Svetlana Kovalskaya of Renaissance Capital -

-- Domestic pool of money = support for local asset prices and the economy. One of the clearest takeaways for Russia from the recent financial crisis is the importance of a functioning domestic pension market. Pension money is long term, stable, consistently increasing and generally domestic-market focused.

-- The highly regarded Chilean model: In 1981, Chile was the first emerging market economy to create a three-pillar pension system, with obligatory and voluntary pension savings invested in financial assets. The country's pension assets have since increased at a compound annual growth rate (CAGR) of 39% over 28 years, and reached 65% of GDP in 2009, almost as much as the US on this metric.

-- The Russian pension market: Small, but growing. Russia instigated pension reform in 2002 and adopted a system similar to the Chilean one. It has since seen its pension assets increase at a CAGR of 42%. However, at the end of 2009, pension assets were $38bn, or just 3% of GDP - similar to the Chilean level in 1982. If in 2010 Russian pension assets were 12% of GDP, similar to the Kazakh level a year ago, they would be more significant, at $176bn.

-- Equities account for only 7% of pension assets under management (AUM), with clear upside potential. Russia's state money manager, Vnesheconombank (VEB), manages 49% of the country's pension money, but cannot invest it in equities. Private managers could allocate up to 70% of their portfolios to equities, but allocate only 13%. This suggests room for increasing investment of pension AUM in equities, as private managers take up a larger share of the pool and/or invest more in equities.

-- Pension money to hit the domestic market in February-March. We expect $6.6bn of fresh pension contributions to be transferred to money managers in the first quarter. However, of this only about $3.1bn can be invested in equities, and if the existing portfolio allocation is maintained, the potential inflow to the domestic equity market is only $0.6bn.

Feeling Chile

The classic pay-as-you-go (Paygo) pension system traditionally run by governments worldwide has gradually been replaced, as global birth rates have fallen and life expectancy increased. It has simply become unsustainable for Paygo systems to fund current pension liabilities, as the contributions paid by workers are insufficient to fund retirement pensions.

The World Bank initially recommended the key aspects of modern pension reform. It introduced the idea of separating the savings function from the redistribution function as a key focus. It suggested establishing separate mechanisms for funding and administration pensions, with two different, mandatory pillars - one under public administration, with resources generated by taxation, and the other under private management, with resources consisting of accumulated savings. These would be complemented by a voluntary pillar for those seeking more substantial benefits, normally with tax incentives.

Chile led the way when, in 1981, it pioneered radical social security reform and set up a pension system along the lines recommended by the World Bank. The Chilean system rests on three key pillars:

1. The state, in its subsidiary role, finances a proportion of the minimum pensions and all welfare pensions granted to poor elderly people.

2. The AFP (pension fund administrator) manages the mandatory social security savings, thereby contributing towards relieving the burden of the first pillar.

3. Workers save voluntarily to increase or advance their pensions.

The system is based on individual accounts managed by private institutions. The second pillar is designed to enable workers to fund their own future pensions, allowing the state to free up resources to prioritise its subsidiary role and guarantee basic benefits in the first pillar.

Following Chile's early lead, a number of emerging market countries have pushed ahead with pension reform, with Poland (1999) and Kazakhstan (1998) coming in for particular praise for their reform processes. Nigeria is the most notable country in sub-Saharan Africa to have successfully reformed its pension system. Latin America has welcomed the Chilean model, with Mexico, Bolivia, El Salvador and the Dominican Republic having also implemented funded pensions.

Bear necessity

The existing Russian pension system emerged as the result of a reform process initiated in 2002. Prior to that, the country ran a classic Paygo obligatory state pension system, inherited from Soviet times. Similar to elsewhere in the world, by the turn of the century, Russian demographic trends (a rapidly ageing population and declining birth rates) called for a reform that would replace the old pension system with a variation of what has become the aforementioned global benchmark, a three-pillar one.

Below, we summarise the structure of the Russian three-pillar system as it stood in January 2011. Recent changes to the original 2002 system, as well as proposed further reforms, are discussed in the following section.

Pillar 1

-- Pillar one is funded from social insurance contributions, which are mandatory and paid by employers to the government budget at source. 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 the insurance part.

-- Pillar one is Paygo, ie. social insurance contributions paid by current workers are used to pay the current pensioners. There are no balances left to be invested.

-- Extra subsidies from the budget are normally necessary, as current workers' contributions tend to fall short of the government's liabilities to current pensioners.

-- The insurance part provides an earnings-related benefit. To facilitate this, each worker's contributions to the insurance part are recorded in a notional account over his/her working life (and to that theoretical balances are added for the years an individual had worked prior to the introduction of the three-pillar system).

Pillar 2

-- Pillar two is 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 will not start until 2020.

-- Funds accumulate in employees' personal pension accounts and are invested. They are for that specific employee's future pension and are not used to pay current pensioners In pillar two, each individual worker is given a choice to go with either the public or private sector, at two levels: the account holder and the money manager.

-- First, each worker chooses who will hold his/her personal pillar two pension account and assume responsibility for pension payments at retirement - the State Pension Fund or a qualified non-government pension fund.

-- If the worker chooses the State Pension Fund as the account holder, he/she can then choose who will actually manage the money - the government asset management company (VEB) or a qualified private asset manager. For pension accounts transferred to NPFs, the NPFs themselves are obliged to further subcontract to money managers.

By default, the pillar two contributions go to the State Pension Fund as the account holder and VEB as the asset manager. All employees are given an opportunity to change their choice once a year.

Pillar 3

All employees are given an opportunity (and are in fact encouraged) to contribute to the accumulative part of their pension. Such voluntary contributions form the third pillar of the state pension system.

-- Every worker can contribute extra money to his/her individual accumulative pension account, be it held by the government or non-government pension fund.

-- By law, for every rouble contributed by the worker the government adds another rouble (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).

-- Employer can also make contributions to employee's accumulative pension accounts, and such contributions yield tax benefits.

Pillar two and three pension fund investment policy into different asset classes is set by government regulation, which we discuss later.

The key principles of the three-pillar system are summarised in this table:

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

Private savings

Co-existing with the state-led three-pillar pension system is a privately run pension system revolving around the NPFs (which are also involved in the three-pillar state system). NPFs actually came into existence in the early 1990s and began operating independently of the state pension system. The mechanism is as follows:

-- An NPF signs a contract with a client (an individual or a corporate employer). Beneficiaries of the system can be a corporate client's employees, individual clients themselves or their relatives.

-- The clients make regular payments into the fund, which accumulate in beneficiaries' individual accounts.

-- The fund invests this money and assumes responsibility to pay a pension to the beneficiaries (participants), over and above the state pension.

Approximately 90% of current private pension savings (those not part of the public three-pillar system) have been contributed under corporate pension schemes. Such schemes can be as flexible as the corporate client may wish. Many are based on the co-funding principle, whereby an employee's personal contributions to his/her private pension account get topped up by the employer in a pre-specified proportion.

Schemes may also be designed in such a way as to provide stimuli for employees, for instance to retire early or late.

The largest NPFs in Russia are those established and sponsored by big corporates (such as Gazprom and Lukoil) for their employees. As of June 2010, there were approximately 7.3m private pension system participants in Russia and as of September 2010, the private pension system's AUM stood at two-thirds of that in the state system:

$20bn vs $30bn, and state pension savings for the first time exceed private in 2010.

Figure 7 summarises the flows of money in the state pension system and private pension savings industry.