Russia is Byzantine. The idea that Moscow is the “third Rome” heir to the Byzantine Empire and its legacy, is central to the country’s national myth. But Russia is also Byzantine in the other sense of the word: complicated from an administrative viewpoint, often times arbitrarily so. This is especially true of Russia’s pension system (and more broadly, its social spending), which plays an outsized role in both the federal budget and in the local political economy in general. In the following post, I’ll be focusing on Russia’s pension system: how it works, what challenges it faces, and what these challenges mean for Moscow and the country as a whole.

How pensions work in Russia

Russia’s pension system has two pillars: the insurance portion and the funded portion. The former is a pay-as-you-go pension, much like Social Security in the United States: current workers are charged payroll tax (directly from their wages) that redistributes money to current retirees. These payouts are determined by a point system (each point is worth about RUB74, or $1.16), wherein pensioners are assigned a certain number points based on their income and other characteristics (state sector work, veteran status, etc).

The second pillar is perhaps better described as a nest egg: current workers can elect (more on this shortly) to divert a portion of their payroll tax into an individual account that is either state run or privately managed. To note, this is not a private arrangement like a 401(k) in the US: all pension funds collected through payroll taxes are first sent to the Pension Fund of Russia (Pensionniy Fond Rossii, or PFR), and are then transferred to whatever management arrangement a worker has selected.

Until 2016, workers born after 1967 were able to select between two pension options (the deadline remains extended for Russians younger than 23 years old): pay the full payroll tax (22%) directly into the insurance portion, or split the payroll tax between the insurance portion (16%) and a funded plan (6%).

According to Sberbank, lax financial oversight has proven a problem for a number of privately run pension funds, which as of recently were not required to disclose their investments, and often invested in assets owned by the fund managers. These issues will likely be addressed by the Central Bank of Russia (CBR) as it increases its regulatory role (Russia lacks an independent financial watchdog equivalent to the US Securities & Exchange Commission; the CBR plays this role), but remain unresolved for now.

The pension freeze

There have been numerous reports about how the funded portion contributions have been “frozen” for three years running, a freeze that will be continued into next year. But what does this actually mean?

First, a couple of important notes. It is important to keep in mind with pensions that seemingly minute percentage changes in the system’s revenue and expenditures are hugely important. According to current estimates for the 2017 federal budget, social expenditures (about RUB4.6 trillion) are very close to a third of total spending. Second, per analysis from Sberbank, payroll taxes bring in about 5.0-5.5% of GDP in revenue, while pension outlays require about 8.0-8.5% of GDP in expenditures. This is a great example of point one: the pension deficit is about RUB2.3 trillion, very roughly 15% of total spending. When oil prices were high, this was not particularly problematic (thanks, Mineral Extraction Tax!): there was plenty of revenue to go around. Now, however, things have grown more complicated.

To answer the question, a pension freeze entails allocating funded portion contributions to current insurance portion expenditures. In other words, using current workers’ “private” pension savings to pay current retirees. This manoeuvre saves about 0.5% of GDP in expenditures, which frees the finance ministry (and the government as a whole) to maintain spending on other priority line items. While this is effectively taking peoples’ money, until this year it was at least being used to pension-related ends, ie. funding retirees.

But this year frozen contributions (totaling RUB342bn, or $5.4bn) were turned into a “Presidential Reserve”, (which sounds like a Putin-themed whisky brand to me, but I digress). RUB150bn of this reserve was used to bail out the struggling VEB bank, which in addition to acting as a piggy bank for irresponsible state projects, also happens to be a manager of funded pensions. The remainder will go towards paying off defence sector debt.

Avenues for Reform

Issues related to pension reform, as in other countries, have tended to be sensitive. Not only are the fiscal stakes high, but pensioners are an important voting bloc for President Vladimir Putin. Prior reform efforts, such as in 2005, resulted in fairly widespread protests by pensioners. Authorities seem well aware of the risks posed by rash action here, and also know that until Putin is re-elected, they lack the political capital to launch painful reforms. As such, it’s worth noting (and officials note themselves) that the proposals to follow look likely only after 2018.

First is the question of the retirement age. The OECD average as of 2014 was 64.6 years for men and 61.1 years for women. In Russia, the figures are 60 and 55, respectively. Taken alone, the early retirement age represents an increased fiscal burden, but it’s also coming as Russia faces a demographic crunch, particularly in the next decade. The problem is not so much that “Russia is dying out”, a popular narrative that’s not really true, but that the ratio of workers to pensioners is contracting. The peak of this contraction will come in the mid 2020s (source: Rosstat).

 

In contrast to this chart from a 2015 piece by Sergei Aleksashenko, the above scenario looks relatively optimistic and does not include a longer-term downward trend as Russia’s population declines.

All this being the case, and barring fairly significant changes, pensions will grow into an increasingly large and likely unsustainable fiscal burden. The current plan with regards to retirement age is to begin gradually raising it to 65 years for both men and women (to be increased by six months to a year per year once the reform is implemented). The government has already begun to implement higher retirement ages for state workers. But to repeat an earlier point, this will be a delicate process that will require careful management. Whatever the case, adjustments here seem inevitable: per Aleksandr Surinov, head of Rosstat: “we need to raise [the age], we needed to ten years ago, or else we won’t survive”.

The other major reform measure that has been discussed is the implementation, targeted for 2019 or 2020, of a Private Pension Fund programme to replace the funded portion. The new format would be a voluntary payroll contribution of up to 6% on top of the 22% rate, which would be allocated entirely towards the insurance pension.

Perhaps most importantly, the finance ministry and the central bank have made assurances that money contributed on top of the 22% payroll tax would be the property of citizens; no longer an extra source of funds for the federal budget in times of crisis. This would be an important step, as the ongoing freeze has not only reduced incentives to save, but also encouraged participation in black/grey market employment as well.

Takeaways

When Russian authorities talk about structural reform, a term that has become somewhat of a buzzword, pension issues are a key item. Given the percentage of the budget they make up, discussions on rejuvenating (or reviving) Russia’s economy cannot be considered serious without pension reform. Steps to address the problem thus far have arguably been indicative of the authorities’ approach to structural reform as a whole: “peripheral” measures that make the current system work marginally better, but do not address the fundamental issues that must be overcome.

Putting a spoiler on a car that needs a new engine may make it more aerodynamic and fuel efficient, but it does not get at the heart of the issue.

This blog originally appeared on bearmarketbrief on November 1, 2016