1bn to $3bn annually in the future, without taking into account the investment return on the pension assets.
These funds are all currently invested with the Pension Fund of Russia. Fifty-five investment managers have just received approval to manage these funds. The race is on to attract employees who can choose from these managers and their funds. This is the part of the timetable that has slipped: originally the funds had to be transferred from the pension fund before 31 December 2003. In theory, this will now happen in early 2004. Conspiracy stories of the Pension Fund of Russia’s intent to hold on to funds for as long as possible abound.
For those who do not elect a specific investment vehicle, a default asset manager has been selected with a strategy to invest in a prudent fashion. Prime Minister Kasyanov stepped in in March 2003 to appoint Vneshekonombank or VEB the government’s foreign debt agent. Critics have commented on the possible conflict of interest, as VEB will presumably invest the pension money in government bonds.
The framework legislation contains provision for limits on investment strategies, including asset classes and investment in international markets (only allowed via index-tracker funds). Regulation of many of the financial markets is still required. Much of the outstanding legislation concerns the investment of funded pensions. Regulatory control, corporate governance, administration, and annuity markets still need to be addressed.

Where next?
Another area of legislation still required is the conversion of accounts to pension. Russia does not have an annuity market, so no open-market option exists. The legislation provides for the government to specify a life expectancy with which the Pension Fund of Russia will calculate the annual pension. The government is currently investigating its options.
And, say it quietly, will retirement age be on the agenda after the elections?