THE INSIDERS: Russia's failing pension reforms

By bne IntelliNews November 28, 2013

bne -

After Chile launched its pension reforms in the 1980s, it saw pension assets under management soar from 3% of GDP to over 65% in about five years. Russia made its last stab at pension reform in 2002 and nearly a decade later the amount of pension assets under management are still at 3% of GDP.

Russia's capital markets have soared since the exchanges were set up in 1995, but they remain bizarrely lopsided: accounting for half the market capitalisation of the entire former Soviet Union, there is still no long-term domestic institutional investors. Poland's stock market is much smaller than Russia's, but in every other way it is much more mature, with domestic pension and insurance funds accounting for a third of the entire market capitalisation. With trading in Russia dominated by international hedge funds and local banks with spare cash on their accounts, everyone in the Russian market is a speculator, which is one of the reasons why Russian share prices are so volatile.

And time is running out for the Kremlin. With the federal budget likely to go into deficit next year and with a long 'to do' list when it comes to infrastructure projects, the government desperately needs that long-term money to finance rebuilding the country. The lack of pension reform is only adding to this financial pressure.

"The current pension age - 60 years for men, 55 for women - is clearly something the country's economy struggles to afford, but the government is adamant and will not raise it upfront, although measures to stimulate delayed retirement are coming into effect. Why so adamant? Because the pensioners are the biggest single electorally important constituency," says Daniil Khavronyuk, head of PR and communications at Raiffeisen Pension Fund. "Another little known feature of the system, a Soviet heritage actually, is that a lot of employees are entitled to an early retirement, so the average retirement age now is 54 for men and 52 for women."

The situation is made even worse by the country's demographics. Russia's population has returned to growth for the first time in 20 years after the birth rate turned positive in 2008, creating more taxpayers to pay for the pensioners. However, the respite will be temporary as the deep demographic dink caused by the collapse of the Soviet Union in 1991 works its way through and those people who were middle aged two decades ago begin to retire. In Soviet times, there were two workers to pay for one pensioner, but that ratio is set to fall to one worker for one pensioner in the coming years - known as the "Russian Cross."

A gap between what the state has promised to pay its aging, swelling retirement community and the amount of money actually available in the Pension Fund of Russian Federation (PFR) has already appeared and is eating up about 5% of GDP of budget spending - a huge bill for any state. Much of this spending is self-inflicted: during the parliamentary election campaign in 2011, then Russian Prime Minister Vladimir Putin increased pensions by about half, widening that gap.

On the flip side, getting pension reforms right can be transformational for an economy. Access to cheap long-term financing opens up a new world to companies and governments, which both increases prosperity and creates a solid floor for asset prices (as pension funds tend to buy and hold securities), thus reducing the gut-wrenching swings most emerging markets suffer from.

Maths homework

Organising a pension system properly is all about the numbers: so what does Russia's maths look like?

"The pension tax rate for most of the workforce is 22%, assessed at the source of income on top of salaries, and it goes to the PFR," says Khavronyuk. "For all those born in 1966 and earlier, the whole of it goes straight through to a pay-as-you-go (PAYG) system. For 1967-ers and their juniors, 16% goes to PAYG and 6% to OPS, the funded component of the Russian pension system."

Although Russia has a flat tax system with 13% on individual income (plus higher social taxes), there is also a RUB568,000 ceiling for the full-rate pension tax in 2013; any income exceeding this ceiling is taxed at a 10% rate, and the proceeds go solely to PAYG.

However, as the government is already short of cash it decided to raid the pension system for investment cash last year. "Although there were many calls to nix the funded component contributions entirely, in the end it was decided to reduce the payment rate for the 'molchuny' (the silent ones) to 2%, which seemed a generous compromise," says Khavronyuk. "The 6% rate was supposed to remain for all those who either filed a special request with PFR or had moved their account to an privately run non-state pension fund (NPF). But the window of opportunity to move accounts to private funds will be shut right in their silent faces on December 31, 2015."

As of the end of 2012, about a quarter of Russians in the funded part of the system (or 20m people) had made use of the option to move the investible part of their pension contributions from the state-run to private-run funds.

But the wrangling is over. More recently, the state has dithered over whether to keep the 2% payments at all. "The current alternative looks like a toss up between 6% versus 0%," says Khavronyuk.

And that is not all. Next year the contributions to the funded part of the system will simply be expropriated by the state to make up for an expected federal budget deficit and to finance the gap in the PAYG system between liabilities and cash in the state pension fund, while in the second half of 2013 contributions will be frozen and transferred to the NPFs only after respective funds receive a CBR's clearance for going joint-stock company and joining the national pensions accumulations' insurance framework. "Starting 2014, no payments to the funded component will be made for "molchuny" and all 22% will go to finance PAYG payments. If they wish to continue those payments, however, they will have two more years to make their choice and migrate their accounts to a private fund," says Khavronyuk.

It could be worse. In other countries of the former Eastern Bloc, like Hungary and Kazakhstan, the squeezed budgets have led to the state simply taking over the private pension business in toto, so the fact that the Kremlin has tried to compromise at all is something. But the monkeying about with rates and cash-grab all smack of short-term solutions, when the larger problem of building up a big and healthy pension system to serve the needs of both the state and the people is still being ignored.

"The key objective of the current reform is to reduce the budget deficit of the PFR," says Khavronyuk. "Currently, the pension taxes collected cover about half of pension payments made, while the other half is covered by a special transfer from the state budget which keeps growing, and which is a matter of acute concern for the government."

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