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Cumulative level of the pension system: in search of model and parameters

For most of the population, pension reform is associated with pension modernization. However, the changes to the retirement age rules and formulas, adopted back in October 2017, are merely the first parametric step in the pension reform. The next phase is the structural stage of the pension reform, which envisages the introduction of a mandatory cumulative component of the pension system.

Proclamation of the focus on the pension reform after the Revolution of the Dignity made the issue of introducing a mandatory cumulative (funded)  level of the pension system a burning one (according to the terminology of the Ukrainian legislation: “Funded Pension System”). Appropriate measures for the introduction were envisaged by the Coalition Agreement between Factions of the Verkhovna Rada of the Eighth Convocation, the Comprehensive Program of Ukraine Financial Sector Development and other documents defining the state policy agenda for 2015 – 2020. Moreover, the legislative and executive branches have even taken specific steps in this direction: the Law of Ukraine “On Amendments to Certain Legislative Acts of Ukraine Regarding Pensions Increase” No. 2148-VIII adopted in October 2017 provided for the introduction of a funded pension system as of January 1, 2019, and the Government of Ukraine adopted a special decree containing a list of measures to create institutional components of this system. However, right now, “that’s the way it is”: the mandatory cumulative component has not been actually introduced.

Early parliamentary elections will result in a quick reorganization of the government and major changes in the political class, which will have to rethink its vision of further reforms. Pension reform is no exception in this sense.

Despite the fact that the election campaign messages of the top contenders were dominated by the emotional component, some ideas about their intentions to reform the pension sector could be received from the pre-election program provisions. More or less clear position on this issue is described only in the programs of the Servant of the People and the Voice. Both political forces declared the intention to introduce a “funded pension system” as the main “retirement” message. Although the European Solidarity only mentioned some slogans on raising pensions and guaranteeing old age in its program, however, given the pre-election rhetoric and the upper part of the election list, we can expect that it will support the implementation of structural reforms in the pension sector. Rather extravagant provisions of the Fatherland’s election program grab our attention, as it offers the introduction of a personalized pension system, although it has existed for many decades, and proposes to refer pension contributions to each person’s personal account at a state bank, which would certainly be a novelty in the world practice of building pension systems. We did not manage to find out the position of the Opposition Platform regarding pensions, since the program is probably not necessary to implement its ideological foundations – peace, stability and development (we did not manage to find the program on the political force’s website or anywhere else on the Internet). At the same time, its position is unlikely to be decisive in the adoption of key decisions by the Verkhovna Rada.

In general, there is reason to hope that the new composition of the Verkhovna Rada will be committed to the course of further pension reform. First of all, the authorities will need to resolve the issue of ensuring the prerequisites for the introduction of a funded pension system, to determine the model and basic parameters of such a system.

Ensuring the prerequisites for the introduction of a mandatory cumulative level of the pension system

The prerequisites for the introduction of a mandatory cumulative level of the pension system are understood by the authorities and the expert environment, first and foremost, as the creation of a proper regulatory and supervisory system capable of reliably protecting the rights of its participants (beneficiaries). This requires, at the very least, legislation that provides for the consolidation of supervisory functions in the field of funded retirement provision and establishes the necessary powers, independence and institutional capacity of the supervisory authority. Relevant draft laws – “On Amendments to Certain Legislative Acts of Ukraine on Consolidation of Functions in State Regulation of Financial Services Markets” (No. 2413a, or the so-called “split”) and “On Amendments to Certain Legislative Acts of Ukraine on Protection of Investors from Capital Market Abuses” (No. 6303-d) – was repeatedly put on the agenda of the Verkhovna Rada, and the first one even passed the first reading and was adopted in principle in 2016. However, the Verkhovna Rada lacked the “political will” to vote on these draft laws as a whole, as is often the case when it comes to personal or corporate interests. However, the prospects for the adoption of these draft laws by the new Verkhovna Rada are quite high (though they will have to be re-considered), as they are both identified as a “structural beacon” in the current IMF Economic and Financial Policy Memorandum, signed on December 5, 2018, and will obviously remain in the list of Ukraine’s top priority commitments after the signing of the new IMF Memorandum.

It will be much more difficult to reach a consensus on the model and basic parameters of the mandatory funded level of the pension system.

Model of a mandatory cumulative level of the pension system

The architecture of the mandatory cumulative level model was defined in 2003 by the Law of Ukraine “On Compulsory State Pension Insurance”, which is currently in force, but insofar as it relates to the mandatory cumulative level it is ineffective. This situation arose because the actual introduction of the mandatory cumulative level was dependent on a number of conditions, including the achievement of a balanced Pension Fund’s budget, which had not been met yet. The aforementioned Law provides for the creation of a Saving Fund as a special-purpose off-budget fund to which participants (or other persons on behalf of participants) will transfer insurance premiums, and which allows participants, as an alternative, to send insurance premiums to those non-state pension funds that are licensed for the provision of services in the funded pension system. A somewhat similar model of the mandatory cumulative level is foreseen in the draft law presented by the National Securities and Stock Market Commission (NSSMC) in March this year. Pursuant to this draft law, members of the mandatory funded level will have the opportunity to pay pension contributions either to a public-law Saving Fund or to authorized non-state pension funds, whereby the members of the Saving Fund may additionally choose an authorized company to manage their pension savings. Finally, the fundamentally different – completely decentralized – model is presented, it is provided for by the MP Draft Law “On Amendments to Certain Legislative Acts of Ukraine on Introduction of the Compulsory State Funded Pension System” (No. 6677). According to this draft law, it is non-state pension funds only that will accumulate and manage the funds of mandatory funded level of the pension system. This model assumes that only certain administrative functions, such as collecting insurance premiums, maintaining personal records, etc. ensured by the Pension Fund, will remain centralized.

In other countries, different models of mandatory funded pension systems are used: from rigidly centralized ones, in which only investment activity (i.e., pension assets management) is transferred to private entities, to fully decentralized ones, in which state involvement is limited solely to regulating the pension industry, overseeing the activities of entities providing services to participants in such systems, and consolidation of key data flows. The main advantage of the centralized model is the low level of administrative costs, which is achieved through economies of scale. Instead, it is considered that a decentralized model, which has a mechanism of market self-regulation, thanks to competition (this almighty “market power”), is better able to meet the diverse needs of different participants in the mandatory funded level of the pension system, giving them the freedom to choose pension services on the basis of their own assessment of the acceptable value for money.

Without delving into the controversy between the proponents of the various models of the mandatory funded level of pension system, it should be noted that none of these models has absolute benefits. However, recently, a number of countries, including those with advanced financial markets and pension systems, have resorted to the creation of centralized models or models in which national and private pension funds would function on an equal footing. The UK experience deserves special attention in this regard. Adopted in 2008, the Pensions Act provides for automatic involvement of UK employees to mandatory funded plans. In 2011, the National Employment Savings Trust (NEST), which was created and is maintained by the government, started operating in this country. Therefore, employees were able to choose where to transfer the mandatory pension contributions: NEST or other retirement plans at work. Despite the rather short history of NEST, by the end of the last financial year (Match 31, 2018), more than 6.4 million people joined it. Its main advantage over other retirement plans is free access for employers and low total fees for managing pension plans for participants, which are 1.8% of the contribution and 0.3% for asset management. These conditions for joining/participation make NEST attractive to employers and participants, and at the same time set a benchmark for other entities providing mandatory pension plan services in their tariff policies.

At first glance, the model introduced in the UK looks like those provided for in the Law of Ukraine on Compulsory State Pension Insurance and the draft law developed by the NSSMC. One obvious, but significant, difference remains unaddressed. The law and NSSMC draft law provide for automatic admission of the Saving Fund to the provision of services in the funded pension system, determine special rules for its creation and operation. Thus, the Saving Fund will have a separate status among other pension funds, which, either under a license or through an authorization procedure, will be entitled to provide services to members of the second tier of the pension system. It is difficult to predict whether these special rules will provide a competitive advantage to the Saving Fund or, on the contrary, create additional restrictions for the Saving Fund. However, in any case, there will be a situation where the services in the funded pension system will simultaneously be provided by entities that will have unequal conditions of admission to the market and functioning. Instead, NEST is not mentioned at all in the UK Pensions Act 2008. In fact, NEST establishment was an initiative aimed at increasing competition in the market for mandatory funded pension plans (that is, improving the mechanisms of market functioning), so it operates in the relevant market on an equal footing with peers.

Thus, as the UK experience shows, a model whereby compulsory funded pension services are provided on an equal footing by public/state and private institutions can help to improve the quality of such a market, however, in order to implement the appropriate model, it is not necessary to transform the law on the funded pension system into the law on a state/public law pension institution.

Basic parameters of a mandatory cumulative level of the pension system

Among a set of basic parameters of the mandatory cumulative level of the pension system, particular attention is drawn to those that determine the range of payers of pension contributions and the size of such contributions. The provisions of the Law on Compulsory State Pension Insurance and the two draft laws (by MPs and NSSMC) are similar in these matters: only members of the system (working population) are the payers of the pension contributions, and pension contributions are paid at the rate of 7% (current legislation and MP’s draft law) or 15% (in the published version of the NSSMC’s draft law) of the total income of the system members.

It would seem that this approach should aim to maximize the involvement of the whole economically active population in participating in retirement benefits, emphasizing personal responsibility for own well-being after retirement. However, in reality, it can have the opposite effect, becoming a serious impediment to the introduction and development of a compulsory cumulative component, since it does not take into account the social risks of different income groups of the population.

The need to take into account and apply the concept of social risk management in pension policy making is emphasized in a fundamental report by the World Bank – Old-Age Income Support in the 21st Century: An International Perspective on Pension Systems and Reform, published back in 2005. In the context of the aforementioned concept, when determining conditions of retirement provision, not only the risks associated with age, but also other anthropogenic risks (loss of work, illness, disability, etc.), which are particularly relevant for the poor, should be taken into account. From the point of view of representatives of these walks of life, their participation in mandatory pension system increases the potential negative effects of these short-term risks and reduces the level of well-being. As a result, they seek to avoid compulsory pension systems in order to generate additional current income, which in practice will help to increase informal employment and shadow business.

The problem of selective involvement of economically active people in compulsory funded pension systems applies to all countries, regardless of their level of development, since even in rich societies there are socially vulnerable categories of citizens who receive minimal and/or irregular income. For our country, this problem is particularly acute because much of the working-age population, to some extent even those employed in the formal economic sector, remain poor.

Other countries’ experience shows that the key to addressing this might be to establish a pension contribution base that does not include the “lower” income required to provide an adequate level of current consumption and to cover short-term risks at least. For example, in the same UK law (Pensions Act 2008), the term “qualifying earnings”, which had an upper and lower limit, was introduced. Employees whose income exceeds the lower limit of “qualifying earnings” (currently £ 6,032 over the twelve-month base period) are automatically enrolled in the funded defined-contribution pension plans, and pension contributions are paid from the income that is in the “corridor” of “qualifying earnings”.

The application of such an approach will help, firstly, avoid affecting the vital interests of the poor for whom “cash” is now much more important than the “proper” pension in the future, and secondly, attract the very population which this system should be focused on to the funded pension system: middle class employed in the formal sector of the economy.

Serhii Zubyk