The Multipillar Pension System in the Russian Federation: Completing the ReformMoscow, November 1, 2011Heinz P. Rudolphhrudolph@worldbank.org

Outline

Reshaping the 2nd Pillar Parametric Reforms in the 1st Pillar Building the Payout Phase of the

2nd Pillar

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The framework of the 2nd pillar in the Russian Federation is one of the best

around the world, comparable to Scandinavian countries, but there are serious flaws in the implementation of

the reform

The Russians have spoken, but what are they saying?

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Allocation of Contributors to 2nd Pillar by Type of

Institution

The Russians have spoken, but what are they saying?

About 85% says that they do not understand what the government is trying to do or do not have the parameters for making an informed decision about asset allocation. Financial literacy is low

About 12% says that they trust their employers Do they have an option? Syndicates are strong in large companies /conglomerates

About 3% says that at least they want to have a different portfolio option 5

Our Interpretation

There is a Strong Demand for Guidance

Different policy conclusions: Financial Education? Forcing the Selection of a Pension Fund

Management Company? Benchmarking!

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2nd Pillar in the Russian Federation

Lack of understanding and passive response of contributors to the pension reform is the only outcome that can be expected. Finding the portfolio that optimize individual’s future pensions is too difficult

for the average contributor Russia’s experience Is no different than Australia, Sweden, Denmark, Chile,

Peru. These findings are documented in the behavioral economics literature. But

the literature adds that poorer individuals are the ones more affected by the lack of a good default option.

Lack of capacity to understand it is not an argument for not having funded pillar, but an argument for: Educating the population?... long-term result and not proven results Creating a default option that optimizes the future pensions of individuals

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Lessons from the Reform in Sweden and Denmark

Sweden Government’s initial efforts for encouraging active selection of contributors

for 2nd pillar contributions have proven to be expensive and did not encouraged informed decisions. Initial active selection ($$$), about 70% of contributors Current active selection 5% of contributors In 2010 PPM improved the default option (lifecycle)

Denmark  Danish SP system, gave 3 options:

Default Option Assisted Choice Option Active selection

About 99% of the Danish population followed the default option. The default option was a lifecycle strategy, derived from an optimal strategy.

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Implications on Investments: Default Option

As it is the one with highest coverage, it should be the one with the best investment strategy

No point in having a default portfolio that promises a real rate of return of zero percent In funded systems the bulk of the pensions come from interest

earned Designing a low cost strategy that optimizes the pensions of

individuals at retirement age, that invest in well diversified portfolio with equity and bonds along the lifecycle of individuals. International diversification should be encouraged through ETFs

and index funds9

Parametric Changes (1st Pillar)

Move to price indexation Generous pension increase will have high fiscal costs While inflation is likely to remain high, it preserve the purchasing

power of the pensions (avoid poverty) Typically public finances are hedged to inflation risk Wages in countries with Dutch Disease grow faster than prices

Retirement age needs to be increased, especially for women Linking the retirement age with the life expectancy of individuals

Voluntary retirement age typically do not work Frontloading the 2nd pillar benefits as an incentive is counterproductive

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The Payout Phase: Pensioner and Provider Risks

Pensioner risks: complex and pointing in opposite directions (longevity v bequests, investment v liquidity).

Provider risks opposite to those of pensioners.

General lack of adequate instruments to hedge longevity and inflation risks.

Risk sharing through variable participating annuities but complex regulatory and supervisory issues.

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Examples of Life Annuity, Term Annuity, Lifetime PW Paths(premium = 2,000 UF; interest rate = 4.5%, mortality table = Chilean RV-04)

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5

10

15

20

25

55 57 59 61 63 65 67 69 71 73 75 77 79 81 83 85 87 89Age

Fixed Annuity Lifetime PW (Life Expectancy)Term Annuity/Defined Benefit PW 23 Years Term Annuity/Defined Benefit PW 10 Years

Menu of Retirement Options in Five Countries

Lump-Sums

TermAnnuities

LifetimePWs

FixedNominal

LifeAnnuities

Fixed Indexed

Life Annuities

Variable Annuities

Australia Yes Yes Yes Yes No Yes

Chile No * No Yes No Yes Yes, not implemented

Denmark (1) No (2) No *

(1) No (2) Yes

(1) No (2) Yes

No No guaranteed benefit only

No conditional bonus only

YesYes

Sweden (1) No (2) No

(1) No (2) Yes

(1) No (2) Yes

No No guaranteed benefit only

No conditional bonus only

YesYes

Switzerland Yes * No No Yes NoConditional

No

* Restrictions apply; either regulatory or at the plan level

Product Shortcomings

Nominal annuities cover investment and longevity risks but are exposed to inflation risk.

Real annuities cover all three risks but require access to inflation-linked securities, issued by both the public and private sectors.

All fixed annuities are exposed to annuitization risk.

Variable annuities avoid annuitization risk but may be exposed to high investment and inflation risks.

Phased withdrawals are exposed to longevity, investment and inflation risks.

Main Conclusions on Products and Options

Policy makers should target an adequate level of annuitization but avoid excessive annuitization.

Lump-sum distributions should be subject to reasonable restrictions.

Policy makers should favor a combination of payout options, covering different products at a particular point in time as well as different payout options over time.

A default option should always be specified.

Main Conclusions on Market Structure

Advantages of centralized administration and risk pooling with decentralized asset management.

Decentralized structures require vigilance over growing oligopolies.

Need to regulate marketing through centralized quotation systems.

Need to regulate risk management through maintenance of adequate reserves and prudent use of hedging instruments.

http://go.worldbank.org/RGPDC72D60

Thanks!hrudolph@worldbank.org

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