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A Step Back That Does Not Have to Happen: Why Not Slowly But Surely Instead?

October 22, 2012

Michal Rutkowski Vedomosti, 27.09.2012, #183 (3197)

It was with great interest and attention that I read the proposal of the changes in the pension system published on the webpage of the Ministry of Labor and Social Policy. It is an outline, not a fully-fledged proposal, but I would like to comment on it as a person who has worked on pension systems and pension reforms worldwide for many years, as a practitioner, advisor and commentator.

I know very well that the post-2002 Russian pension system is based on three important principles. The first principle is a principle of individual accounts which means that every worker receives at retirement what he/she paid into the system plus return on his account. This allows, in principle, for important self-regulating properties of the system: workers have an incentive to postpone the retirement as an increase in pension for the each year of postponement is sizeable, as it is based on actuarial principles.   The second principle is a “security through diversity” principle. Even though pillars of the pension system both have individual accounts, they are financed in a different way:  the first pillar remains pay-as-you-go (PAYG), while the second pillar is funded and the contributions are invested. Increased security comes from the fact that the results of each of the pillars depend on different, not always correlated, factors,  so shortfalls in the results of one of the pillars could be made up by the results of the other. This is an old “don’t keep all your eggs in one basket” principle. The third principle is a defined-contribution principle. The first pillar operates as a notional defined-contribution (NDC) pillar, in which account accumulation is divided up at the retirement age by the life expectancy factor, and the second pillar operates as a financial defined-contributions (FDC) pillar, where the exact amount of pension depends on investment returns. The NDC/FDC principle is very important as it makes the system robust with respect to aging and falling dependency ratio (the proportion between workers and pensioners) by encouraging postponing retirement.

All three principles make the Russian pension system modern and well-designed. It has right incentives in place, self-regulatory properties vis- a- vis aging, good risk management and a possibility of higher returns through the second, funded, pillar.  It is also equitable due to the mandatory nature of the system, including the second pillar: not only rich but also less affluent can benefit from higher second pillar returns and “security through diversity” principle.

At the same time the system is in fiscal crisis. The main reason is low retirement age combined with fast-aging population: statutory retirement is 55/60, and effective retirement age is 52/54 (women/men).  The immediate amplifying reason is the unfunded increase in pension expenses that took place in 2010-2011. The total pension expenditure increased from 5.5 to 9.1 % of GDP from 2005-2008 to 2010-2012. This is in part explained by the “valorization” initiative that went into force in 2010, when the GDP was falling because of the crisis. However, in the budget, transfers due to valorization amount to about 1% of GDP. This would suggest that the bulk of the increase in pension expenditure seems to be due to higher indexation, and higher number of pensioners.

While “valorization” and other additional expenditures were supposed to be funded by increases in contributions from 20 to 26 percent, the contribution rate was cut down to 22 percent in 2012, and benefits were not adjusted. As a result, the amount of revenues is projected to decrease by 500 billion rubles in 2012 compared to the previous year.

The proposal of the Ministry of Labor and Social Policy – quite rightly so – includes some measures envisaged to reduce the deficit of the Pension Fund of the Russian Federation (PFRF), especially measures to limit early retirement.  The proposal foresees increases in employers' contributions for occupations with early retirement. This might lead to a reduction in the professions qualifying for early retirement. Transition arrangements foresee higher contributions for those who want to maintain eligibility for early-retirement. It is probably also good that there are proposed increases in the expected payout period used under the PAYG pillar from 19 years in 2013 to 21 years in 2015. Then in 2016 it is proposed for the benefit to be  linked directly to the life expectancy at the age of retirement calculated as an objective variable, which would preserve the integrity of the PAYG pillar as a Notional Defined Contributions pillar, which was the original intention of the reformers.

Overall, the proposal claims that the measures would reduce the PAYG pillar deficit to 1.2% of GDP in 2020, from around 2.2% of GDP recently. However, no details on the calculations, let alone longer-term fiscal impacts, are provided.

The most important and most daring part of the proposal  is the nationalization of the second, funded pillar for  all contributors in the default option (pension fund managed by Vnesheconombank), but allowing contributors that have their 2nd pillar accounts with occupational National Pension Funds (NPFs) or with  asset managers to continue using these vehicles if they choose so.

This is a huge change. As mentioned before, the Russian new pension system was based on a very important idea: that it is a role of the government to provide both more and less affluent workers with the “security through diversity”. The proposal will now provide this additional service of diversity only to most affluent and educated ones who choose another option than the default one. Most of workers, especially less affluent workers, with lower financial literacy, will be stuck with the default PAYG. Workers of companies that do not have pension benefits for their workers and other workers that do not understand the benefits of diversifying the sources of retirement income will be worse off compared to workers of big national private and state-owned companies, for example. The reason is that, currently, about 17% of the contributors have their 2nd pillar account in NPFs and asset managers, but they have about 28% of the total assets of the 2nd pillar. This means that the workers that contribute to NPFs and AMs have higher income than the average. Hence the bias.

One of the main arguments for the change seems to be the low returns of the default fund managed by VEB. It is a valid argument and anybody would agree that the selection of the investment portfolio should be improved. I would like to suggest working towards this objective rather than abolishing the pillar, by modernizing the asset management practices of the pension funds.

 The proposal speaks highly of occupational pension plans, set up by employers, which are a feature of 20th century industrialization and based on the concept of working the whole life for a one employer. Moreover, I am afraid these will be defined-benefit, not defined-contributions schemes (as they usually are, worldwide), yet another step backward. The good Russian pension system deserves to be saved, not dismantled. It is based on sound principles, even though there have been many implementations difficulties, and unsustainable initiatives.

A key element of the proposed reform package is changes in the first pillar benefit formula. It seems the proposal suggests the dismantling the NDC and return to a tweaked pre-2002 conventional defined-benefit (DB) scheme.  This will be a big step backward for the reasons outlined above: transparent individual accounts, both PAYG (notional) and funded, having automatic stabilizing properties are poised to be a future of modern pension systems.  However, Russia will be back to a non-transparent policy of changing coefficients, easily leading to flattening of the benefit distribution and breaking the contribution-benefit link.

There are several speculations on why personification is “not convenient”. I hear that PFRF has difficulties with accounts, referencing complaints from the NGPFs . However - while this may be true to some extent - let us remember that the PFR has issued 80m individual statements in 2011 and has been receiving close to 90% of all contribution records electronically, which is quite impressive by any means. So while there may be some operational problems it does not sound like a disastrous situation on the face of it.

To summarize, elimination of the mandatory DC contributions will produce relatively small results and will help cover only perhaps close to one-third of the current 1 trillion gap. The entire proposal will be a step back for the Russian pension system.

Finally, a very small mandatory DC pillar, if it survives at all, will be a problem as it may not make sense economically and technically (at least for those who have not been able to accumulate sizable savings so far). Administrative costs seem to remain high and are not going to come down lacking economies of scale and noting the fact that the Funds may need now to collect contributions independently. The proposal mentions turning private pension funds into commercial entities. This raises a big question of how this would affect their accumulated assets of more than 2 trillions roubles. While there is nothing wrong with the proposal generally, the practical short-term consequences could be dire.

The process also matters. It is all happening very fast. Sustainable pension systems are usually preceded by long debates (e.g. Sweden). Would it not be better to have a good 6-9 months debate before an important change is legislated? It is good that now decision has been taken to extend the discussion period till the end of the year.

By Michal Rutkowski.
The author is the Director for the Russian Federation in the World Bank and the Resident Representative in Moscow. He worked for many years on pensions, including for Polish government where as a Director of the Office for Pension Reform he was the main author of the new Polish pension system introduced in 1999.

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