Russia pension reform ‘a threat to country’s fledgling financial markets’

Russia is paying a heavy price for having one of the lowest retirement ages in the world (photo:dpa)
Russia is paying a heavy price for having one of the lowest retirement ages in the world (photo:dpa)

Russia’s government is ‘seizing’ funds from private pensions for investment in a move many analysts perceive as desperate as the Kremlin tries to plug a growing hole in the state’s budget. The government is scrambling to find sources of income to help it fulfill spending pledges made by President Vladimir Putin while the economy struggles with low growth amid weak investment.

Russia’s pension system is in crisis. A recent move to sequestrate private pension contributions reflects a growing desperation by the Kremlin over how it can plug a huge and rapidly widening hole in the state pension fund. The Kremlin is clearly fearful of antagonising the country’s 40 million pensioners. It has increased pensions lavishly and promised that there will be no rise in the retirement age. But after the presidential election in 2018, Moscow will have to get serious about reform, or face fiscal ruin. It will also have to face the wrath of the angry, but elderly population, who cannot be dealt with by the riot police.

THE RUSSIAN government has made a move that smacks of sheer fiscal desperation. Faced with a widening deficit in the federal budget, it announced that 244 billion rubles (US$7.6 billion) in anticipated private pension contributions for 2014 would be sequestered. And more of the same will follow in 2015, making a total of 500 billion rubles withheld over two years.

Public reaction was one of surprised outrage. Many denounced the move as a 'confiscation’ of their pension funds

Public reaction was one of surprised outrage. Many denounced the move as a 'confiscation’ of their pension funds.

Former Finance Minister Aleksei Kudrin called the move ‘exceptionally unfortunate’ and a threat to the country’s fledgling financial markets. An angered fund manager claimed that ‘market participants will lose about a quarter of their income and people will underearn’. People with individual retirement accounts voiced fear about pending nationalisation of their savings.

Retirement accounts

The government said the reform, announced in September 2013, was to consolidate the system - to make sure that deposits remain safe. Over a two year transition period, private pension funds will be required to transform their legal status from non-commercial organisations to joint stock companies, and be vetted by the central bank.

Employers’ contributions previously earmarked for individual retirement accounts will be channelled into the state pension system, plugging part of its gaping hole.

It is said that once the process of consolidation has been completed, the money will be paid back. But it is highly unclear when that will be. And many fear that it simply will not happen. Taken aback by the outcry, President Vladimir Putin assured the public that the government was not discussing confiscation of these savings. 'Heaven forbid,' he said.

Russia’s existing pension system was created in 2002.

The neoliberal agenda of encouraging people to save for their own retirement had already caused numerous other countries to reform their pension systems. Inspired by this, the Russian government introduced a funded private insurance component, to supplement the traditional pay-as-you-go (PAYG) system operated by the State Pension Fund.

Employers presently pay a 22 per cent contribution levied on the payroll. This is split between 16 per cent paid to the state Pension Fund – the PAYG – and another six per cent to individual retirement accounts, operated by private fund managers.

Private pensions

The new rules mean that from January 2014 private funds will not be allowed to collect payroll contributions until they have changed their legal status and been vetted by the central bank - a process that is expected to take at least a year. Those pension contributions will meanwhile be channelled into a special state distribution fund.

Prime Minister Dmitry Medvedev told ministers the government needed to check that the money Russians channel to private pension funds was safe. To do this, it will seize 244 billion rubles (US$7.6 billion) from non-state pension funds and put them into the state pension fund.

For the past 11 years, Russians born after 1967 have had the option of diverting the equivalent of six per cent of their salary into privately managed pension savings rather than the state fund. More than US$80 billion has been built up by investors in these accounts, say analysts.

The thinking behind the 2002 reform was to ease the fiscal burden of pension payments, to reduce state control over savings, and to support the emergence of financial markets.

With the federal budget already in deficit, which is expected to double in 2015, the government also desperately needs long-term money to finance rebuilding the country.

As pension funds constitute the backbone of financial markets in developed market economies, the pool of long-term capital is viewed as vital.

Nationalised systems

Russians, however, demonstrate little interest in how their pension contributions are placed. Three out of four eligible households opted to remain passive. Their share of contributions were channelled into accounts at the state-owned bank Vneshekonombank. It holds 75 per cent of all pensions saved by Russians born after 1967.

Russians were not alone in viewing the privatisation of pensions with scepticism. By 2012, seven out of 13 former Eastern Bloc countries that had opted for privatised pension systems had partially or wholly nationalised those systems.

That said, the Russian pension reform has made a firm mark on the country’s financial markets. About one-third of 2.6 trillion rubles (US$79 billion) in funded retirement money is invested in stocks and bonds by non-state pension funds. Choking off the inflow to this market will not only lead to lower yields, as the Vneshekonombank has a poor earnings record, it will also lead to reduced demand for corporate bonds, This will add to troubles already faced by Russian businesses in ensuring financing.

The main problem for the Russian government is that the deficit in the State Pension Fund is running out of control. Under PAYG, it is the government that holds the responsibility for paying pensions. If the employers’ contributions fall short, other means must be found within the federal budget. And the federal budget is now slipping into the red.

Tough choices

Russia is certainly not alone in facing tough choices on how to handle future pensions. Many other countries are faced with the problem of an ageing population which is imposing increasing burdens on those still in work. Two features, however, combine to make the Russian case special.

But no group has been pampered more than the country’s 40 million pensioners. The Kremlin is visibly running scared of a repeat of the wave of protest that erupted in 2005

One is that the Russian system, inherited from the Soviet Union, remains generous when it comes to retirement age. Men may retire at 60 and women at 55. Although life expectancy for men remains low, at 64 years, Russian women may expect to live until 76. Women may expect to draw pensions for over two decades. This was sustainable when pensions were low - but that is no longer the case.

The other feature making the Russian case special is that the country’s economic policy has been made hostage to the political fortunes of President Vladimir Putin. Although the Kremlin has successfully neutered the liberal opposition that took to the streets in mass anti-government rallies in the winter of 2011- 2012, it is clearly worried about antagonising those parts of the population that remain loyal - notably workers in the rustbelt.

As the Russian economy began to emerge from the 2008 global financial crisis, it was clear that the Kremlin would happily ransom the country’s economic future for short-term political needs.

Budget spending

Its desire to shield its loyalist base from financial hardship was demonstrated in January 2009, when the minimum wage was increased by 88 per cent, from 2,300 to 4,330 rubles per month.

And, preparing for the 2010 budget, then Prime Minister Putin said that 70 per cent of budget spending would go on projects with of a social nature.

The beneficiaries of this policy of lavish social spending from 2010 onwards have included teachers and doctors, whose wages are being raised substantially. And it has included members of the security forces, whose loyalty needs to be ensured in case of social unrest.

But no group has been pampered more than the country’s 40 million pensioners. The Kremlin is visibly running scared of a repeat of the wave of protest that erupted in 2005, when it introduced a monetisation of Soviet-era benefits in kind for pensioners.

In St Petersburg, some 20,000 angry elderly people took to the streets, blocking the main, upmarket street, Nevsky Prospekt. They expressed disbelief that money would adequately compensate for lost benefits.

The reason for concern today is not only that pensioners constitute an important group of voters (40 per cent), but that it is also a group that cannot be dealt with like other protesters. Unleashing the riot police to beat up old women would look very bad.

Pensioners

The answer to preventing the elderly from taking to the streets has been a massive expansion of federal spending. During the 2009 crisis year, average pensions increased by 10.9 per cent in real terms, and 2010 brought a 34.8 per cent rise. Total spending on pensions increased from 5.5 per cent of GDP in 2008 to 8.9 per cent in 2010.

And the deficit in the State Pension Fund widened to 1.3 trillion rubles (US$40 billion), or 2.2 per cent of GDP. Although the increase for 2011 and onwards was kept in line with inflation - damage had already been done.

This is alarming, it should be noted that the increase in the rate of benefits has gone hand in hand with an increase in the number of pensioners. It is estimated that the working age population of 87 million is presently shrinking by about one million per year.

Its share in Russia’s total population of around 144 million will fall from 60.1 per cent in 2013 to 56.8 per cent in 2018. Those who remain in the workforce will have to shoulder a combined burden of a rising number of pensioners and a rising proportion of children, born during the good years from 2000 onwards.

Complacency

At the time when Mr Putin embarked on his spending spree, it may have seemed that there was ample room for expansion of federal budget spending. Although the onset of the global financial crisis caused a collapse in the price of oil, and therefore a sharp deterioration in Russian fiscal balance, this was temporary. Global oil markets staged a surprising rebound.

In 2009, the price of Urals crude, Russia’s main export blend, rose from US$34.20 to US$72.08 per barrel. It continued to climb in 2010 and ended the year at US$90.94 per barrel. The Russian government sank back into a feeling of complacency, trusting that the petrodollar inflow would provide a cure for all problems. During his campaign for the presidency, in the spring of 2012, Mr Putin pulled out all stops, promising lavish increases in spending across the board.

By the end of 2012, the deficit in the State Pension Fund had risen to 1.75 trillion rubles (US$59.3 billion) or three per cent of GDP. And calculations for 2013 have shown that while a total of 4,653 billion rubles were paid out from the PAYG, contributions stopped at 2,044 billion rubles. This meant 44 per cent of pensions had to be covered from other sources, i.e. from the federal budget. Projections based on the absence of change indicate that by 2050 pension payments may amount to 16 per cent of GDP. This is clearly not tenable.

Although a broad consensus says the retirement age must be raised, Mr Putin remains adamant that this is not going to happen. According to State Pension Fund head Anton Drozdov no change will be considered before the election in 2018.

Additional borrowing

In the short term, leading up to the presidential election, the problem will remain manageable, albeit at a cost. With a sovereign debt that is presently just above 10 per cent of GDP, the government has ample room for additional borrowing. But looking beyond 2018, the situation is likely to become impossible.

The number of 65 year olds and older compared with the working age population is projected to double from around 18 per cent in 2010 to 36 per cent by 2050.

Unless there is a renewed spike in the price of oil, there is simply no way around implementing serious pension reform

Meanwhile, a slump in birth rates during the 1990s means that the number of women entering childbearing age will fall sharply over the coming decade, implying a renewed drop in birth rates and therefore a reduction in the working age population two decades further on. Demography is unforgiving. You cannot go back and increase the number of children born in the past.

Unless there is a renewed spike in the price of oil, there is simply no way around implementing serious pension reform. One possibility might be to increase funding by raising the payroll tax, but this is generally rejected. It would drive many employers back into the underground economy and perhaps even result in lower total tax receipts.

Widespread outrage

The only realistic option is that the retirement age will have to be raised and that people in work must be encouraged to work longer before retiring. The IMF is in agreement with most Russian experts that a rise to 62 years for women and 63 for men must be implemented. The Kremlin, however, fears widespread outrage.

Today’s pensioners have a vivid memory of how they were defrauded in the past. Hyperinflation in the early 1990s wiped out their savings, and the bank collapse in 1998 did the same again. Mr Putin has repeatedly promised that pensions will increase and the retirement age will remain unchanged. If he goes back on that, he may expect a considerable backlash. But if he does stick to his guns, he will preside over borrowing requirements that threaten to bankrupt the nation.

Russia pensions

  • Pension funds hold more than US$100 billion in assets. Nearly half of that is mandatory savings managed by state-run bank Vneshekonombank. Non-state pension funds and funds affiliated with state-controlled companies hold the rest
  • Russia has one of the lowest retirement ages in the world: 60 for men, 55 for women. Both the IMF and Strategy 2020, an expert group formed by the Russian government, call for a gradual increase of the pension age to 63
  • The real value of the average state pension doubled over the past five years to become around US$300 a month. However, it remains less than 40% of the average wage
  • Pensioners already account for nearly 40% of the electorate. They are much more likely to vote than younger Russians
  • The share of Russia's working age population is expected to decline by the end of Putin's third term in 2018 to 56.8% from 60.1% in 2013 (Russian Federal Statistics)
  • Changes to the law will prevent private pension funds from collecting payroll contributions until they have changed their legal status and been vetted by the central bank. The process is expected to take at least a year
  • Russia's last pension reform was in 2002
  • In Soviet times, there were two workers to pay for one pensioner. Today’s figure is 100 workers for every 87 pensions. By 2020 that figure is set to fall to one worker for one pensioner – known as the ’Russian Cross’
  • Declining birth rates in the 1980s and 1990s have left Russia with too few workers to support those in retirement. Birth rates stabilised in the 2000s but too late to affect the looming pension crisis
  • Experts at Moscow’s Higher School of Economics have calculated the working population’s pension contributions in 2013 would cover a mere 56% of the total 4653 billion rubles required. The other 44% will have to be taken from other parts of the public purse

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