Ben Aris in Moscow -

For most of the last 20 years, Russia has grown under its own steam. The 1990s were wild, but things slowly got better despite, rather than because of, government. Life was hard, but the standard of living has risen relentlessly, largely thanks to the flood of petrodollars. But things will start to get worse from hereon in if nothing is done about the country's pension system - and nothing is being done about at it at the moment. The lack of pension reform has become a ticking time bomb.

Russia isn't unique in facing a looming pension crisis. Average life expectancy is increasing by about two years every decade, according to British scientists, and in places like the US the cost of looking after the old is increasing faster than the revenue that flows in from the various pension schemes. But the combination of the post-war baby boom and the impact of the collapse of the Soviet Union on Russia's demographics has made the situation especially bad.

Birth pains

The latest census shows that Russia's population is clearly shrinking, although more slowly than expected. At the beginning of 2011, the population was 142.9m, 50,000 less than a year before. However, the fall in the size of the population has slowed considerably. Russia's population peaked in 1991 at 148.689m, but was losing 750,000 to 800,000 people per year from the mid-1990s to the mid-2000s, so a fall of only 50,000 last year could be regarded as considerable progress.

In a widely cited report, the UN warned in 2005 that Russia's population could fall by a third to 116,097 by 2050 if current trends didn't improve. However, it seems that this scenario is now unlikely. "The Russian demographic profile is closer to Japan's than most of the other emerging markets' - old and getting older - because the baby-boom generation born after World War II is retiring in 2011-2020," says Viktor Nossek, vice president for research at Renaissance Asset Managers.

The birth rate has recovered a bit since the summer of 2009, but this trend could reverse again soon because while some Russians are confident enough in their future to want children, simply too few people were born in the 1990s to supply enough babies to keep the population level stable. "Although the birth rate has been recovering during the past decade, the size of age groups born during the 1990s was extremely small. These people are starting to reach reproductive age, which means that keeping up the birth rate will be very difficult," says Danske Bank.

Under pressure

Russia's pension system is already running at a loss and recent rises in pension payments have only made the problem worse. But pensions are still too low and will probably have to rise more. Currently, the average pension is barely enough to cover the essentials of life - accommodation, heating and food. Despite a 30% hike at the start of this year, Russian pensions are still modest. The average monthly pension at the end of 2010 was just RUB7,600, or about €190. Pensioners bne has talked to say there is nothing left over for anything else. Almost all of Russia's pensioners depend on their children to top up their income and pensioners without children are simply surviving.

At the same time, the number of workers available to support pensioners is falling. According to Rosstat, the working age population will decline from 87.5m in 2010 to 76.5m in 2030, implying a labour force contraction of 300,000-400,000 per year. That means the pensioner/labour force ratio will steadily increase from 0.35 to 0.50 through 2011-2030.

On the other side of the coin, life expectancy is improving significantly from the lows of 58.7 years for men and 71.9 years for women seen a decade ago. Today, Russian men live another four years after retirement, while women live for another 20 years.

It's a "push-me, pull-you" alignment of problems. Together, these two factors will send the pensionable population soaring from 30m in 2010 to 40m by 2030. Unless the retirement age is raised, spending on pensions will expand by one-third in real terms over 2011-2030, according to Renaissance Asset Managers.

The resources available to the government are still far too low. The total assets in the state-run pension system are on the order of 3% of GDP, compared with 65% in Chile and close to 100% in more developed countries.

Likewise, the Russian government is spending only 6% of GDP on pensions compared with at least 10% in the develop world, which means the state pension fund never has enough money to cover the outgoings. Transfers from the federal budget cover the shortfall. Funding pensions already accounts for a third of the current budget deficit and the gap between income and outgoings is expected to increase rapidly from here.

Deputy Prime Minister and Finance Minister Alexei Kudrin let the cat out of the bag in a speech last summer when he said the state would probably have to hike the retirement age. This caused a storm of protest and the government has spent the past year denying there are such plans. But it will almost certainly be forced to do it. Currently, Russia's retirement ages of 60 for men and 55 for women are among the lowest in the world. The finance ministry is considering a gradual increase in the retirement age, to 62.5 for men (in 2015-2020) and to 60 for women (in 2015-2025), in order to cut future pension expenses.

Fluffed reforms

With Duma elections set for December and presidential elections in March next year, no-one even wants to mention the word "pensions" let alone start work on a plan.

Russia has already made one stab at reforming the system, but immediately fluffed it. The first round of reform was launched in 2002 when the Kremlin introduced a system based on the Chilean model. At the end of 2003, some 55 special asset management funds were registered that can invest part of workers social taxes and 40m Russians received a "happiness letter" informing them of exactly how much money the state pension fund has put aside for their retirement.

But the entire effort ended in fiasco. Few Russians understood the letter and fund managers say that the whole process was hijacked by big financial groups and regional governments. "Pension reform has got off to a disastrous start. There was a respectable blueprint that would have qualified funds with track records and transparent structures, but it was changed at the last minute," says Elizabeth Hebert, CEO of Pallada Asset Management, one of the 55 special funds. "We ended up with 55 management companies, most of them unknown, that have no requirement to disclose their owners. Three-quarters of these companies are owned by groups and invested into their related companies."

Real funds like Pallada began to tour large companies to explain to workers the benefits of putting the "investable" part of their state payments into a private fund. What these managers found was typically the shop floor foreman had been offered a bounty - typically $1 per worker - for every employee that signed his private pension contribution away to one of the big groups.

Needless to say, most workers simply didn't bother and by not acting all their pension contributions remain with the state pension fund. Nearly 10 years on from the reform, Russia has a total of $38bn of pension assets under management, or just 3% of GDP, which is the level Chile got to in the second year of its reform.

Benefits of a working pension system

The need to reform pensions goes way beyond a country's ability to pay its pensioners a decent income or even its effect on the financial markets. Creating institutional investors, such as pension funds, unleashes a whole new type of capital on the market with the long-term perspective that emerging markets so desperately need. It is a game changer and will benefit everyone, not just the OAPs. "A well-functioning, fully-funded pension system can transform an economy and is among the most important reforms a government can undertake," says Plamen Monovski, CIO of Renaissance Asset Managers. "Successful reform will mobilise domestic capital, diversify credit sources, encourage long-term investment and result in accelerated growth."

Russia remains badly underinvested with about €1,000 per capita of foreign direct invetsment in 2008 compared with the €4,000-€8,000 that most of the Central European states have attracted. However, there is enough money on deposit in Russia's banks to finance all of the state's mooted RUB1 trillion infrastructure programme. The trouble is that this money is hard to get at for anyone but the biggest companies.

Leaving domestic capital idle is costing Russia about 1.5% a year in lost growth, according to Renaissance Asset Managers. That feeds through into lower productivity. Institutional investors tend to invest into long-term projects that boost productivity, but a survey by consultant McKinsey & Co. found Russia's workers are a third as productive as the average American.

More specifically, pension funds will unlock access to credits for small and medium-sized enterprises that are in turn a major driver of productivity, diversification and innovation, as well as a significant employer. For instance, pension funds in the UK and the Netherlands allocate up to 10% of their funds to venture capital and private equity investments.

And as pension funds look for returns measured in decades, not quarters, they add stability to stock markets. Russia is one of the richest countries in the world, but its stock market is a slave to the commodity cycle - either it is amongst the best performing markets or the worst, depending on what happens to oil and metal prices. Without many institutional investors in Russian stocks, most playing the market are speculators with a short-term horizon. Pension funds and insurance companies account for over 70% of the tradable shares on the London and New York bourses, more than three times as much as on the Moscow exchanges.

Moreover, the lack of institutional investors makes a mockery of the state's plan to turn Moscow into an international financial centre. There is little point debating the details of the insider trading law or the new Central Depository when a giant chunk of investment is missing from Russia's capital market. "Pension reforms are an opportunity profit for society, as any reform to pensions will do more than make life better for pensioners, it will make life better for everyone in Russia. At the end of the day, the grey matter," says Monovski.