Home > Publications > Case Studies > Russian Pension System Faces Major Revamp

Russian Pension System Faces Major Revamp

Sergei Blagov

During the era of the Soviet Union, Russia’s pension system was fully backed and guaranteed by the government, as one of the cornerstones of a policy that focused on consistent provision of social benefits. The once notorious “120-ruble-a-month” pension was instrumental in providing people of the former Soviet Union with a warm feeling of safety and stability. Things began to change under former President Mikhail Gorbachev’s “perestroika” policy, when controls on the economy were eased and inflation started to wipe out the value of the 120-ruble pension. And the very notion of safety came to an abrupt end when the USSR collapsed in 1991 and subsequent radical market reforms brought on hyperinflation, which drove people’s pensions and savings to rock bottom levels.

Some 40 million pensioners live on the system’s benefits and many of those live in virtual poverty, due to the inflation-led erosion of their benefits. In addition, an aging population, tax evasion and other problems have all led to a deficit in the pension system. Simply put, if the current set-up is not fixed, it will run out of money. According to the World Bank, Russia badly needs to overhaul its pension system to deal with high contribution rates and weak compliance. The current pension system, like its Soviet predecessor, is funded by a 29 percent payroll tax and is replenished from the budget if it falls short. Employees’ direct contributions are either zero or minimal, placing the burden almost entirely on the employer, formerly the government, but now commonly private. This encourages managers to evade tax by under-reporting their payroll. The gap between official and actual contribution rates, coupled with other budgetary problems, has led to a deficit in the pension system.

Moreover, the share of pensioners in the overall population has been rising. Overall, between 1959 and 1990 the population over the age of 60 doubled, to some 20% of the population. The system dependency ratio is high, with just under two workers to every pensioner. And despite increasing life expectancy rates, Russia still sticks with the relatively low retirement age of 55 for women and 60 for men. This is rather lower than the retirement ages set in comparable Eastern European transition countries, such as Hungary, where men and women retire at 62, or Bulgaria, where men retire at 60 and women at 65.

Private voluntary pension schemes, or non-state pensions, have been available since the mid-1990s. There are more than 250 licensed pension funds in Russia with some 21 billion rubles ($700 million) under management and 15.5 billion rubles in reserves (more than $500 million). These funds are predominantly established under corporate sponsorship, but there are pension funds open to the public. Nevertheless, private funds represent a mere fraction of Russia’s overall pension system. The sum total of Russian pension payments made in 1999 was equivalent to 5.5% of Gross Domestic Product (GDP), compared to 6.9% of a larger GDP in 1992.

HISTORY OF REFORM EFFORTS

Russia has launched several bids to reform its pension system. The first formal attempt at pension reform in Russia was made in August 1995 when the government approved a pension reform draft. The blueprint implied a three-level system and some changes, notably customized registration of individuals, took place. However, the funded element of the pension system failed to materialize. Then, in 1997, another “Pension Reform Concept” was drafted. The scheme caused some debate but was never officially adopted.

After that the Russian government began preparing a reform that would rest on a multipillar approach combining pay-as-you-go and fully funded systems through direct worker contributions to a retirement account. The World Bank loaned Russia $800 million in 1997 to assist the reform by strengthening the Pension Fund’s revenues through better collection and enforcing compliance by larger companies. The plan also aimed to introduce a minimum pension floor of 80% of the minimum subsistence level, adjusted according to inflation. The World Bank forecast that the floor would ensure that 12 million pensioners would receive minimum pensions and about 4 million would experience an improvement in living standards.

After much debate at the government level a cautious, stage-by-stage introduction of the new principles was accepted. However, due to the August 1998 financial meltdown, few actual changes were ever made. In late 2000, Russian authorities once again moved to revive the pension reform. A year later, in December 2001, President Vladimir Putin approved the three basic laws of the ‘pension package’ which had been earlier passed by the parliament.

The pension reform introduced a multi-pillar pension system in a major shift from a defined benefit pension scheme to a defined contribution pension system. The defined contribution system is comprised of a first pillar, a notional defined contribution (NDC) pay-as-you-go pension scheme, mandatory funded second pillar, and a basic benefit. The funded part of the Russian pension system is operated by the Pension Fund of Russia (PFR).

The reform intends to address several problems founding the old pension system, including very complex and overlapping benefit formulas and generous eligibility conditions, including early retirement for many occupations. The reform is also supposed to take care of the growing financial burden from a declining number of contributors and increasing number of pensioners, a result of increasing layoffs, tax avoidance, growing unemployment, and the aging of the population. The reform also aims at reducing the complexity of the pension system through a simple benefit formula and transparent eligibility conditions. Another objective of the reform is to increase an individual’s incentives to contribute and work longer in order to improve the fiscal solvency of the pension system. Finally, the objective of the funded scheme is to increase the pension benefit, while deepening capital markets and promoting economic growth.

LESSONS LEARNED

A pension system must increase workers’ incentive to contribute

  • Russia’s pension reform has been criticized for not providing any real incentive for workers’ to increase their contributions or to work for longer, both factors that are needed to bolster funds in the system and reduce its costs.
  • Pensions should be indexed to inflation and that indexation must be implemented. Currently, by law Russian pensions should be linked to inflation, but in practice they are not raised to keep pace. As a result, many pensioners live in poverty.
  • The retirement age should be increased to reflect the fact that Russians are now living longer, giving workers’ incentive to stay working and contributing to the pension fund.
  • The low notional rate of return that workers can expect to receive and the fact that most of what they contribute is taken through tax is seen as another disincentive.

 

The reform has given management of the second pillar, a provident fund, to the Pension Fund of Russia, a government agency. Critics such as the World Bank argue that management of the fund should be contracted out to an international asset manager through competitive bidding, so that the handling of workers’ investment would be transparent and easy to follow, as well as being more competitive.

The system must be fiscally sustainable

The World Bank has said that if Russia’s economic growth falters, then the pay-as-you-go portion of the system is likely to fall into deficit. While the basic benefit pillar of the reform is expected to have surpluses in the coming years, those could not be used over the long run to offset the pay-as-you-go deficits.

The success of the reform is also partially pegged to a gradual decline in the pension replacement rate, which is the ratio of average pensions to average wages. But a fall in pensions compared to wages is likely to create political problems for the government. One way to raise the replacement rate instead of seeing it decline, would be to raise the retirement age and have more people contributing to and fewer drawing on the pension system, according to the World Bank. Alternatives such as increases in payroll taxes and improvements in compliance are not sustainable or realistic in the medium term.

A pension system needs stable and functioning financial markets

The accumulation of long-term financial resources from Russia’s multi-pillar pension system will place enormous pressure on the Russian financial market to safeguard pension assets. The development of a funded pension system hinges on the confidence that members of the pension system have that their pension savings will be invested safely while obtaining adequate returns.

A central requirement with introducing funded pension systems is to ensure that banks can be trusted for safekeeping of assets. Yet if Russian depositors do not entrust banks with their savings, as they currently do not, and cannot regard them as sound custodians of their securities, it is difficult to envisage how other parts of the financial system that are necessary for a funded pension system, such as capital market institutions, will prosper.

The World Bank has noted that lack of trust in the Russian financial system has stimulated the development of a number of activities - such as use of barter and non-cash payments, which have only recently diminished, and reliance on insecure and inefficient savings forms (mattress savings and capital flight).

The Bank recommends allowing for foreign investment of a substantial part of Russian pension funds so as to increase confidence in the new system. The knowledge that their savings are not hostage to the whims of the local market would increase confidence in the system. While Russia has achieved a measure of macro-economic stability, its financial and capital market infrastructure is still weak. The core financial market requirements to launch and maintain a successful multi-pillar pension reform are mostly absent. Thus, the weakness of financial and capital markets pose serious risks for the successful implementation of the pension reform in Russia.

Pension reform needs a strong and transparent administration to implement it

Russians are told that they are responsible for their pension savings yet in fact the PFR is still in charge of everything, Christof Ruhl, chief economist in the World Bank’s Russia Country Office told journalists in Moscow in March 2003.

Critics have been especially incensed at the Pension Fund’s plan to triple its own funding to nearly 22 billion rubles (some $700 million) in 2004. Pension Fund head Mikhail Zurabov has been rejecting these accusations, saying that as a result of pension reform, Russia would get "a comprehensible and decent pension system.”

There has been also a controversy over investment of pension assets in Russia. While the choice of the Central Bank of Russia to be the asset manager for government securities denominated in rubles caused few debates, the designation of the Vneshekonombank (Foreign Economic Bank) as the asset manager for those denominated in eurobonds sparked a bit of controversy.

Vneshekonombank, or VEB, is not only empowered to manage the country's Pension Fund money, which by law must be invested in government securities. It is also empowered to manage Russia's foreign debt or the Paris Club and the London Club debt converted into bonds. As the manager of Russia's foreign debt, VEB has an interest in reducing the debt. But as manager of the Pension Fund money, VEB has an interest in seeing the value of its government securities rise.

Economic Development Minister German Gref reportedly urged Prime Minister Mikhail Kasyanov to remove VEB from its position to manage pension funds, estimated at $8 billion a year. Nonetheless, in February 2003 the Russian government announced it was not going to review its decision to empower VEB to manage the country’s Pension Fund money.

The workings of the administration should also be transparent and the pension fund should issue workers an annual statement of their contributions and balance, as well as publish audits of its money management process. Analysts have long argued that the pension reform would require considerable transparency and accountability of the Pension Fund of Russia. However, circumstantial evidence might arguable indicate that this vital goals still some time off in Russia.

Publication Information

Type Case Study
Program -
Download Not Available