Nikolai Roussanov
Economics 2470: Reform of the Welfare State
Final Paper
Russian Pension Reform
This paper attempts to meet three goals. First, we explain why Russia needs a pension reform. Secondly, we present the Russian Government’s (still evolving) approach to reform and concrete proposals considered by the policymakers. Thirdly, we analyze the Government’s approach using the set of principles and objectives, on which, we believe, a sound pension system should be based.
Why Reform?
Ten years have passed since the collapse of the Soviet Union and the beginning of Russian economic reforms, but the idea of a systemic reform of the country’s pension system has only appeared in the economic policy discourse. Arguably, the pension system is the most entrenched and unshaken artifact of the socialist economic system, even compared to the other sectors of the welfare state. Although the pension system has been undergoing a nominal “transformation” throughout the past decade (the Pension Law setting the new principles of national social security was passed as early as 1990), in reality it operates essentially the same way it did under communism, at least from the viewpoint of the workers and the pensioners[1].
The latter, however, are greatly dissatisfied with the output they get from the system, i.e. their pensions, since the amounts they receive do not let them maintain the consumption level they enjoyed under socialism, especially compared to the rest of the society. The workers are worried about the lack of financial security awaiting them in the future, and feel that their pension fund contributions are being wasted by the government. The employers are discontent because the rates of payroll contributions to the Pension Fund are too high, while there is no positive incentive to contribute, part from the threat of punishment. So for the employers this is just another tax, and a highly punitive one, since it produces disincentives for the creation of new jobs and increase in workers’ wages. Finally, the government is dissatisfied since it has to deal with all these discontent groups – hungry pensioners who fuel the engines of political instability, labor unions who press for special retirement privileges for their workers, and businessmen who try to do their best at evading the payments.
Under the socialist system, every worker was entitled to a state pension starting at a certain age. (For a while, though, certain groups of the population were excluded, for example members of the collective farms [kolkhoz] did not receive any state pensions until the 1970’s and had to rely on their own gardens and livestock for subsistence, as well as some help from the kolhoz). The size of benefits was determined by the number of years of labor and the wage at the moment the person was retiring. Certain “privileged” groups of the population had the right of early retirement and/or higher benefits. By manipulating these privileges, the state created incentives for people to take certain jobs (such as miners) or move to underpopulated areas (in particular, the northern territories). However, within each group, the distribution of benefits was fairly uniform. The party officials along with some other “important” people (such as distinguished scientists and artists) were entitled to the so-called “personal pensions.” Along with greater benefits (the size of which was determined on, indeed, a much more “personal” basis), these individuals received a bundle of other, non-monetary privileges, such as access to special stores, higher quality health care, etc.
This system was an integral part of the command economy under a totalitarian government, so as soon as the latter fell apart, it was believed that a new pension system needs to be established, one compatible with the market economy. The idea that was laid down as the ground for the new system was that of social insurance, which was the basis of most of the world’s social security schemes. The State Pension Law of 1990 set up the general framework, consisting of the following basic principles:
· pension insurance is administered through the autonomous off-budget Pension Fund of the Russian Federation (PFR)
· every employee must be “insured,” regardless of his/her or the employer’s willingness to make the mandatory payments to the Fund
· benefits and their distribution are set up by the law and cannot be changed arbitrarily by the government or by an agreement between employer, employee and the Pension Fund
· the size of the benefits must depend on the size of the contributions made on behalf of a particular worker, although indirectly – the benefit formula was based on the number of years the person has been insured, and the person’s wages over used to calculate the size of the contributions over that period.
· the funds of the PFR cannot be used for any purpose other than paying out the benefits (even the administrative costs incurred by the Fund must be financed by the government from the general revenue).
In reality, however, the insurance ideas were never implemented, and the above principles, soon after being legislated, were bent by the government and the parliament due to political and lobbyist pressure. In particular, the Pension Fund became strongly dependent on the government, and its finances (the contributions collected from the workers and the employers) used for other purposes besides paying out insurance-based pension benefits. Due to the irregular funding by the government, the Pension Fund was forced to use its insurance funds for paying the non-insurance pensions (e.g., the war invalids’ benefits, etc.), financing its daily operations, as well as various other ad hoc expenditures (such as sponsoring the celebration of the World War II Victory, etc.).
Even more importantly, the size of the benefits was still disconnected from the amount of personal contributions. Most of the pension privileges that existed in the Soviet system (early retirement and higher benefits for miners, northern workers, etc.), except for the “personal” pensions, remained intact. The number of privileged categories even increased substantially, subject to the political pressure from the respective interest groups[2]. As a result, the Soviet-style leveling was largely preserved, with existing differentiation between pensions being independent on the insurance contributions – in certain instances, individuals who contribute smaller amounts over a smaller number of years, retire earlier and receive higher benefits than others, who contribute more and retired later.
In addition, due to inflation the real value of pension benefits dropped significantly a number [3]of times over the past ten years, the adjustments (often insufficient) being made with a delay of up to six months or even more. Governments’ fiscal problems, such as irresponsibly drafted budgets and difficulties in collecting taxes and payroll contributions to the Pension Fund, lead to arrears in paying off the benefits, particularly severe (up to several months) in 1996-1998 (FIPER 2000).
The demographic trends pose a more distant, but very serious fiscal threat, common for most of the pay-as-you-go (PAYG) pension system. Increased life expectancy leads to a shrinking ratio of the number of workers contributing to the system to the number of benefit-collecting pensioners. Currently there are 60 pensioners per 100 contributing workers, but by the year 2015 this number is projected to grow to 70, 2023 – to 80, 2033 – to 90 , and 2053 – to 108 pensioners per 100 contributors (FIPER, 2000). Without a dramatic increase in the real wages (which is not expected) the PAYG scheme is clearly unsustainable – even though the Pension Fund is currently running a slim surplus, it will soon face an increasing deficit. In order to maintain the current level of pension benefits of at least 35% average wage, in the year 2056 the Pension Fund would need to spend 10.3% GDP (vs. 5.0% GDP in 1995). If the share of wages in the GDP stays at the same level of 17.8%, the existing pension mechanism is clearly
unsustainable (FIPER, 2000).
The set of possible solutions consists of raising the retirement age, reducing benefits, and/or raising the rate of mandatory contributions to the Pension Fund (or other taxes, if it is decided to finance the deficit from the general revenue). Raising the rate of payroll contributions to the Pension Fund above its current level of 30% (29% paid by the employer and 1% withheld from the employee’s wage) does not seem viable and would most likely effect economic growth quite adversely. Such a solution is also contrary to the general macroeconomic policy of the current government that takes great pride in reducing the payroll tax to the flat rate of 13%. The effect of this tax cut would be clearly offset by an increase in the social tax[4]. Reducing the size of benefits is clearly not an option simply because they are already incredibly low. The only remaining option is to raise the retirement age to at least that of the developed countries (currently the retirement age in Russia is 60 for men and 55 for women). There has been indeed some debate over such a proposal. But even if it were implemented, the positive effects of such an ad hoc solution would be short-lived and partial. The purely fiscal problems can be fixed temporarily, but more general adverse economic effects cannot. Among these, as it has been pointed out, is the fact that “poorly-designed public pension systems can distort life-cycle savings and work decisions, leading to dead-weight losses, lower output level, and a lower growth path of output” (Holzmann, 1999). Given the overall state of disarray and imbalance in the Russian pension system, a more systematic approach to reforming it seems to be necessary.
Government’s Approach to Reform
Most of the problems with the existing pension system were evident to the government economists since the early 1990’s. However, there was no political support for any moves towards the real reform of the pension sector. The Conception of the Pension Reform based on the World Bank’s multi-pillar approach[5] was first drafted by the Russian government in 1995. Certain measures required for implementing this plan were introduced, such as the creation of personal pension data registries that would allow keeping track of workers’ contributions. However, the core principles that needed to be legislated as a law could not gain enough political support at the moment. These principles included the creation of three “pillars”:
· basic pension, a uniformly fixed size of benefits that every citizen would be entitled to upon reaching the retirement age;
· labor pension, whose size would depend on the number of years in the workforce and the wages (and thus, indirectly, on the amount contributed to the system);
· additional non-state administered pension (presumably - private managed pension plans).
By 1997 the basic conception of the pension reform was refined, in particular, the idea of partial funding was articulated more explicitly. In the newer version, which engendered quite a bit of controversy and debate in the policy circles, the modified “pillars” were:
· social pension, unlike the basic pension in the earlier version, is provided only to the most needy, those who where not able to accumulate enough contributions to the system (i.e., whose benefits otherwise would not reach the poverty line); financed from the general revenue;
· mandatory fully-funded pension insurance, the main component of the pension system, providing all retiring workers with benefits; dependent on the amount of their contributions and the accrued capital gain;
· additional pension insurance, privately managed retirement plans, voluntary for all workers and mandatory for some categories of employers (in order to replace the special sector privileges of the current system).
The transition to the fully funded system, as planned in this proposal, would be slightly more rapid than in the pension-reform pioneer Chile. This is meant in a sense that all the workers under the age of 30 would be required to switch to the funded system, although not fully – only 11% of their wages would be contributed to the funded system. (In the Chilean system only new workers were required to participate in the new system, current workers independent of their age were given a choice). This more radical proposal was never approved by the Government, which resulted in creation of still another modified version of the program, taking in account the need for a smooth and gradual transition from PAYG to the fully-funded via combination of PAYG with partial funding. In fact, this program, approved by the Government, followed the World Bank approach most closely.
The major changes concern the main, second “pillar” of the system – the “mandatory pension insurance.” It would consist of a PAYG component and a funded component, with a gradual increase in the share of funding (from 1% payroll contribution in 2000 to 8% in 2010). The first partially funded pension benefits were expected to be disbursed in the year 2005.The target share of funding by the end of the reform period would match the PAYG component.
The funded part of the mandatory pension insurance would be implemented in the form of Defined Contribution (DC) accounts, and the unfunded part as Notional Defined Contribution (NDC) accounts. In fact, for each employee this could be a single, “semi-notional” account, whose value at any point in time represent the amount that would be accumulated if all of the person’s contributions were invested. It was originally intended that upon reaching the retirement age the total amount accumulated on the personal pension account (both DC and NDC) would be converted into an annuity providing the pensioners with monthly benefits. Presumably, the benefits would be financed from the person’s DC savings and PAYG revenues of the PFR proportionally. However, alternative proposals included measures allowing pensioners to pass the remainder of their DC savings to the successors after their death. On the one hand, it would provide workers with greater incentive to contribute to their pension insurance (especially if the DC component were matching the PAYG part), on the other, it would probably substantially complicate annuitization and reduce the benefits.