Changing the system: the necessity of Russian pension reforms.

Kwok, James

Over the past decade Russia's economy has been buoyed by renewal and newfound prosperity. Since the financial meltdown of 1998, the country has achieved positive economic progress. Driven by higher oil prices, Russian exports totaled US$317 billion, and annual GDP growth reached a significant 6.8 percent. The percentage of population below subsistence level dropped from 29 percent in 2000 to 17.6 percent in 2004 and continues to decline.

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However, while economic indicators provide reason for optimism among Russia's citizens, the poor financial state of the national pension system poses a threat to the standards of living of current and future Russian retirees. Without the right kind of reform, these retirees will find themselves with a lower standard of living and increased poverty. Most current retirees live on a basic fixed-income pension provided by the state--the monthly pension is roughly 2,726 rubles (US$103) per month. Even though particular groups such as World War II veterans receive an extra 550 rubles (US$21), fixed-income payments from the government for retirees are not sufficient to sustain a comfortable standard of living. As Rimma Markova, a pensioner and the head of the Pensioners Party in Russia told Lateline, "They've kicked us in the teeth and the most vulnerable people remain neglected. The current pension is 20 percent of the average salary, it's just enough to stop us dying of hunger." Others echo a similar sentiment: Tonya Fominyh, a 79-year-old pensioner, told the Guardian, "now our pensions means nothing [sic]." In addition, the small base pension rate is only periodically indexed to the price level. Given that inflation has been above 10 percent over the last five years, the purchasing power of these pension payments is being constantly eroded. Russia's population--in particular, its proportion of workers to pensioners--is also shrinking: the UN Population Division projects that the country's citizenry will fall from around 140 million people to around 108 million by 2050. This population dynamic poses additional challenges for Russia's pay-as-you-go pension system in the long term.

While the system has undergone gradual reform since 2001, continuing these efforts is necessary. In order for the government to ensure adequate living standards for its retired population, the Russian pension system requires initiatives that address the following challenges: the aging dynamic of Russia's population, the need for the pension system to provide adequate retirement income, and the proper role of the government in encouraging this reform.

Demographics

As with other countries around the world--including the United States--Russia's current pension system is pay-as-you-go: a portion of current taxation levied by the government on businesses is used to pay the benefits of current retirees. As long as the working population and wages have a positive growth rate, current workers can expect their future retirement benefits to be larger than the total tax they paid to social security as workers.

However, the population of Russia currently is shrinking. In 1992, the rate of natural decrease was 219,800 persons. The rate of natural decrease in the population since then has increased markedly and now hovers around 800,000 per year. As a result, the proportion of the population over the working age is now 20.4 percent, and the population under the working age has fallen as recently as 2005 to around 16.8 percent. Given that retirement benefits under Russia's pay-as-you-go pension system come solely from government taxation of then-current workers' wages, this presents a problem for the solvency of the Pension Fund of Russia (PFR), the government organization responsible for distributing payments.

Fundamental pension reform is probably the most economically and politically effective way of maintaining the solvency of the Pension Fund. Demographically focused methods seem either unpopular or difficult to implement in the near future. For example, President Vladimir Putin recently proposed a pro-natalist program in his Annual Address to the Federal Assembly of the Russian Federation, arguing that "the programme to encourage childbirth should include a whole series of administrative, financial, and social support measures for young families." This seems both difficult to implement and ineffective at increasing solvency in the near future. Encouraging immigration, which would allow the working population to increase, is not politically feasible: a recent Economist survey demonstrates that workers in Russia feel threatened by the presence of foreign workers such as western Europeans and Africans, and, if given the choice, would rather they not live and work in Russia. Therefore, the most promising solution in the short-term seems to be reforming the national pension system. The process of pension reform began shortly after Putin took office in 2001. Under the direction of Prime Minister Mikhail Kasyanov and with the help of Minister of Health and Social Development Mikhail Zurabov, a number of reforms were passed from 2001 to 2004, progressively instituting piecemeal reforms to the pension system.

The current pension system is based on federal laws passed during this three-year period and is a "three-pillar" system--each "pillar" refers to a separate source of retirement incomes for retirees. The first pillar is comprised of the basic pension from the Russian government, which as recently as April 2007 was 2,726 Rb (around US$103) per month. This in essence is the pay-as-you-go portion of retirement income. The second pillar is referred to as the insured portion. Eight percent of a worker's wages are withheld by the employer, and moved directly to the PFR. Upon retirement, a certain return is assessed on one's lifetime contributions to this fund, and payments are made to the individual accordingly. The third pillar, which was implemented in 2004 for all workers born after 1966, is the accumulative portion. This is in essence the fully funded portion of Russian social security. Six percent of wages are withheld by the employer and paid to the Pension Fund. From there however, these "savings" can be moved by the employee to one of around 55 licensed private pension management corporations in Russia; in essence, workers' contributions are being moved to individual pension accounts. In all cases, the withholding of these wages is performed under the auspices of the unified social tax system, which is in this sense equivalent to the social security tax that Americans pay.

The system's general strategy, which aims to provide a mix of government provision and private savings, has two key benefits. Firstly, it increases the likelihood that the Pension Fund of Russia will remain financially solvent by encouraging citizens to supplement their government-provided retirement income with private savings. This restrains the growth of government benefits being issued without necessarily decreasing attainable living standards. Secondly, mandated savings provides Russia's economy with a much larger pool of capital. These extra pools of savings could spur economic growth.

The troubles with the current system and solutions

While this type of reform is a step in the right direction, there are still problems. The main challenge the government will face when rectifying these problems is the political pressure against changing the federal entitlement program. Six percent of wages as a contribution to an investment account may not be sufficient for retirement savings. The administrative costs for the government, given the commissions that pension companies require for funding, may make the program prohibitively expensive. The contributions of the investment portion of the fund should be augmented to make the accumulative portion of the pensions a more feasible way of financing retirement pensions. This need not come from an increased percentage of wages withheld on the part of the worker. One possible course of action would be a matching grant system. For example, the government could enact a policy in which for every one percent of wages contributed to the accumulative portion of the account, the Russian government could promise to contribute a proportional amount such as 0.5 percent. Such a plan would augment the retirement savings of a Russian worker without increasing the six percent requirement. The funds for such a policy could come from Russia's "Stabilization Fund," which was established in 2004, to collect revenues from Russian oil and natural gas exports. The size of such a fund--currently, it is almost US$76.6 billion--makes such a matching grant policy financially feasible.

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The current pension structure also leaves out some retirees. All those born before 1966 were not allowed to participate in the new system. Instead, they were grandfathered into the pay-as-you-go system before the implementation of the new system in 2002. In some sense, this may hurt this incoming generation of retirees. Since this group is not doing any saving in investment accounts, government revenues are necessary to finance their retirement. However, these revenues put tremendous pressure on federal coffers. The PFR in 2006 sustained a US$3.3 billion deficit, which is covered by the federal budget. Recently, Russia's fiscal situation has improved: helped by the high prices of oil and natural gas, the government is projected to generate a budget surplus of US$57.87 million in 2007. However, if Russia's particularly strong energy sector suddenly faces natural gas or oil price drops, the PFR may become inadequate as a source of retirement income for these groups. Given that the deficit in the PFR is projected to persist without any changes, a sharp decrease in income from lower oil and gas prices may accelerate the shrinking of the PFR and force Russia either to reduce benefits to this group or to raise debt to finance it--options which are unsustainable either for dependent retirees or for the government.

It is necessary for the government to find ways to encourage this group to continue saving. Those born before 1966 could still be given a retirement account--they would undoubtedly be accumulating retirement savings for fewer years, but this could be offset through higher government benefits for this generation. The government, for example, could supplement their savings with in-kind transfers, such as subsidized food, housing, and transportation-related consumption. It could also simply provide a block-grant to all those born before 1966 to be contributed to the accumulative portion of their pension savings. This would allow them to maintain higher living standards without facing the disadvantage of starting to save later in life.

The accumulative portion of the pension system, which is supposed to be a key source of retirement income, has so far not worked as planned. Workers have thus far chosen to keep their retirement savings in the PFR rather than to move them to private funds and asset-management firms. As of 2006, only around four to five percent of those in the pension program had chosen to transfer their retirement savings from the PFR to private asset managers. The rest of the funds are invested by the PFR in low-yield debt instruments such as state bonds. These low-yield bonds may not provide a sufficiently high return to workers to sustain consumption during retirement, and thus ways of inducing people to invest these savings in equity is necessary. From a cultural perspective, lack of interest in investment in the private sector may be an artifact of the Soviet era, when state-controlled economic activity was pervasive, and private investment was discouraged. Probably more importantly, this type of reform occurred very suddenly for most workers, and people may not actually understand how the system works.

Low investment rates for the accumulative portion of the pension can be increased in a number of ways. The government should ensure that workers are well aware of where their accumulated savings can be invested. This could include larger advertisement campaigns and readily accessible information for the public. Crucially, Russia needs strong capital markets. The rate of return for pensions depends heavily on the state of the market. To ensure that returns on retirement saving are not wiped out by financial meltdowns, the government should work to strengthen investor protection and investor rights in Russian firms, and to ensure simultaneously that monetary and fiscal policy work to stabilize the economy. To some extent, the government has already taken steps in this direction. The Russian government currently permits up to 65 percent of one's savings to be invested in the stock market, and as much as 80 percent of savings can be invested in corporate bonds. However, these percentages are rather high, and without reducing the maximum proportion of the savings that can be invested in these securities, stronger fiscal, monetary, and regulatory institutions in Russia are necessary to ensure that financial crises, such as that of 1998, do not occur.

Finally, the pay-as-you-go portion of Russian pensions is in need of reform. The large deficit of the PFR is in part caused by poor tax collection as in-kind payments and unreported income remain commonplace in Russia. After the introduction of a market economy, a great deal of economic activity went underground to avoid high prevailing tax rates. Estimates made by Goskomstat, Russia's State Statistics Service, find that 30 percent of all wages paid at the end of the 1990s were in the form of unreported income. This could include both in-kind payments and simple cash payments. Though recent policies have provided incentives to bring money back from the underground economy, a great deal of tax evasion persists, thereby compromising the fiscal sustainability of the Pension Fund.

The tax evasion that is partially responsible for the increasing deficit of the PFR can be mitigated with a combination of tax incentives and tighter regulation of firms. The government could reduce taxes on personal income. Currently, the standard rate for most individuals is 13 percent. This would be decreased slightly to decrease the returns to tax evasion. A matching grant system made by the government to the accumulative portion of the retirement account mentioned earlier could also increase the incentive for workers to truthfully report income. On the regulatory side, general accounting procedures for firms can be expanded to force firms to report more of their financial activity and wage payments. With less tax evasion, the financial troubles of the PFR can be mitigated, and pay-as-you-go pension payments can effectively supplement the accumulative portion of the pension.

The Responsibility of the Government

Whether any effective policies are enacted to meet the challenges facing the Russian pension system hinges on the responsiveness of the Kremlin to a very temperamental populace. Thus far, Mikhail Zurabov, the Health and Social Development Minister who has spearheaded the recent pension reforms, has become widely reviled in Russia. His reforms have met and continue to meet heavy resistance. Boris Gryzlov, State Duma Speaker, criticized Zurabov's attempts at reform, saying that "they implied fraudulent schemes." Protest posters outside metro stations have read "Zurabov Resign!" Zurabov's proposals to monetize compensation rather than providing discounts on transportation and medicine were perceived as a benefit cut to millions of retirees, including veterans and disabled workers. His proposal to create an accumulative retirement savings account also has been relatively unpopular, especially among retirees who believe that the Russian Federation should continue the Soviet Union's strong commitment to state-guaranteed retirement income. Protestors believe that as a more market-oriented and "liberal" reformer, Zurabov is out of touch with common Russian citizens and is not fit to enact these reforms. While Vladimir Putin has expressed no intention of running again in the next Russian election, the possibility remains that the politically unpopular topic of reforming Russia's pension system may force Putin, Zurabov, or whoever succeeds them to abandon this politically charged reform. This would only be to the detriment of social insurance in Russia. Stalled reform not only threatens the living standards of current retirees, but also puts the welfare of future retirees at risk.

Russia's current pension system is undoubtedly fraught with pitfalls and problems, but these problems can be alleviated with government policies that fine-tune pension rules and improve economic regulation. Fundamental pension reform has been a step in the right direction for improving social insurance in retirement. Whether the Russian government can push through all their reforms depends on the how well policy makers can cope with the political ire arising from their reforms.

senior editor

JAMES KWOK

RUSSIA BY THE NUMBERS

Population (millions) $144.8
Employment (millions) $64.8
Unemployment (millions) $6.9
Dependency ratio 53%
GDP (billions USD) $282
GDP per capita (USD) $1940
Value of pension assets (billions USD) $0.73
Pension assets as % of GDP 0.3%
Pension assets per capita (USD) $5
Inflation rate (CPI) 24%
Exchange rate RUR/US$ (6/2007) 25.940

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