Nicholas Watson in Prague -

bne, like many other Russia watchers, has been calling for some time for the Kremlin to start tackling the thorny problem of the pension system, and now Standard & Poor's has waded into the debate, warning in February that the country's debt could soar to 585% of GDP by 2050 as the population declines and the government spends more on pensioners, pushing its 'BBB' credit rating below investment grade.

S&P says the government's spending on its aging population - the population will probably shrink to 116m by 2050 from 140m in 2010 - will remain "moderate" until the early 2020s, but then outlays on its pension system will soar as more people approach retirement. The rating agency predicts spending on pensions will increase to 18.8% of GDP by 2050 from 9.4% last year.

"Russia's aging population will likely place substantial pressure on economic growth performance and public finances," says S&P credit analyst Frank Gill. "By 2035, we expect that Russia's fiscal indicators will have weakened such that they would be more in line with sovereigns currently rated in the speculative-grade category, because, in our view, the projected improvement in GDP per capita would not be able to offset the potential fiscal deterioration."

Clearly, something needs to be done, but what?

Pillars of society

Russia has a three-pillar system that was itself a reform in 2002 of the classic, but now widely discarded, pay-as-you-go system inherited from Soviet times.

Pillar one, the insurance part of the three-pillar system, is funded from social insurance contributions that are mandatory and paid by employers to the government budget at source. It's essentially still the pay-as-you-go part of the system, as social insurance contributions paid by current workers are used to pay the current pensioners, so there are no balances left to be invested. For employees born before 1967, 26% of salary goes to fund the insurance part; for those born in 1967 or later, 20% goes to fund this insurance part. Unsurprisingly, then, according to Svetlana Kovalskaya of Renaissance Capital, "extra subsidies from the budget are normally necessary, as current workers' contributions tend to fall short of the government's liabilities to current pensioners."

And this situation will only worsen - S&P forecasts that Russia's old-age dependency ratio, defined as the number of people aged 65 and older divided by the number of those between the ages of 15 and 64, will increase to 39% by 2050 from 18% in 2010.

Pillar two, the accumulative part, is also funded out of the same social insurance contributions as pillar one, but only from the contributions of employees born in 1967 or later (6% of their salary goes to fund pillar two). Payments from this segment to pensioners won't start until 2020 and aren't being used to pay current pensioners. The funds accumulate in employees' personal pension accounts and are invested, either by the State Pension Fund (whose asset manager is VEB) or by a qualified non-government pension fund (NPF).

Pillar three is the part where employees are given an opportunity and encouraged to contribute to the accumulative part of their pension. For every rouble contributed by the worker, the government matches that up to a maximum of RUB12,000 per year for workers under pension age and a maximum of RUB48,000 per year for those who reached the pension age but continue working). Employers can also make contributions to employees' accumulative pension accounts, and such contributions yield tax benefits.

Over and above the three-pillar state pension system, Russia has developed a private pension savings industry, in which the key players are non-government pension funds.

Suggested reforms

The first pillar of the system is the one putting most pressure on the state's finances and will increasingly do so. The most straightforward reform, therefore, would be to increase the retirement age, which is much lower than in other European countries with men entitled to retire at 60 and women at 55.

Indeed, in December, the pro-Kremlin party Pravoye Delo (Right Cause) proposed increasing the retirement age. And Finance Minister Alexei Kudrin earlier said that raising the retirement age would help bring down the increasing deficit of Russia's State Pension Fund, which stood at RUB1.3 trillion (€32.8bn), or an estimated 2.9%, in 2010.

However, Prime Minister Vladimir Putin, with an eye on his poll ratings and ahead of crucial Duma elections scheduled for later this year, said in August that the government was "not even going to consider" the issue.

With that avenue closed, Russia's Ministry of Social Development recently issued a report looking at the shortcomings of the accumulative part of the obligatory state pension, the second pillar, and calculated that if the entire 26% social insurance contributions were directed to the pay-as-you-go pillar one, then the substantial deficit of the State Pension Funds would be eliminated. The ministry also highlighted another concern centring on the low return on the investment of state pension savings, resulting in low expected future pensions relative to income.

Considering the above, the ministry suggested the following reforms to the accumulative part of the system:

• Keep the current size and obligatory status of the accumulative component, but implement a number of changes. In particular: stop investing the pension savings of those employees who make no choice, but put them on bank deposits instead to promote an active approach to choosing a pension savings manager; ease legal restrictions on investing pension savings, as long as the portfolio's risk is in line with the risk profile specified in its investment policy ("VEB has the most conservative investment profile, it is not allowed to invest in equities," says Kovalskaya); let pension plan participants choose to receive their pensions during a specified number of years or as one lump-sum payment, as well as to pass their pension savings to heirs.

• Make accumulative pension savings completely voluntary.

• Keep the accumulative component within the obligatory pension system, but reduce contributions. In particular, the ministry has suggested either exempting employees with below-average income from contributions to the accumulative part, or reducing the proportion of this component in the social insurance contributions from 6% to 3%.

Kovalskaya stresses that these changes are still subject to discussion, and there is no specific timeline at this stage. However, with the Russian government agreeing to raise pensions in the country by 8.8% to RUB8,500 roubles from February 1, some reforms to the system will be needed sooner rather than later.