How to Make the Pension System Sustainable
The sustainability of the system relies on introduction of the compulsory accumulative system – the second pillar of the pension reform. Why is it being postponed?
depositphotos / palinchak
As many other countries in the world, Ukraine is facing an ageing population. The share of population aged 60+ was around 23% at the beginning of 2019 and is estimated to reach 33% by the year 2050. This is a challenge for the traditional pay-as-you-go (PAYG) system that brings the necessity for additional pension provision to make the pension system sustainable over the long run. The first attempt to change the pension system was made in 2004 when in addition to traditional pay-as-you-go system the voluntary accumulative pillar was introduced.
However, measures taken in 2004 were not sufficient to make the pension system sustainable. PAYG first pillar had suffered from high deficit covered by the state budget. Effective pension age was markedly lower compared to OECD countries (58.5 years for men and 55.9 for women). This is lower than the official pension age at that time (60/55) due to early pension opportunities for a number of professions. There are also “special” (privileged) pensions which are paid from the state budget. Overall transfers from state budget to pension fund amounted to UAH 142.6 bn in 2016 (20% of total state budget expenditures – see Figure 1).
Figure 1. Pension Fund balance, per cent of GDP
Source: Pension Fund Budget, State Statistics Service
Population ageing is just one of the pension system problems. State Pension Fund revenues are undermined by the widespread practice of unofficial salary payments. This way employers pay lower taxes and employees receive slightly higher salaries. Among the reasons for this are overall low levels of trust to the government, high political and economic volatility. On the other hand, sometimes people are forced to accept informal employment arrangements if they want to get a job. This is a consequence of outdated labour legislation which makes it very costly to formally employ a person. As a result, Pension Fund does not have the money to pay pensions.
As for the voluntary pension savings, despite being introduced 15 years ago, this sector remains small, with total assets of UAH 2.8 billion (~USD 104 million), compared to the annual State Pension Fund expenditures of UAH 438.6 bn, and has low coverage. It was hit hard by the economic recessions of 2008-2009 and 2014-2015.
Introduction of Compulsory accumulative pillar was constantly postponed. The discussion of the second pillar recommenced since 2017.
To stabilize the pension system, in October 2017 the parliament passed important legislative changes to pay-as-you go system. First, the link between tenure during which a person made contributions to the Pension Fund and his/her old age pension was strengthened. The minimum tenure to be eligible for old-age pension increased from 15 to 25 years in 2018 and will gradually rise to 35 years by 2028. Although formally the retirement age remains at 60 for both sexes, those with lower tenure will retire later – at 63 or 65 depending on the duration of their employment.
The law also eliminated the majority of “special” (privileged) pensions, including those for public employees, MPs, prosecutors, journalists, scientists etc. Previously granted special pensions remained but they are not adjusted for inflation anymore. Therefore, the burden of these higher pensions will fade out gradually.
The reform also reduced the coefficient for tenure in pension calculation from 1.35% to 1% for each year in employment, so new pensions will become smaller. On the other hand, the law implied revision of current pensions based on the average wage over 2014-2016 and eliminated discrimination of people who retired earlier. Further revision of pensions should be performed automatically every year by 50% of three-year average wage growth plus 50% of the annual CPI. The first revision was done in 2019. As a result, the law omitted significant increase in average wages in the beginning of 2017 when doubling of minimum wage drove an increase of average wages.
These measures helped to reduce the pension fund deficit, while overall disbursements from State Budget to the Pension Fund were reduced to UAH 150,0 bn in 2018 (15% of total budget expenditures), though the full effect of the reform will be evident only in the long run.
Apart from PAYG system changes, the law also foresees introduction of the second pillar of the pension system based on compulsory personalized contributions. As for now, the introduction has been postponed as important prerequisites for it are still missing. There are two alternative views toward realization of the idea.
The first idea is the decentralization model described in the draft law recently recalled. This model foresees compulsory contributions to private pension funds starting from 2% of the salary and gradually rising to 7%. At the point of retirement funds thus accumulated are used to buy the annuity life insurance. An alternative idea was offered by the National Securities and Stock Market Commission. They suggest to pool all compulsory contributions into a single Savings Fund which will be managed by a competitively selected asset management company or several companies. Contributions will be paid independently of single social contribution to PAYG system, starting from 2% of labour income and gradually increasing to 10%. The Savings Fund will have supervisory board and administrative office. The head of administrative office will be appointed by the Supervisory Board. Unlike the other draft law, this model allows investment into foreign stocks and bonds.
However, the most important prerequisite for introduction of compulsory contribution pension provision lies not with pension laws but with other issues. This is the financial markets reform that would introduce much tighter and sophisticated oversight of asset managers (including private pension funds) and insurance companies. And certainly we cannot leave out the broader context of reforms such as property rights protection, judicial reform and others. Absence of these has been the main reason to postpone the introduction of the second pillar of the pension system (compulsory contribution scheme) as without it them the risks of money losses by pension funds are quite high. And it the government has to cover these losses, the burden on the budget will be even more substantial than today.
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