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Why is the Russian pension system in need of reform?

[DJ: No figures here]

An ageing demographic profile is one of the most important challenges facing the Russian economy in 2010-2020. According to Rosstat, the working age population will decline from 87.5mn in 2010 to 76.5mn in 2030, implying a labour force contraction of 300-400k pa. Meanwhile, life expectancy is improving significantly. Today, while Russian men live on average for four years after retirement (similar to Bismarck's 19th century pensioners), women live for 20. This threatens to put the pension system under intolerable strain, and could cause a few arguments between men and women, too (we are studiously neutral on this).

Problem No. 1: Real growth in liabilities, due to an ageing population. The Russian demographic profile is more similar to Japan's than emerging markets', because the baby-boom generation born after World War II is retiring in 2011-2020 (see Figure 1). The aggregate number of men and women of pensionable age will gradually rise from 30mn in 2010 to 40mn by 2030 (see Figure 2). In addition, an improvement in health services and living conditions, after a relatively gloomy 1990s, increased life expectancy throughout 2000-2010. Indeed, after the introduction of the current pension system in 2002, life expectancy for men and women had by 2010 risen to 63.4 years (from 58.7) and 75.4 years (from 71.9), respectively. Therefore, unless the retirement age is raised, spending on pensions will expand by one-third in real terms over 2011-2030.

Problem No. 2: Lack of revenues, due to a decline in 1990s births. During 1990-2000, a decline in birth rates was not sufficient to replace an ageing labour force (see Figure 3). As the 1990s generation enters the workforce, the pensioner/labour force ratio will steadily increase from 0.35 to 0.50 through 2011-2030, thus intensifying the mismatch in the PAYGO pension system.

Problem No. 3: The federal budget will need to increase transfers. Although government spending on pensions is only 6% of GDP and rather low compared with developed markets (see Figure 4), the pension fund never had sufficient funds to service spending, and the shortfall was covered by transfers from the federal budget. After the 2009 anti-crisis stimulus package was introduced, the magnitude of the pension gap relative to federal budget expenses expanded to 27% in 2010. After temporary relief from the approval of a 34% pension tax rate in 2011, the relative volume of federal transfers to the pension fund will grow, to reach 25-26% as early as 2013 (see Figure 5).

Problem No. 4: Political resistance to retirement age increases. Pensioners make up a substantial part of the electorate, hence any changes in the retirement age are potentially damaging to politicians. This is the only explanation for why, in the midst of such a serious demographic problem, the retirement age in Russia - at 60 for men and 55 for women - is the lowest among the country's demographic peers. For example, the retirement age for men in the UK is 65, and for women will gradually increase to 65 by 2020. Germany is expected to establish an official retirement age of 67 by 2030.

Lately, some sections of the media have suggested that the pension fund deficit may be covered via the 2015-2020 state privatisations. This can only be stop-gap measure, in our view, and a tool that should only be used as a last resort. We are certain that the government will conduct a series of pension reforms, though these are unlikely to be carried out before the 2012 elections. It seems that one-sided reform is not enough in the current situation, and that reform of both the income and liability aspects of the pension system are required. Below we describe the most likely steps towards achieving this:

The retirement age will be raised. Despite the political obstacles (see above) MinFin is considering a gradual increase in the retirement age: to 62.5 for men (in 2015-2020) and to 60 for women (in 2015-2025) in order to cut future pension expenses (referred to as the 62.5-60 scheme). Under these proposals, the government would be able to relieve pressure by 2020 (compared with the present system) and save around 0.5-1.0% of GDP pa (see Figure 6).

Modify the pension tax scale. The operational rating setup proposes that a 34% pension tax rate be applied to any annual salary below RUB463k ($16k) and a fixed payment of RUB157.4k ($5,580) be paid once a salary exceeds this cap. Thus, the scale of the pension tax is super-regressive rather than flat (see Figure 7). We do not rule out a pension tax scale review in the near future in order to distribute the pension tax burden more evenly and minimise the incentive to explore a super-regressive tax system to optimise tax payments.

Balancing cash payments with medical insurance coverage. MED is considering another pension reform approach, which proposes dividing pensioners into young and old categories. Through this separation, MED will target a higher salary substitution ratio (close to 60%) for the younger group. The older group will receive wider medical coverage in exchange for less generous cash payments.

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