Ben Aris in Moscow -

Short of money to close an estimated 2.8% budget deficit predicted of the end of this year, the government decided to raid the pension system again on October 7 and froze contributions to the state pension fund for a second time, according to the chairman of Russia's Pension Fund Board, Anton Drozdov.

The state froze contributions last year, but reinstated them again this May, as the economy appeared to be stabilising. However, a renewed bout of ruble and oil price instability over the summer has wrecked Russia's chances of a return to normalcy, leaving the state reaching for emergency measures yet again.

The decision comes at a high cost. With the demographic dip caused by the economic chaos in the 1990s about to hit the working population, the state pension fund is already underfunded; whereas the social contributions (a 6% tax on income) from two workers used to fund the pension of one retired worker, that ratio is rapidly moving towards one worker paying for one pensioner.

On top of that, the pension funds are the solution to the problem of funding that has come with Russia's current pariah status in the world. The financial sanctions imposed by the US and EU have cut the country off from the long-term cheap financing it so badly needs to re-start the virtuous circle of investment-profit-growth. With the consumption-led growth model clearly exhausted, the new model is based on low inflation, low interest rates and domestic investment, of which the pension funds are supposed to be a big source of long-term domestic capital.

And pension reforms had been starting to move, albeit at a gradual pace. Russian pension fund assets could triple to be worth almost a fifth as much as the entire economy by 2020 if the government continues its reforms as planned, a recent report by Goldman Sachs posited. "Having cleaned up the pension system in 2013-14, the Russian government now seems ready to allow resumption of contributions to private pension funds. The impact will be large: we forecast Russian pension fund assets will increase to [approximately] $200bn by 2020 from $64bn today. The creation of this sticky, long-term domestic investor base is likely to produce significant benefits for Russian capital markets, particularly for stocks," concluded Goldman Sachs analyst Dmitry Trembovolsky and his colleagues in a report titled "The rise of Russian pension funds", released at the end of August.

The Central Bank of Russia (CBR) is still working on fine-tuning the system and could announce a major overhaul within a month, Sergey Shvetsov, first deputy central bank governor, told reporters in New York on October 7.

While the shape of the new system remains unclear, it looks like Russia will plump for some version of the "three pillars" that was pioneered by Chile and taken up with enthusiasm by the Baltic states in the noughties: the state pension fund will remain the backbone providing cover for everyone, but workers then can chose to have part of their social contributions managed privately and can also take additional privately funded pension cover. Just how these parts are weighted and what financial investments are put in place to encourage their growth is the meat of the current debate. "The new system can't be entirely voluntary," Shvetsov said. "In any case, there'll be some kind of encouragement for either people or companies to set money aside for non-state pension funds. We're trying to formulate an alternative that would be less costly for the budget, but not less effective in terms of the size of the funds attracted from the population."

Third time lucky

The modernisation of Russia's pensions began in 2002, when the government required 6% of every employee's salary to be contributed to state or private pension funds. Over the last decade Russia as seen its pension assets under management (AUM) go from 3.0% to 5.6% of GDP today.

However, the government is now assuming that the Western financial sanctions are a permanent feature, so it is being forced to build up domestic capital resources. And that is without the problem of funding generous pension payments in the coming years to relative young OAPs (women retire at 55 and men at 60 in Russia). The upshot is that funding pensions is already eating into the federal budget.

According to official statistics, the private pension funds client base has grown to 28mn people compared with 52mn in state pension funds, while the asset split is $33bn in private funds and $31bn in state, according to Goldman Sachs. Private pension funds are slowly eating into the share of the State Pension Fund.

Like everywhere else, the key to the pension reform is putting in rules that prevent funds from taking excessive risks and collapsing, leaving the state with a costly bailout.

The current pension reform proposals include: a change in the legal status of pension funds to for-profit; the establishment of a special insurance fund to guarantee savings in the case of bankruptcy; and merging the previous regulator (Federal Service for Financial Markets) with the Central Bank of Russia (CBR), and shifting oversight to it.

The cash-strapped Russian government raided the fund and froze transfers to private pension funds in 2013-14, but pension contributions were unfrozen this year in May, with the government handing back RUB530bn ($8.4bn) of employer contributions it kept in 2013 to private pension fund managers.

Still, the government says it plans to unfreeze pension contributions as soon as possible. And if the government sticks to its plan, then Goldman Sachs forecasts Russian pension fund assets will increase by about $120bn by 2020 to reach a total of $200bn, on a combination of inflows and investment returns.

Equity market impact

Creating such a large, new pool of money would have an enormous affect on Russia's equity markets. Although pension funds are already allowed to invest into equities, currently about 80% of their money goes into bonds and, to a lesser extent, bank deposits. That's typical of a young pension system. But as pension funds grow in size and sophistication, fund managers usually move towards equity investments: following South Africa's pension reforms, the fixed income share of investments fell from around 70% in the 1970s to 38% in 2014. "In Russia, additional tailwinds should come from lower interest rates and regulation. We estimate Russian funds can hold up to $60bn of local equities by 2020 (55% of total estimated free float), compared with $6bn now and $32bn owned by foreign investors," Goldman's report said.

And domestic pension funds are desperately needed, Evgeny Fetisov, Moscow Exchange's (Moex) chief financial officer and member of the executive board, said in a recent interview with bne IntelliNews. As the bulk of investors in Russian equities is a mix of foreign hedge funds, Russian banks and day traders, almost everyone in Russian stocks is currently a speculator with little more than a six-month time horizon. The appearance of genuine domestic institutional investors will deepen the market and dampen volatility, as well as increase dividend payout ratios, while in fixed income pension funds will likely create demand for long-term, secure, inflation-linked products.