pension_reform_eng by United Nations in Ukraine ООН в Україні

Blue Ribbon Analytical and Advisory Centre Project funded by the EU, co-funded and implemented by UNDP

PENSION REFORM: CHALLENGE FOR UKRAINE

Đ&#x161;yiv-2008

Blue Ribbon Analytical and Advisory Centre Project funded by the EU, co-funded and implemented by UNDP

Pension Reform: Challenge for Ukraine:

Prepared within UNDP Blue Ribbon Analytical and Advisory Centre project: ”Pension system – the need for reform. Revival of public debate”

Kyiv- 2008

Аuthor:

Marek Gora

Edited by:

Marcin Swiecicki Inna Chapko Anastasiya Yermoshenko

Marek Gora. Pension reform: Challenge for Ukraine / Edited by Marcin Swiecicki, Inna Chapko, Anastasiya Yermoshenko. - К.: UNDP Blue Ribbon Analytical and Advisory Centre, 2008.-67p. This brochure introduces the results of the research on the Pension Reform challenges. It describes demographic, economic and other reasons of its carrying out as well as experience of other countries that made a reform (more detailed on Poland ) and conclusions for Ukraine Author devoted special attention to the discussion of advantages and shortcomings of the rationalization of the traditional pension system and pension system based on individual pension accounts. Brochure is for public debate of pension reform in Ukraine for the representatives of government, parliament, scientists, students, media, and general public.

Content Content................................................................................................................................................5 Glossary ..............................................................................................................................................6 Foreword .............................................................................................................................................7 Summary.............................................................................................................................................8 Goals of the pension system and methods applied ...................................................................14 Pension systems’ dilemmas...........................................................................................................17 Public education focused on pension related issues .................................................................18 Pension systems in times after demographic transition ............................................................23 Pension systems and population structure..................................................................................27 Long-term liabilities created in pension systems........................................................................30 Demographic situation in Ukraine .................................................................................................32 Pension expenditure in Ukraine ....................................................................................................34 Rationalisation of the pension system (parametric reform) ......................................................37 Beyond parametric adjustment – What can be achieved if a deep reform is implemented on the top of rationalisation?..........................................................................................................41 Pension benefits ..............................................................................................................................42 Individual accounts in mandatory (universal) pension system .................................................45 Individual accounts and social security........................................................................................46 Types of individual accounts..........................................................................................................47 Can financial markets work for social security?..........................................................................50 Public versus private pensions......................................................................................................53 Financial markets in Ukraine .........................................................................................................56 Transition to a new system ............................................................................................................58 An example of a successful reform – Specific features of the Swedish/Polish approach ...60 A look into the future .......................................................................................................................62 Annex.................................................................................................................................................63 Polish approach ..............................................................................................................................63

Glossary Demographic dependency ratio – number of pensioners divided by the number of working age people Demographic transition – population number change, characterised by transition from high birth rates and high death rates to low birth rates and low death rates FDC, financial defined contribution system accounts – individual accounts based on instruments traded in financial markets Fertility rate – a number of children born per women Life expectancy – the expected time remaining to live, can be calculated for any age. NDC, non-financial defined contribution system accounts – individual accounts based on government quasi-bonds NOA, a non-old-age part of social security – pensions based on disabilities, work injury, sickness, death of breadwinner and others. OA, an old-age part of social security - pensions granted on retirement age base. Parametric reform – measures of the pension system rationalisation based on changing of existing parameters the system (e.g.: higher retirement age, indexation of pension benefits etc.) Portability – ability to preserve the rights to pension by employee when he/she changes a job Replacement rate – relation of pension benefit to the wage before retirement Systemic dependency ratio – number of pensioners divided by the number of contributors

Foreword The brochure, initiated by the Blue Ribbon Analytical and Advisory Centre (BRAAC), aims at contributing to public debate on pension reforms in Ukraine. It presents rationale for reform, explains what the possibilities of rationalization of the traditional pension system are, and explains the mechanism of the reformed system based on individual pension accounts. The brochure demonstrates several striking differences in psychological, social and economic consequences of old and reformed pension systems. The goal of this brochure is to contribute to better understanding of policy challenges and options existing in the area of pensions in Ukraine. We hope that well-informed public debate can help to achieve a consensus allowing for implementation of a reform. We believe this brochure will help in such public debate on pensions in Ukraine. Professor Marek Gora, Warsaw Scool of Economics, prepared the main text of the brochure. Data used in the brochure was also received form the Institute for Demography and Social Studies of the National Academy of Sciences, Ministry of Labour and Social Policy and publications of Ukrainian and international institutions namely: World Bank, European Commission, OECD, UNDP, and others. I prepared summary and together with Inna Chapko and Anastasia Yermoshenko edited the brochure. BRAAC expresses its gratitude to Ella Libanovna, Director of the Institute for Demography and Social Studies of the National Academy of Sciences and Olena Garyacha, Vice-minister of the Ministry of Labour and Social Policy, for their information and consultations regarding the progress of the pension reform in Ukraine and also to the representatives of Parex Asset Management Ukraine and OPF “Khreschatyk" for their contribution to analysis of Non-state Pension Funds development in Ukraine. However, the views and ideas expressed in this brochure are only those of author and BRAAC experts only.

Marcin Swiecicki

Director

Summary Premises for reform Initially established, pension systems aimed at poverty alleviation. It was assumed that the beneficiaries were old and poor. Few workers survived until retirement age. Pension system was designed as insurance against risk of being old and unable to work. It was similar to insurances against other risks like of disability, work injury, sickness, death of breadwinner, etc. Demographic trends and policy of lowering retirement age have dramatically changed the functions and sustainability of the old system. Old system was based on demographic structure shaped like pyramid (younger – below, elder – on top): each new generation was much more numerous than older generations, therefore, the number of contributors to pension funds, being at the same time producers of GDP, was outnumbering by far the number of pensioners, being only consumers of GDP. Pension system worked like an insurance scheme in which many workers with small contributions were supporting very few who happened to survive to pension age and became pensioners. Today pyramid mechanism is not functioning any more. New generations in European countries are less numerous than older generations. Old insurance scheme is not justified any more. Being old is not “a risk” of a few. A lot of people live many years beyond the retirement age. Both demographic and policy driven processes led to a situation in which in 2004 average man in OECD countries drew a pension for 18 years and average women for 23 years, while in 1970 that numbers were 11 for men and 14 for women. Ensuring pensions for a large number of pensioners requires much higher contributions from working population the more so that number of population in working age is shrinking. The relation between contributors and beneficiaries deteriorates sharply. But the more you tax working group the less motivation they have to work: they move to grey economy, emigrate, and work less. Low mandatory retirement age and many privileged groups that can retire earlier exacerbate the problem. It should be stressed that due to demographic reasons the cost of pension systems imposed on individual workers now is much larger than it used to be a couple of decades ago. Transfers in GDP are increasing. The goal is to stop that increase, which is just protecting interest of the workers. Without reform demographic trends will gradually push pension system towards financial crises. In Ukraine the absolute number of population in working age will start to go down in 2015. Ukrainian labour force of 22.4 million in 2007 will decrease to 14.4 in 2050; employment will decrease from 20.9 to 13.9 million. The number of pensioners will grow at accelerated rate. The number of pensioners per number of contributors (systemic dependency ratio) will grow from 0.90 to 1.39. In other words there will be 139 pensioners per 100 of contributors. It is really gloomy perspective for the workers. Each worker will have to work for himself and besides make

contributions to cover pension of one pensioner, plus almost 40% of pension of another pensioner. Pension systems ceased to work properly also from the point of view of poverty allocation. In Ukraine poverty rate among the prime age workers (around 8 percent) was much above the rate among pensioners (around 4.5 percent) in 2005. Traditional pension system design is socially and economically inefficient. Without profound reform the crisis of the pension system is guaranteed. All the public finances will be under intolerable burden. Rationalization of traditional system Before we present key assumptions of the reformed system let us offer several ways in which traditional pension system can be improved (world practice approaches). Higher retirement age The option that is commonly accepted as an element of the rationalisation package is increasing retirement age. This option automatically increases the number of contributors and reduces the number of beneficiaries. It should be stressed that this does not affect the really old people, whom society can provide with higher benefits at the lower expense imposed on the workers. Increasing retirement age have a powerful effect on economy in the long run. It contributes in particular to: -

Lowering average contribution to insurance fund since the number of contributors increases whereas number of pensioners lowers

Increasing both average net wage and average pension

Additionally increasing pensions and wages since the GDP is higher due to higher supply of labour.

Later retirement is very rational for social and economic reasons. Therefore retirement age is being increased virtually everywhere throughout Europe. Putting retirement age on a gradually increasing path seems particularly important for Ukraine where both legal and actual retirement age is extremely low comparing to other countries. So gradual, well prepared increasing the retirement age can be perceived as the key policy goal within rationalisation process of the old pension system. Short life expectancy at birth in comparison to other European countries is sometimes called upon as an argument against increasing the retirement age in Ukraine. The argument is misguided. The life expectancy at the retirement age should be considered here. The mandatory retirement age in Ukraine, 55 for women and 60 for men, is one of the lowest in Europe. One of the consequences

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of it is that Ukrainians spend more years as pensioners than for example the average in OECD countries. In 2007 life expectancy for average Ukrainian at the moment of retirement was 23.1 years whereas the same average for OECD was 20.5 years (for 2004). The Ukrainian women work smaller number of years but stay at retirement longer than women in any other European country! Ukrainian women stay longer years as pensioners than women in Austria, Germany, Spain, United Kingdom, etc. The Ukrainian man works shorter number of years than majority of men in Europe and stays on retirement lower than average West European but comparable to the number of years of EU new member states. Contributing to higher employment Higher employment means higher supply of labour into production, which contributes to GDP growth. Growth is also stronger since smaller individual contribution to pension fund per active person means higher net wage he/she is paid, which contributes to stronger incentive for supplying labour. Indexation Choosing this method and its scale should be subject to public choice of the society. However, the society should be well informed that – given the scale of other expenditure financed out of the product of the working generation – higher indexation mean not only higher income of the pensioners but also lower wages of the working generation and vice versa lower indexation of pensions contributes not only to a reduction of pensioners’ income but also to creating a possibility for wages to grow. This is really the difficult choice. Rationalisation is strongly needed in virtually all pension systems in Europe. It is insufficient, however, for creating pension systems that can cope with problems of pension systems faced nowadays. If not reformed, traditional pension system would need to consume growing and growing share of GDP. Reformed pension system based on individual accounts The reforms of traditional pension systems with individual accounts are based on the following assumptions. 1. The pension system is built as a mechanism of allocation of individual income across her/his lifetime cycle. Each participant is saving during his/her work period and consumes savings at the retirement period. 2. The new reformed system gradually (generation after generation) but entirely replaces the old system.

3. The solidarity issues, supporting the poorest, related to payments on disability, work injury, sickness, and so on are separated from old-age pension system mechanism. 4. The insurance mechanism is exploited to certain extend since pension benefit is calculated on the basis of individual account value (accumulated savings plus interest) and expected average life expectancy whereas some people live shorter and some longer than average. Individual accounts The pension system using individual accounts is easy to understand. It can be summarised as follows: 1. Worker pays fixed part of his/her earning as a contribution to pension fund. It is collected on his/her individual account; 2. Every year interest is added to the value of account. Interest depends on the type of individual account: a) Investment type of account – interest is a result of earned rate of profit from investment made by pension fund b) Non-investing account – interest is a state normative, established by law at the outset of the reform, usually yearly rate of GDP or wage fund growth in economy 3. At the time of retirement the value of account is “annuatised”, that is value of monthly pension is calculated on the basic of: a) value of account b) average life expectancy for given gender at the time of retirement c) implied future interest. The system based on individual accounts provides a very clear promise: a worker will receive back the amount that he/she paid as contributions plus interest earned. This means allocation of earned income within everybody’s life cycle. Since monthly pension is calculated on the basis of the average life expectancy the pensioners who is lucky to live longer than average live expectancy for pensioners will get more than his/her contributions plus interest whereas the pensioner who lives less than average will get less than his/her account provides. This feature of the system is based on insurance principles. System based on individual accounts ceases to be a financial pyramid. Consequently, such pension system can work in any given demographic situation. A pension system automatically adjusts to changing demographic factors. In the old system adjustment were made by politicians. In the reformed system adjustment is made automatically outside political system. Individual accounts are very efficient as a method of income allocation over life-cycle.

In the old pension system people perceived participation in the system as just paying another tax. In the reformed system of individual accounts participants tend to perceive contributions as personal savings that will be returned to them. As we have already mentioned there are two types of individual accounts in reformed system. (a) Investing accounts that accumulate savings and keep them with pension funds. Pension funds invest savings into financial assets: stocks, shares, bonds. Value of individual account is changing according to the value of assets in which pension fund invested savings. Pension funds that invest in real economy contribute to the stronger GDP growth. The role of the state is to set save rules for pension funds and supervise them. (b) Non-investing account, value of which is increased every year by the same percent as the growth of GDP (growth of wage fund in national economy is sometimes used as a proxy). The rules of calculating increase are established by law on reformed system. Contributing to non-investing account can be compared to buying a kind of government bonds with guaranteed income in the future. The Non-investing accounts are the easiest to implement (no costs, no fiscal problems).They can probably be applied as a leading (basic) type of individual accounts in Ukraine. However, contributions to non-investment individual accounts are, as any bond-type revenue of the government, mostly spent on current consumption. Liability of the government vis-à-vis each individual account holder does not change this. In practise both types of individual accounts reflect the growth of economy. In Ukraine financial markets are not yet sufficiently developed to provide enough abundance and choice to support reformed pension system with universal coverage. Therefore pension funds can play important but only supportive role in the reformed system. Successful utilization of financial markets in social security require also some additional efforts focused on improvement of the institutional structures, especially protection of property rights, politically and financially independent supervision of financial markets, independent judiciary, availability of information, and so on. It is possible to reform the pension system without using financial markets. However, using them can accelerate both the pension reform itself, as well as other reforms and changes going on in other parts of the state. Ukraine can implement a good pension reform. There is no constraint that is in Ukraine harder with that respect than in other countries. Additional voluntary schemes of various shapes are interesting and important for countries reforming their traditional pension systems. In the World Bank’s so-called three-pillar approach these schemes are called the “third pillar”. Voluntary schemes – even if they work well – cannot fix problems of large and inefficient traditional mandatory systems.

The “third pillar” has become a new element of pension panorama in Ukraine from 2004 on. There were about 100 private pension schemes in Ukraine with 260,000 participants by end-2007. Additional voluntary schemes are still very limited both in terms of the number of people participating as well as in terms of assets. Hopefully these schemes will grow in both terms. In a country where workers retire early, as in Ukraine, pensions are low. In traditional systems, the motivation to start claiming the benefits as soon as possible is strong. In reformed system participants voluntary are opting for a longer work. In a saving-based system working longer means not only paying in more contributions but also a longer period the value previous contributions is multiplied. Late retirement means larger account value that is used to pay benefits in a shorter period. Altogether the effect on benefits is really strong. People are less eager to retire at the earliest possible moment. That contributes to both higher benefits and also stronger growth of the economy (due to increased labour supply). In traditional system people tend to reduce their contributions to social security funds. In reformed system they are motivated to contribute since they are contributing to their own account. Pension system based on individual accounts introduces a strong motivation for individuals: -

to register their work,

to contribute more than required minimum to individual pension account,

to work longer number of years and allow account to grow.

Reformed system regulates pension size without political interventions. Granting pension privileges in order to raise short time popularity of the government always means breaching the rules of the reformed system. The only exception that can be accepted is when reformed system produces pension that seems to be too low in comparison to minimum. In such a case state can supplement pension to the minimum level. It would be financed from regular taxes. This would be justified as the expression of solidarity. Solidarity requires protective measures to avoid abuses. Therefore even in the reformed system the mandatory statutory retirement age should be kept at reasonable level in order to prevent massive exodus of workers towards low contributions that would result in such a low pensions calculated on the basis of individual accounts that the use of supplementary financing would be needed. Without reasonable statutory retirement age even the reformed system can, to certain extend, degenerate into the system similarly flawed as the traditional one.

Goals of the pension system and methods applied Initially, many decades ago, pension systems aimed at poverty alleviation. It was assumed that the beneficiaries were old and poor. Nowadays, people retire relatively early throughout Europe (particularly early in Ukraine); pensioners are not necessarily more than primary age workers exposed to poverty. Pension systems ceased to work properly from the point of view of poverty allocation. They have turned into a structure allowing for income allocation over life cycle: part of the income earned during working activity

Initially, many decades ago, pension systems aimed at poverty alleviation

period for post activity period of life. However, traditional pension system design that suited poverty alleviation in the past does not suite income allocation nowadays. In the latter case it is socially and economically inefficient. The quest for pension reform is fuelled not only by the necessity to restore financial sustainability of pension systems but also by the necessity to provide societies with both efficient methods of income allocation as well as income alleviation. The latter two goals contradict each other to an extent. Consequently attempts to reach them together are inefficient. Each of the two goals is important. However, for reaching them two different methods are needed. Poverty alleviation needs flexibility, income allocation needs stability, the first will benefit from spreading costs over entire population (costs of helping the poor are financed by the rest of population), the second will benefit from individual participation (each participant receives what he/she has paid in plus interest). Tax financed budget transfers are appropriate for poverty alleviation, while individual savings are appropriate for income allocation over lifetime. In countries that have already implemented newly designed pension systems the two functions are either entirely separated, which means there is no redistribution within the pension system and minimum pension level guarantees are financed on the current basis from general revenues of the state budget (Sweden, Poland) or partially separated, which means that the old system is downsized but kept to provide poverty alleviation while the new system does not include poverty alleviation (in countries following the World Bank’s “three pillar” approach). In other words, if countries

Old system is kept to provide poverty alleviation

decide to do more than just rationalisation, then they introduce individual accounts as the central element of the new pension system or a part of it. This brochure is focused on old-age pension issues, which is the largest part of social security but only a part not entire system. Social security covers also other so-called social risks. Here we come to a very important point. Individual accounts fit well the old-age part of social security that – given the current and projected population structure – in the activity period is just a method of

income allocation. The rest of social security is much stronger risk related, so these elements of the system (disability, work injury, sickness, and so on) need more insurance based approach instead of savings based one. This is only the old-age pensions that were turned from risk related benefits into a kind of savings. Figure 1 illustrates the change that occurred between the moment when traditional pension systems were designed and nowadays. It should be explained that in previous ages the population structure by age reminded a pyramid because the number of survivals was significantly decreasing with age rising. Nowadays population structure has a different shape due to the fact that longevity of life is much higher during lifetime. Figure 1. Effect of the change of population structure on the traditional type of pension systems

Previous demographic structure and consequences for pension systems

Current and projected demographic structure and consequences for pension systems

All workers pay contributions but very few survive to the retirement age, insurance against old age incapability works like insurance against other risks: e.g. disability, work injury, sickness, and so on

All workers pay contributions and majority of them continue to live after retirement; they live on what they saved during activity period (even in traditional systems, in which participation is not individualized). Longevity starts to differentiate significantly above retirement age. Pension systems in workersâ&#x20AC;&#x2122; activity period are based on saving approach rather than on insurance against risk

The main factor that influenced over the demographic structure is onset of death. In Previous

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demographic structure the life longevity was lower, and a lot of people died before the retirement age (that is why the structure looks like a pyramid), on the opposite side in Current and Projected demographic structure the life longevity became higher and death now onsets mostly after retirement age. The change of population structure suggests not only individualisation of participation but also separation of old-age pensions within social security. Actually, this is one of key preconditions for reforming the system since nowadays the nature of participation in the pension system in the period of activity is closer to saving rather than to insurance. Individual longevity starts to differentiate much later than in the past. Other parts of social security, such as disability, remain strongly risk related, so insurance is the appropriate method in their case, while – given population structure – this method suits the old-age part of social security well only in the payout phase.

Change of population structure suggests pension system based rather on insurance than saving principles

Pension systems’ dilemmas Pension systems are reformed throughout Europe, and also in a number of regions outside Europe. Traditional pension systems do not work well in times of high longevity of life and low fertility. That type of systems were designed in times of lower longevity and higher fertility. In other words previously many workers shared their product with few retirees, while nowadays few workers have to share their product with numerous retirees. These are two different situations. It is hardly possible to keep previously applied methods unchanged in the new situation. This does not mean giving up the goals of social systems. In order to be effectively achieved the unchanged goals need to be aimed at applying appropriate new methods. The longer inefficient methods are applied the higher the eventual social cost. Majority of countries, if not all of them, face the same universal challenge called ageing of population. Countries are at different stages of ageing. The more advanced is the process the stronger problems arise. It really makes sense to design, communicate to the public and implement new methods. – The sooner the cheaper. On the other hand the traditional ways of providing various social benefits, including old-age pensions, have been fully understood and accepted by societies. The more affluent country this constraint is stronger. This leads to a paradoxical conclusion: less affluent countries can probably go ahead quicker. This is an advantage of countries in Central and Eastern Europe. Some of them used this chance: in 2007 pension reforms are in general more advanced in new EU

Pension reforms are more advanced in new EU Members

Member States than in the old ones. The same chance exists in the case of Ukraine. To an extent the chance has been used in Ukraine. Some changes have been introduced within the Ukrainian pension system. This brochure aims at helping in further attempts to adjust the Ukrainian pension system to the needs and possibilities of Ukraine and the Ukrainians. In our view the help means providing: some general knowledge, pieces of experience form other countries, and also highlighting possible misconceptions and traps. Pension reform is a process that needs public support. Such a large scale change cannot be implemented without public acceptance. This brochure aims at presentation of the difficult issues of the new approach in a way that can be used for general public.

Public education focused on pension related issues Internalisation of new pension arrangements needs time. The better and clearer they are designed the sooner they are internalised. On the top of that this process can and should be pushed by a public education campaign. It is needed because of many reasons but the most important is that the new arrangements – irrespective to particular design of the new system – need to take into account the new situation, namely the collapse of the pyramid (see box 1) the previous system used to finance pension expenditure. Box 1. Financial pyramid A concept called financial pyramid needs to be recalled here. Financial pyramid (in this context called also Ponzi scheme) is a structure that does not produce anything but generates very high profits. Old participants are being paid by contributions of new participants. As long as the new ones entering the scheme are outnumbering the old ones it is able to generate the high profits for old participants out of nothing but new contributions. To this moment this sounds nice. The sad story starts when the number of the newcomers is too small. – The pyramid goes bankrupt. The last – the largest – cohort of participants loses. It can be easily proofed that every pyramid will go bankrupt one day. This is why running a scheme of the characteristic of pyramid is illegal. However, traditional pension systems were design in the way that assumed that the flow of new participants will grow endlessly, which is really very similar to the pyramid scheme. In the case of the state running the pyramid politicians assumed it would be possible to run the scheme endlessly, and the general public loved to believe they were right. That belief was based on the expectation, that “people will always have children” – which as we hope is true, but insufficient to have the pyramid kept scheme working. It is the number of children that also matters. Nowadays, it is clear the number of new participants is too small in comparison to the previous ones. The pyramid-base pension schemes are already bankrupt even if they keep paying benefits out. They are the so-called actuarially bankrupt, which means their future revenues are insufficient to cover their future liabilities. In that situation countries need to use the so-called state guarantees to support pension system. However, these guarantees are a bit perverse. If the entire population is covered by the system and the system cannot deliver then the entire population need to subsidise the system in order to get what they have been promised. That subsidisation may mean higher contributions, higher taxes, pushing out expenditure on for instance health care or education, and so on. The promises of the traditionally design pension systems cannot be fulfilled unless necessary number of new participants appear. According to demographic projections all over Europe and in many other countries the required number of the newcomers will not appear.

Typically people extrapolate the present to the future using linear trends. This more or less works but only in the short run when nonlinear relations can be approximated linearly. Participation in the pension system is probably the most long-term individual activity, so if the notion of “long-term” is used it should be used in thinking on participation in the pension system, which is just saving (even if not well-designed). Understanding the benefits people can get from the long-term savings needs a piece of additional

explanation. We use an example to give the reader a hint. Figure 2 provides an illustration of the example. Figure 2. Account value compared to contributions paid in (an example: 100 UAH per month; 5% interest annually)

Let us assume a worker pays to his account 100 UAH per month. Say, it is a contribution to an account based pension system, however, this can be any type of long term saving. We assume rate of return is 5 percent a year. Everything is calculated in real terms (no inflation). In this example the account value (the red line in the figure) a person owes after 40 years (say, when he/she retires) is 144 960 UAH, which is approximately three times larger than the sum of contributions paid to the account during his/her activity period (represented in the figure by the blue line), which after 40 years equals 48 000 UAH. This is not only the contributions paid but also the time they are in the system what pushes up the account value.

Get from the system what you have paid in plus interest

The saving-base system is discussed later in this brochure. Here we just mark that this type of pension system – contrary to the traditional one – makes only one type of promise, namely you will get from the system what you have paid in plus interest. If people internalise that they are less eager to hide income, which should contribute to a reduction of the shadow economy. This matters especially for Ukraine, where the scale of the shadow economy remains high.

In a country where the shadow economy is large taxes on regular activities need to be high. They are very high in Ukraine. The higher they are, the stronger the incentive to hide economic activity

and income, and, in turn, higher taxation needed to finance the same expenditure. The savingbased pension system can contribute to breaking that dangerous vicious circle. In a country where workers retire early pensions are low. In Ukraine workers retire in one of the lowest. So pensions are low also for that reason. In a saving-based system working longer means not only paying in more contributions but also a longer period the value previous contributions is multiplied. A look at the red line in the figure 2 clearly illustrates that. The longer the period of saving the steeper the line, hence the stronger increase of the account value. The nonlinear mechanism of saving is very strong but there is another strong mechanism on the top of it. This is life expectancy that is also nonlinear. Life expectancy does not apply to any particular individual. For a given human population life expectancy means the expected time remaining to live, and it can be calculated for any age. The later a person retires the shorter average life expectancy, which means the account value divided by smaller number of years is turned into a flow of larger monthly benefit payments. Figure 3 illustrates an increase of monthly benefit payment in a system with individual accounts compared to traditional system. Figure 3. Monthly payment in terms of replacement rate for those who retire early and those who retire late (an example)

Replacement rate â&#x20AC;&#x201C; relation of pension to wage before retirement It is up to any society to decide what is early, and what is late retirement. In principle work create welfare, so working longer rather than shorter makes a lot of sense. The earlier people deactivate the poorer the society is. For the case of this example we can assume that early retirement is at 55 years (it is really very early at European standards) and late retirement is at 65 years (more or less regular by European standards). Traditional systems, also the one currently working in Ukraine promote earlier rather than later

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retirement. Such system redistributes from those who retire late to those who retire early. The increase of pensions for those who postpone retirement is very modest. The motivation to start claiming the benefits as soon as possible is strong. In a modern pension system that individualises participation: later retirement means larger account value needed for a benefit paid on average for a shorter period. Altogether the effect on benefits is really strong. Having that internalised people are less eager to retire at the earliest possible moment. That contributes to both higher benefits and also stronger growth of the economy (higher labour supply contributes to stronger growth). Table 1a: The impact of the later retirement on value of the pension benefit and replacement rate for women in Ukraine. Сontribution rate 20%;

Age of retirement

Working period,

Starting wage

years

Wage Life before expectancy retirement at ret.age UAH/month

Account value at ret.. age

Pension Benefits, UAH/month

Replace -ment rate

1500

4221

22.7

354 547

1 813

0.43

1500

4893

18.7

469 733

2 766

0.57

65*

1500

5672

14.7

612 618

4 346

0.77

Assumptions: start of working activity at 20; initial wage 1500 UAH, continuous working (paying contributions); contribution rate 20%; wage growth rate 3% annually; account value growth rate 3% annually; implied future interest 3% (for annuitization) Table 1b: The impact of the later retirement on value of the pension benefit and replacement rate for men in Ukraine. Сontribution rate 20%;

Age of retirement

Working period,

Starting wage

years

Wage Life before expectancy retirement at ret.age UAH/month

Account value at ret.. age

Pension Benefits, UAH/month

Replacement rate

1500

4893

14.1

469 733

3 445

0.7

1500

5672

11.6

612 618

5 276

0.93

There is much more issues related to pensions that should be clearly presented and explained to the people. It should be stressed that unawareness and misunderstanding of pension reform options by public decelerate its progress in many countries. So only well informed people who understand at least basic relationships within the pension system can eventually take a rational decision on

Unawareness and misunderstanding of reform options decelerate its progress Â

the way of its reform.

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Pension systems in times after demographic transition

Pension systems were invented long time ago to help in alleviating old-age poverty. That time pension systems worked more or less well thanks to the effect of population structure observed. For instance in Germany life expectancy at birth was 65.3 for men and 69.6 for women in 1950; fertility rate (a number of children born per women) was 2.16. After 50 years, in 2000 the same coefficients were: life expectancy 75.0 (men), 81.1 (women), fertility rate 1.29. The situation in 2000 dramatically differs from the one in 1950. This change, observed throughout Europe and many other regions of the World, is a part of a phenomenon called demographic transition. Figure 4 illustrates that process. Figure 4. Demographic transition

The process that has led to the current population structure is probably irreversible. Demographic projections are gloomy. Even countries like Sweden and France where fertility rates have recently increased have these rates much below the reproduction level. Their grate success is not a reversal of the demographic process but just slowing down its pace. On the top of the demographic change, pension systems suffer from implications of policies aiming at higher generosity of pension systems (higher benefits and earlier retirement). Those policies are hardly promoted nowadays. However, they led to the situation when the relation of average

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number of years of life after retirement compared to the number of years of employment is substantially higher than in times when pension systems were designed and implemented in Europe. Both demographic and policy driven processes led to a situation in which in 2004 average man in OECD countries drew a pension for 18 years and average women for 23 years, while in 1970 that numbers were 11 for men and 14 for women. Nowadays governments are more rational and try to promote employment rather than inactivity. Promoting employment means creating incentives for workers to participate in the labour market and at the same time contributing to their employability (for instance through training or retraining) as well as incentives for employers to employ more people. Promoting inactivity means pushing people out of the labour market (for instance through early retirement) offering them in exchange various types of transfer financed benefits instead of wage. The latter type of policy is very costly and dangerous for societies since inactivity rather than work leads to lower welfare. Among the European countries Ukraine has the lowest retirement age (table A), particularly for women, at the age of 55, although life expectancy at the statutory retirement age for women is longer than in many European countries. Ukrainian women stay longer years as pensioners than women in Austria, Germany, Spain, United Kingdom, etc.(See Table A) Statutory retirement age for man is 60 in Ukraine and therefore his life expectancy at the retirement is shorter than in the most developed countries of Europe but comparable with his peers in Eastern

Ukraine has the lowest retirement age among European countries

and Central European countries. Table A. Life expectancy at statutory retirement age in selected countries Life expectancy at statutory Country retirement age Male Female Male Female Ukraine 60 55 14 25 Austria 65 60 17 24 France 60 60 20 26 Germany 65 65 16.3 19.8 Spain 65 65 16.8 20.9 United Kingdom 65 60 15.7 23 Slovakia 62 62 15 18 Poland 65 60 14 22 Romania 65 60 13 20 Hungary 62 61 16 20 Source: United Nations, Demographic Yearbook; World Bank Statutory retirement age

Raising retirement age is a highly debated in Ukraine in the context of the fact that life expectancy at the retirement age in 2005 is still lower than it used to be in 1990(see table B). The positive

Â 24 Â

trend is very week in case of women and not existing in the case of man. However, this period is characterized by a long lasting and deep transformation depression that has been reversed only from 1999 on. Moreover pension reform will be realized at least in 10-20 years when one can expect increase in the life expectancy as it occurred in other successful transformation countries. Table B. Life expectancy at age 60 in Ukraine (1990-2005) 1990

1995

1996

1997

1998

1999

2000

2005

Male

15.4

14.1

14.0

13.8

14.2

14.1

Female

19.7

18.5

18.4

18.2

18.5

18.9

Source: UNDP, Ukraine: Human development report 2003 Increasing employment of workers aged 55+ is among priorities of majority of governments. Legal measures such as for instance the retirement age are also adjusted to that goal being increased up to 67 years for both men and women. Nonetheless, demography rules anyway and pushes pension systems towards financial instability. In OECD countries one person aged over 65 is per five people aged 20 to 65 years. In 2050 there will be one per two. This process is

In OECD countries one person aged over 65 is per five people aged 20 to 65

strongly advanced mostly in continental Europe and in Japan. Table 1 presents projections of pension expenditure but only from public finance in EU member states. Payments received from individualised pension accounts are considered non-public. Table 1. Projection of pension expenditure made out of public finance as percent of GDP Country

2004

2025

2050

Δ(2050-2004)

Greece

n.a.

Estonia

6.7

5.1

4.2

-2.5

Latvia

6.8

5.3

5.6

-1.2

Malta

7.4

10.0

7.0

-0.4

Poland

13.9

9.5

8.0

-5.9

United Kingdom

6.6

7.3

8.6

2.0

Lithuania

6.7

7.6

8.6

1.8

Slovak Republic

7.2

7.3

9.0

1.8

Ireland

4.7

7.2

11.1

6.4

Netherlands

7.7

9.7

11.2

3.5

Sweden

10.6

10.7

11.2

0.6

Austria

13.4

13.5

12.2

-1.2

Denmark

9.5

12.0

12.8

3.3

Germany

11.4

11.6

13.1

1.7

Finland

10.7

13.5

13.7

3.1

Czech Republic

8.5

8.9

14.0

5.6

Italy

14.2

14.4

14.7

0.4

France

12.8

14.0

14.8

2.0

Belgium

10.4

13.4

15.5

5.1

Spain

8.6

10.4

15.7

7.1

Hungary

10.4

13.0

17.1

6.7

Luxemburg

10.0

13.7

17.4

7.4

Slovenia

11.0

13.3

18.3

7.3

Cyprus

6.9

10.8

19.8

12.9

Portugal

11.1

15.0

20.8

9.7

Source: European Commission (2006). Note:

low and/or decreasing intermediate high and/or increasing

Expenditure in Ukraine was 15.3 percent of GDP in 2005 (which is high, or increasing). Among the EU countries only a few ones – mostly new member states but also Sweden – have already reformed their pension systems in a way that will contribute to lower pension expenditure to be born by the next working generation. In the decades to come the most substantial reduction of public expenditure achieved thanks to a pension reform is projected in Poland. A brief description of the Swedish/Polish approach is provided later in this brochure. It should be explained that a reduction of pension public expenditure does not mean lower pensions but higher wages. Pensions are higher if GDP is larger. To achieve the latter the working part of population needs to be paid. If transfers to retirees grow then wages grow slowly, hence, GDP does not grow strong as well, consequently, pensions are lower – just contrary to what people usually expect. The only way to achieve sustainable increase of pensions is to contribute to GDP

Reduction of public expenditure on pensions does not mean lower pensions but higher wages

growth.

Pension systems and population structure The pension system is an institutional framework for intergenerational exchange. The working age population (actually its active part) takes part in production receiving only a part of the value of the product. The rest is shared with the retirees. The particular choice of pension system matters for efficiency of that exchange but cannot change its nature. The retired consume a part of GDP produced by the young. If a pension system is well designed the process of sharing GDP by the young and the retired goes smoothly and do not affect performance of the

Pension system is an institutional framework for intergeneratio nal exchange

economy. An ill designed pension system does not provide the population with necessary benefits and slows down long-term economic performance of the economy, which leads to social welfare deficiency. In the pension system there are only those who pay (the young) and those who receive (the retired). There is nobody else in the system. The state does not finance the benefits. It only provides a structure in which the young finance consumption of the retired. In short: there is no single hrivnia that can be spent on benefits that is not withdrawn from the value of the product of the young. This is a bad news. It means there is no possibility to make a miracle. In consequence, the pension system should not be blamed or glorified on the basis of the level of pensions. The system should aim at balancing of interests of the retired and the young.

Pension system should not be blamed or glorified on the basis of the level of pensions

It is much easier to find a solution to the pension problem if we take into account that “the old” these are former “young”, and “the young” these are future “old”. So the intergenerational exchange it is in fact just income allocation over individual life-cycle. When we are young we work, we contribute to the GDP produced but we receive a part of the value of our contribution. The rest comes back to us when we are old and we do not contribute to the GDP produced then. It is produced by the next generation. We just have abstract rights to get a part of this future GDP. If the number of the young is large in comparison to the number of the old then the individual share of contribution of the former needed to finance consumption of the latter can be relatively low. That was the situation long time ago (a couple of decades) when the structure of population by age was more or less similar to the shape of a pyramid. Nowadays this structure does not remind any pyramid. This is a common feature of current population structure all over Europe and in very many countries outside Europe. Consequently, countries have to take a

Increase contributions paid by the young or decrease pension benefits?

decision whether to increase contributions paid by the young or to decrease benefits received by retirees or to combine the two. There is also another option that can be superior to

the former options. This option is postponed retirement. That option automatically increases the number of contributors and reduces the number of beneficiaries. It should be stressed that this does not affect the really old people, whom society can provide with higher benefits at the lower expense imposed on the workers. It should be stressed that due to demographic reasons the cost of pension systems imposed on individual workers now is much larger than it used to be a

Postponed retirement increases the number of contributions and reduces the number of beneficiaries

couple of decades ago when the overall cost was smaller as a part of GDP (smaller share of retirees in population) and the cost was spread over a relatively larger population (larger share) of workers-contributors who paid the cost. Nowadays the cost is larger and spread over a relatively smaller number of workers, hence individual cost imposed on a worker is larger for both that reasons. That change can be illustrated as in Figure 5. Figure 5. Share of GDP spent on remuneration of production factors versus the share spent on pension transfers

C=T

W- Workers’ welfare, T- pension transfers C- contributions. In Figure 5 the circle on the left represents GDP1 produced by generation 1 a couple of decades ago; the circle on the right represents GDP2 produced now by the generation 2 (say, children of the workers of the generation 1). Pension transfers are financed out of GDP produced by the working generation, hence remuneration of this generation is reduced (W=GDP-C; C=T). Generation 1 paid contributions C1 needed to finance transfers (pensions) T1 to previous retired generation.

Economic activity (work and investment) of that generation was remunerated well W1 as compared to the value of the product they produced. Because of aging population the number of pensioners is increasing. That is why current generation (2) of workers being less numerous in comparison to the previous generation (1) and its remuneration W2 is reduced because of increasing amount of contributions to cover the cost of pensions for generation 1 (T2/W2>>T1/W1). This means welfare of the current generation is less than welfare of the previous one. In the figure 5 T2 is larger than T1 for two reasons. First – because GDP is larger; second – because the share of pension transfer in GDP is growing. Pension systems need to be reformed throughout Europe since the relative share of pension transfers in GDP is increasing. The goal is to stop that increase, which is just protecting interest of the workers.

Long-term liabilities created in pension systems

In the period of activity, workers have their remuneration reduced since they pay contributions. After retirement former workers do not contribute to production of GDP but they are entitled to take part in consumption of the consumed part of this GDP. This is either just pure saving – if a pension system is designed as a saving system, or “saving-like” way of income allocation – if the system is not well designed, as it is the case in traditional systems, in which a relation between contributions and benefits depends a lot on changes in legislation, in other worlds on politicians and their decisions. If the system is based on individual accounts (savings) then pension rights are constantly valuated, which reduces a need to provide the system with constant adjustment. This also means the system is less exposed for possible ill adjustment or political manipulation. If the saving nature of income allocation within the pension system is weak and hidden under technical regulations then people perceive participation in the system as just paying another tax. In such situation they are much more exposed to political decisions that one day may proof to be suboptimal. In reformed system individual contribution to individual pension

Reformed system is less exposed for possible ill adjustment or political manipulation

account let people to internalise the financial situation of the system. After some time they start thinking of the system as of “a game” everybody plays with himself/herself rather than like in the traditional system “a game” played with the rest of the people. If the system individualises participation then the role left for the state is regulation and supervision. Still, that development can bring good outcomes only if additional conditions are fulfilled. The more people are informed on how the system work the more needed is stability of the system and its rules. However, the system work as a part of the entire institutional framework of the state. The more they are informed the more they understand that the pension system is a long-term business that in turn requires clear, well designed, stable legal infrastructure. So reform of the pension system is a part of modernisation of the entire state. A modern design of pension

Modern design of pension system requires developed institutions

system requires developed institutions in other elements of the state. The other elements needed: 9 well designed and executed property rights; 9 well developed (well designed rules and appropriate scale) financial markets;

9 well developed and independent supervision over financial markets; 9 well functioning social security institution able to serve a new system. Are these institutions well developed in Ukraine? We do not asses them in this brochure. However, there are reports published by various international institutions that suggest state infrastructure for economic activity is rather weak. Heritage Foundation Index of Economic Freedom 2007, World Bank’s Doing Business 2007, Transparency International Corruption Perception Index 2007 – they all do not consider Ukraine a business-friendly country and rank Ukraine in the second hundred of countries analysed. The impressive economic growth recorded in Ukraine in the current decade is great but at the same time insufficient from the point of view of institutional development needed for pension reform. Implementation of a new system will need much better infrastructure than the one that currently exists in Ukraine. So thinking of the pension reform one should take into account the entire modernisation challenge not only the part directly related to the pension system. Business climate is important not only for actual and possible future providers of pension services. This climate matters also for ordinary people who are expected to believe the system will be sustainable for the decades to come. A worker in his/her twenties will start claiming benefits after some 40 years and will probably continue for another 20 ones. For him it really matters the system is sustainable not only in a couple of years to come but also for the entire period of

Business climate is important for ordinary people

his/her life. Sustainability it is not only about aggregated revenue and expenditure of the pension system. Participants expect also stability of regulations. This is better understood if we remind that each period entire GDP is spent. So saving does not mean not spending our contributions – they belong to that GDP. Saving it is an abstract notion related to legal rights. Property rights are commonly used for saving. We buy them in one period paying with a part of GDP we owe and sell the rights after some time exchanging them for a part of GDP produced in that later period. We could even define participation in the pension system as purchasing today a part of future GDP. That can be done with or without using financial markets. In both cases well defined and executed property rights are strongly needed. If they are lacking then our long-term “transaction” is put into hands of future politicians, whom we even do not know yet. The traditional

Participation in the pension system- is purchasing today a part of future GDP

pension system needs discretional adjustment, and the only people that can decide are politicians. The system base on individual accounts does not need such type of intervention. However, the new system will work properly only if necessary institutions are present and work well.

Demographic situation in Ukraine

Demography rules also in Ukraine. The working generation shares its product with the retired generation. The government enables that sharing of GDP. Demographic situation of Ukraine is similar to developments observed in other European countries being at the same time different. So studying experience of other countries is strongly needed but at the same time insufficient.

Demographic situation of Ukraine is similar to other European countries

The typical experience of the recent decades in Europe is: high and increasing longevity of life together with low and decreasing fertility. That hassled to the current and projected problems of the European pension systems, especially their lack of sustainability. The Ukrainian experience is similar with respect to low fertility being strongly different with respect to low longevity that in Ukraine – especially for men – is much below the one observed in the vast majority of European countries (similar undesired demographic developments are observed in Russia). See Figure 6. Figure 6. Demographic trends

Average life expectancy, years 80 78

Poland

Estonia

Lithuania

Latvia

Ukraine

CIS 2005

2004

2003

2002

2001

2000

1999

1998

1997

1996

1995

1994

1993

1992

1991

1990

1989

1988

1987

1986

1985

Source: Institute for Demography and Social Studies (2006). Ukrainian population substantially fell from 51.7 million in 1989 to 46.5 in 2007. According to

demographic projections that trend will continue. In 2050 population of Ukraine will decrease to 33.2 million (based on a set of assumptions that are not discussed here). Ukrainian labour force of 22.4 million in 2007 will decrease to 14.4 in 2050; employment will decrease from 20.9 to 13.9. Demographic dependency ratio (number of pensioners divided by the number of working age people) will increase from 0.42 to 0.91. Even more striking is the increase of the systemic dependency ratio (number of pensioners divided by the number of contributors) from 0.90 to 1.39 (in other words 139 pensioners per 100 of contributors). It is really gloomy perspective for the workers. Each worker will have to work for himself and besides make contributions to cover pension of one pensioner, plus almost 40% of pension of another pensioner. These projections assume a substantial

In 2050 each worker will have to work for himself and for pensions of 1.4 of pensioner Â

increase of fertility rate from 1.30 in 2007 to 1.51 in 2050. Table 2 provides projections of key demographic indicators based on a model used by the Institute for Demography and Social Studies. Table 2. Key demographic indicators Indexes

2007

2025

2050

Population (millions)

46.5

41.1

33.2

Population aged 18-59 (millios)

28.5

23.4

16.1

Population aged 60+ (millions)

9.5

10.5

12.0

Labour force (millions)

22.4

19.5

14.4

Employment (millions)

20.9

18.7

13.9

Pensioners (millions)

13.3

13.8

13.6

Old-age pensioners (millions)

10.6

11.1

Other pensioners (millions)

2.7

2.5

Population above average retirement age to 0.42 population aged from 16 to average retirement age

0.56

0.91

Pensioners to contributors

0.90

1.04

1.39

Life expectancy at 60 (men; years)

13.7

16.7

19.6

Life expectancy at 60 (women; years)

19.1

21.3

23.2

Life expectancy at ave.ret. age (women; years)

23.1

25.4

27.4

Source: Institute for Demography and Social Studies (2006). Projections, as presented in Table 2, suggest the changes in Ukrainian demography will be really substantial.

Â 33 Â

Pension expenditure in Ukraine

The pension system in Ukraine creates a very high cost for the society. Thinking on pension systems run by state institutions we often do not remember that expenditure on pensions is financed by the working population. They produces 100% GDP but the equivalent they are paid to take home is lower due to common needs such as national defense, law and order, roads, public schools etc. Let us assume that public needs in Ukraine consume 25% of GDP. If no other such burdens exist the working individual would get 75% of what he/she produced. But in addition to common goods the state forces working population to make obligatory transfers to those who do not work. After the minimum pension hike in 2004 (minimum pension up by 177 percent) the cost of pensions jumped from 9.2 percent of GDP in 2003 (a moderate level at European standards) to 15.3 percent of GDP in 2005 (the most expensive system among EU as well as non-EU countries). Additionally, the high share of pension expenditure in GDP is a result of low mandatory retirement age.

Cost of pensions jumped from 9.2% percent of GDP in 2003 to 15.3% in 2005

The minimum pension level compared to the average net wage is the highest in Europe. That partially contributed to a substantial reduction of the poverty rate from 31.7 in 2001 to 7.9 in 2005. However, that rate has been constantly decreasing since 2001 and effect of the increase of the minimum pension does not look as the key factor behind that process. Moreover, poverty rate among the prime age workers (around 8 percent) was much above the rate among pensioners (around 4.5 percent) in 2005. At the same time the mandatory retirement age in Ukraine (55 for women and 60 for men) is the lowest in Europe and the part of earned income that must be contributed to the pension system (33.8 percent) is one of the highest in Europe. The very high level of expenditure on pensions has led to introducing measures contributing to its reduction. In 2005-2006 pension parameters were changed (indexation of benefits below inflation). That allows to project pension expenditure decreasing to 12.2 percent of GDP in 2010 and 11.0 in 2015 (status quo scenario) or event to 11.6 in 2010 and 9.9 in 2015 (additional measures introduced). The projected reduction of pension expenditure – if hold in reality – will be spectacular. The measures introduced or to be introduced in a couple of years to come will improve fiscal sustainability of the pension system in Ukraine. However, these regulations will lead to a sharp reduction of relation of pension benefit to the wage before retirement (so called replacement rate) from 42.6 in 2006 to 35.5 in 2010 and 29.7 in 2015 (status quo scenario) or even to lower levels if

additional measures are introduced. These reductions if they occur will improve current financial sustainability of the system. Without that reduction of the replacement rate this situation would be difficult. On the other hand however, these will be really sharp reductions of pensions in relation to wages. We do not discuss these changes here. They seem to bring the pension system back to a sustainable fiscal situation in the short run. However, the measures introduced and planned within the parametric adjustment are insufficient in longer perspective. Figure 7 provides a clear illustration of this argument.

Figure 7. Employment in Ukraine

millions

20 15 10 5

20 54

20 51

20 48

20 45

20 42

20 39

20 36

20 33

20 30

20 27

20 24

20 21

20 18

20 15

20 12

20 09

20 06

Source: Institute for Demography and Social Studies (2006). Indexation of pension level to inflation looks well in for the period of relatively good situation in employment. The vertical dotted line corresponds to the time horizon of the fiscal projections. This line also delimits two periods, namely the period until 2015 when employment is projected more or less stable and replacement rate of pension benefits will decrease and the period after 2015 when projections show substantial decrease of employment, hence smaller contribution revenues, and at the same time further reduction of the replacement rate will probably be hardly possible. In other words in 2015 the situation will be the following. The replacement rate (pension benefits devided by wage) will be quite low (29.7%). The number of population in working age will start to go down. The number of pensioners will grow at accelerated rate. This guarantees the crisis of the pension system. For the period after 2015 a deeper reform is needed. Given time necessary for implementation and maturation of a reform there is little time left for designing and starting a pension reform. It is always good to stress that long term sustainability of the system is a promise for the workers who are currently charged

For the period after 2015 a deeper reform is needed Â 35

contributions and who expect their pensions will be paid out when they are old. There is an additional factor that should be taken into account in the case of Ukraine. Ukrainian men on average live short. Much shorter than men in other European countries, except for Russia. This is not a natural situation. There must be reasons for that situation. However, they cannot be constant but rather temporal. We may assume factors that are reasons for that strongly undesired situation will disappear in the future. Examples of other countries, especially examples of countries like Poland or the Baltic States provides some optimism for future developments in Ukraine. Men will eventually live longer in Ukraine. This will be the great achievement. However, the pension system should be prepared to receive that gift. If the improvement in life expectancy comes sooner than assumed in projections – which we hope will be the case – then the very difficult financial future of the Ukrainian pension system will be even more difficult.

Rationalisation of the pension system (parametric reform) Several countries take measures that can contribute to bringing their pension systems closer to sustainability. There is a number of measures that can be taken. We call them rationalisation of the system or parametric reform. It does not change the system itself. Parametric reforms aim at improving pension systems in their existing shape reducing effects of their inefficiencies not removing them. There is no possibility to reverse the effect of the demographic change. The change itself (lower fertility and higher longevity) is probably also irreversible. Policies aiming at higher fertility rates – even if bringing effects in a few countries (actually in few countries) – cannot bring population structure back to a one that would solve a substantial part of the demographic problem. Consequently, the effects of the second demographic transition have to be just taken as a natural situation. Pension systems can adjust to that situation –

Policies aiming at higher fertility rates cannot bring population structure back

which is better, or ignore the change of the nature – which leads to high social and economic costs. The demographic situation of countries is additionally affected by international migrations. Migrants are usually in working age, so flowing into a country they improve the demographic dependency ratio (the share of pensioners divided by the number of working age people). Systemic dependency ratio is improved only if they work legally and are covered by social security, which means they participate in financing the system. When migrants flowing out of a country this contributes to worsening of demographic situation. We start from a short discussion of measures that can be taken as pieces of rationalisation. The measures can improve the relation between working age population and the number of pensioners (the so-called systemic dependency ratio). Theses are: increasing retirement age, increasing the number of years required for minimum benefit guarantee, contributing to higher employment and covering by social security larger part of employment. The measures can also lead to a reduction of expenditure without any effect on the systemic dependency ratio. This can be achieved through

Rationalisation: increasing retirement age, increasing required period for minimum benefit guarantee

indexation below the inflation level. Additionally, the same goal, namely bringing systemic rate closer to the demographic one, countries can aim at contributing to higher net migration (immigration minus emigration).

Higher retirement age The option that is commonly accepted as an element of the rationalisation package is increasing retirement age. This change has a strong effect on the system since people work and pay contributions longer and draw benefits on average for a shorter period. Nowadays people work shorter in comparison to their life span than they did a couple of decades earlier when life expectancy was much lower. This gives a very strong argument for the change. Later retirement is very rational for social and economic reasons. At the same time it is strongly contested by societies that are used to easy access to early retirement. Nevertheless, retirement age is being increased virtually everywhere throughout Europe. This applies

Retirement age is being increased everywhere throughout Europe

both to an increase of legal or statutory retirement age as well as to actual retirement age that is often lower than the legal one due to privileges of early retirement for some professions or branches of economy. Increasing of the retirement may mean an increase in the legal retirement age for all workers or abolishing early retirement schemes or both. Introducing changes putting retirement age on an increasing path seems particularly important for Ukraine where both legal and actual retirement age is extremely low. So increasing the retirement can be perceived as the key policy goal within rationalisation process. Short life expectancy at birth in comparison to other European countries is sometimes called upon as an argument against increasing the retirement age in Ukraine. The argument is misguided. The life expectancy at the retirement age should be considered here. Ukrainians spend more years as pensioners than average in OECD countries. In 2007 life expectancy for average Ukrainian at the moment of retirement was 23.1 years whereas the same average for OECD was 20.5 years (for 2004). This is due to lower statutory retirement age and many early retirement privileges in Ukraine. When life expectancy at statutory retirement is

Ukrainians spend more years as pensioners than average in OECD countries

compared Ukrainian women enjoy the longer years as pensioners than women in many other countries. The Ukrainians work smaller number of years but stay at retirement longer or similar number of years as population in many developed countries. It should be stressed that increasing of required length of employment covered by social security is a much weaker version of rationalisation. The former is often used as a requirement for a minimum benefit guarantee. For improving pension system sustainability a policy aiming at later retirement is much more

A policy aiming at later retirement is much more effective Â

effective. Contributing to higher employment Workers, or in a broader sense the economically active population, finance pensions. The

Â 38 Â

larger the active group the smaller is the individual share of that cost per worker (contribution). Higher employment means higher supply of labour into production, which contributes to GDP growth. Growth is also stronger since smaller individual share per active person means higher net wage he/she is paid, which contributes to stronger incentive for supplying labour and capital. Higher employment contributes to its own potential for further increase. Employment of production factors leads to welfare. The active, mostly workers, are better off as well as pensioners are better off. State organised redistribution can contribute to spreading the welfare over the entire population but state redistribution does not create the economic base of welfare. Employment of labour contributes to GDP but only covered employment, which means those who pay contributions, finance the pension system. Rationalising pension systems government aim not only at higher employment but also at higher coverage of employment by social security. Actually in Europe the two are typically almost identical. This is not the case in Ukraine, where covered

Only legal employment finance pension system

employment it is only around 70 percent of total employment. Increasing the share of covered employment together with increasing employment itself can be perceived as another key policy goal. Indexation Indexation was invented to protect income of pensioners in times of high inflation. Without indexation that income would be automatically reduced. On the top of protecting pensioners’ income, indexation can aim at a real increase of that income in times of strong economic growth. In times of pension systems sustainability problems indexation can be used as a method balancing revenue and expenditure of the systems. Indexation can produce substantial effects if used for that purpose. Using indexation to improve pension system sustainability does not need to be promoted in Ukraine since it is used. Other than the measures briefly discussed above, indexation below inflation can be advocated or criticised. None of the two is a goal in this brochure. Choosing this method and its scale should be subject to public choice of the society. However, the society should be well informed that – given the scale of other expenditure financed out of the product of the working generation – higher indexation means not only higher income of the pensioners but also

Higher indexation means higher pensions but also lower wages

lower wages of the working generation and vice versa lower indexation contributes not only to a reduction of pensioners’ income but also to creating a possibility for wages to grow. This is really the difficult choice.

Migrations (external) The issue of migrations go beyond the scope of this brochure. There is many various factors behind migrations. We just stress that the key factor with that respect is difference of earning opportunities between countries. This implies that on the top of productivity differences there is also another factor, namely burden caused by the necessity to pay for government expenditure imposed on the workers. The higher government expenditure the lower net wages. Consequently stronger emigration pressure. Altogether a lot can be achieved through rationalisation. However, it cannot reverse demographic trends that generate effects much stronger than even very strong rationalisation can counteract. Consequently, countries – including Ukraine – need to introduce a reform that goes beyond rationalisation.

Ukraine needs to introduce a reform that goes beyond rationalisation

Beyond parametric adjustment – What can be achieved if a deep reform is implemented on the top of rationalisation? Rationalisation is strongly needed in virtually all pension systems in Europe. It is insufficient, however, for creating pension systems that can cope with problems of pension systems faced nowadays in the period after the second demographic transition. A new design of the systems is probably needed. The old one developed as a financial pyramid does not work properly any more. It does not deliver and create problems itself contributing to public finance indebtedness as well as to microeconomic incentives. Moreover, rationalisation is not easy since it imposes measures that are usually perceived as at least unpleasant by the people. A new design of pension systems can contribute not only to their performance but also to strengthening effects off rationalisation.

New design can contribute to strengthening effects off rationalisation

Being insufficient rationalisation is absolutely necessary. The quest for pension reform should not mean less focus on measures than can lead to even minor improvements. However, the pension reform goes much beyond that. This can mean: 9 implementation of a mechanism that generates pension rights, hence also sets pension expectations at the level that can be maintained without an increase of burden put on the next generation, hence, intergenerational equilibrium; 9 channelling flows of contributions in a way that generates positive externalities for GDP growth, using financial markets; 9 combination of the above two. So what can be done on the top of rationalisation to improve the situation of pension systems? This question is crucial. It is currently discussed throughout the World. Although some knowledge based on theoretical considerations is already available as well as some experience learned in countries that tried to go for pension reforms, possible answers to that question are probably still far from common acceptance. Key elements of discussion on pension reform options is focused on a number of issues of which the following are discussed in this brochure: 9 Individual accounts 9 Using financial markets for social security goals 9 Private management of pension services providers.

Pension benefits In discussions on pension reforms the level of pension benefits is particularly sensitive. However, does the level of benefits depend on the type of pension system? Yes and no. Yes applies to their absolute level measured in hryvnias. No applies to pension level measured in relation to wages (the so-called replacement rate, usually presented as percent). Individual accounts can contribute to higher pensions measured in absolute terms. If a pension system can make pension funds available for investment then it contributes to stronger GDP growth. However, individual accounts neither decrease nor increase the level of pension benefits

Pensions - part of GDP produced by the working generation devoted for pensioners

measured in relative terms since – irrespective to any type of pension system – all pensions in any system it is just a part of GDP produced by the working generation but devoted for pensioners. See Box 2. Box 2. Level of pensions Relative to wages level of benefits (replacement rate) depends only on two factors, namely: (1) the burden put on workers and (2) the ratio of retirees per worker:

z – replacement rate (benefit divided by wage); c – contribution rate; d – dependency ratio (number of retirees per worker) Benefits measured in absolute terms (in hryvnias) are not constrained by demography. Their level increases when GDP growth is strong. The benefits can increase in absolute terms even if the replacement rate decreases. Distinguishing the difference between the two measures of pension benefit level really matters for designing new pension system arrangements. They should aim at neutrality with respect to the factors that pretend they can cause a sustainable increase of benefits in relative terms (for instance overpromising). New arrangements should also aim at stimulating factors that can generate positive externalities on the top of reaching social security goals (for instance effects of channelling pension system flows of money through financial markets). Traditional pension systems have ceased to be neutral due to disappearing of demographic pyramid. If not reformed traditional pension system would need to consume growing and growing share of GDP. Reintroducing this neutrality (intergenerational equilibrium) can be partially achieved through

If not reformed pension system would need to consume growing and growing share of GDP 42

parametric reforms as discussed above. Figure 8 follows Box 1 and illustrate possible outcomes of that reforms. Figure 8. Effects of rationalisation on the level of costs for the workers and the level of benefits for the pensioners Z – replacement rate - ration of the pension to the wage before retirement C – contribution rate – ratio of income paid to a pension fund to the total earned income

Replacement rate

Aging population C1

Early retirement C2

Diminishing the C4 number of employed

Increasing the number of unregistered workers

C C5

Contribution rate

Each line OL represents the points that show the replacement rate adequate to contribution made. In other words, certain percentage of workers income (contribution rate) can finance certain replacement rate. The greater the contribution the higher replacement rate. But the slopes of the lines differ depending on demographic factors. As demography worsens as well as when institutions push people out of the labour market, the slope becomes more horizontal and therefore a greater contribution is needed to get the same replacement rate. Let us use the above scheme to analyze the developments in recent years in many countries including Ukraine. In order to keep the replacement rate (relation of pensions to wages) at level z1 the contribution (c) has been increasing in recent years due to following factors:

¾ aging population - line L1 is replaced by line L2, contribution c1 increases to c2; ¾ granting early retirement – line L2 is replaced by L3, c2 increases to c3; ¾ diminishing the number of employed line L3 is replaced by L4, c3 increases to c4; ¾ increasing the number of unregistered workers line L4 is replaced by L5, c4 increases to c5. Therefore,, the burden put on average worker is increasing. It can be lowered if the replacement rate is lowered (e.g. by abandoning indexation), but this can’t be accepted for a long time. Resistance to lower replacement is much stronger, so pension systems go along the horizontal axis, which means increasing the burden put on workers income. The red arrow in the Figure illustrates the effect of indexation lower than inflation, which leads to a reduction of burden on the active part of population. The green arrow illustrates desired effects of: an increase of the retirement age, an increase of employment, an increase of coverage, and other pieces of rationalisation that can be introduced in the system. We should keep in mind that rationalisation of pension systems has its limits. Going beyond the limits needs a reform leading to changing the system based on the pyramid for a system based on individual accounts.

Rationalisation of pension systems has its limits

Individual accounts in mandatory (universal) pension system Individual accounts let design the pension system in a way that leads to intergenerational equilibrium, which means to a situation when interests of the workers and the retirees is equally valued. In other words, a system based on individual accounts ceases to be a financial pyramid. Consequently, such pension system can work in any given demographic situation. This does not mean individual accounts can finance pensions irrespective to demographic situation. Unfortunately not. Demography rules. A pension system can adjust to its changing shape or not. It is much better for the people if the system adjusts automatically. Participation in the pension system using individual accounts is easy to understand. This can be summarised as follows: 9 worker pays fixed part of his/her earning contribution to pension fund. It is collected on his/her individual account; 9 every year interest is added to the value of account. Interest depends on the system of individual accounts: a) earned rate of profit investment made by fund b) state normative, usually yearly rate of GDP growth or wage fund in economy 9 at the time of retirement the value of account is “annuitised”, that is value of monthly pension calculated on the basic of: a) value of account b) average life expectancy for given gender at the age of retirement c) implied future interest. Individual accounts are very efficient as a method of income allocation over life-cycle. However, they do not provide minimum pension guarantee. It is to be financed out of general revenues of the budget. For a number of reasons that method is superior (broader redistribution basis, adjustability to changing social needs, and so on) to financing the minimum out of pension system revenues.

Individual accounts and social security The term “solidarity” is often used for traditional systems. In this brochure we do not use that term since we do not think this term is appropriate for any mandatory system irrespective to whether for pension benefits it uses tax revenues or savings. Using in the pension system individual accounts does not contradict a social role played by this system. Individualisation does not mean participants have to rely only on themselves. If a pension system is universal, which means it covers entire population of workers using the same rules for everybody, then it is social in the sense that instead of the

Individualisation does not mean participants have to rely only on themselves

obligation to pay social taxes, individual working participants are obliged to buy pension rights from the previous generation of already retired participants. Both generations end up with similar result. The difference occurs in human minds. An example is provided in Box 3. Box. 3. Tax distortions – an example A worker produces output. It is worth 1000 UAH (amounts are pure examples and do not matter in this example). His input is 50 percent. However, he does not receive the entire 500 UAH since a contribution to the pension system is to be paid (say, 20 percent). We assume there is no taxation. So he his disposable income is 400, and 100 UAH is paid into a system. One day in the future as a pensioner he receives 300 hryvnia out of that 100 paid long time ago. Let us assume the payout is exactly the same irrespective to whether he paid a tax equal 100 or saved that 100. In short, in both cases he paid 100 and afterwards he received 300. Do the cases differ? Yes, they do! In the first case his disposable income was 400, while in the latter it was 500, of which he spent 100 on savings. Consequently, tax distortions in an economy he was a part of had smaller distortions in the latter case since they depend not only on amounts paid but also on what people think when they reduce their disposable income.

The system based on individual accounts provides only a very clear promise: a worker will receive back the amount that is the sum of contributions paid plus interest earned which is income allocation. On the top of that the society provides additional conditional promise: a worker will receive a top-up payment if his pension out of the account value is below certain level, which is redistribution. If the two are separated the system can provide better outcome in each of that cases.

Types of individual accounts Individual retirement accounts are commonly perceived as a part of the method of using financial markets for pension systems. The Chilean example is commonly quoted with that respect. A growing number of countries use that example in heir efforts to reform pension systems. However, there is another example that can also be useful in this area, namely individual accounts that do not need financial markets. This is the example of Sweden and Poland. It is called nonfinancial defined contribution system (NDC). In order to have appropriate corresponding name for the former type of accounts now we use in literature abbreviation FDC for accounts using financial markets (F stands or financial). NDC – contributions by individual wage earner are invested into government quasi-bonds. Bonds by law are earning interest that annually is equal to the growth of wage fund in economy (in the long-run this converges to GDP growth rate). When worker retires, he/she receives back

NDC- contributions to individual accounts invested into government quasi-bonds

his/her contributions enlarged by earned interest generated by growth of the real economy, and assuming average life expectancy for him/her at the age of retirement. FDC – contributions are channelled to pension funds. Pension funds invest in stocks of companies and/or government bonds. When worker retires he/she receives back his/her contributions enlarged by earned interest generated by financial markets (choice of a pension fund to which his/her contributions are paid matters), and life expectancy at the age of retirement.

FDC– contributions to individual accounts channelled through pension funds

The FDC type of individual accounts is much more known since they have been used in private schemes for a very long time, while NDC can be used only in universal systems. So the history of the latter is much shorter. It is worth realising that well defined NDC is very similar to FDC in the case when FDC pension fund portfolio consists of only government bonds. The advantage of NDC is that its implementation does not so strongly require well developed financial markets and property rights. This feature of NDC makes it an interesting option for countries that still have to improve their institutional structure. This option is also interesting for all other countries since ongoing management of NDC is cheaper than management of FDC. NDC based pension system has yet another advantage that is worth considering. This is the way in which pension system flows are accounted. This particularly matters for European Union countries that are constrained by the so-called Maastrich criteria (certain limits on: deficit, debt, inflation rate, interest rate). In short, implementation of FDC is interpreted as if public expenditure was increased, while in the case of NDC it is assumed to be neutral for public finance. It is probably illogical but this is the way pension reforms are perceived in practice. Consequently,

implementation of FDC generates “transition cost”, while implementation of NDC does not. On the other hand, using NDC does not generate positive externalities such as financial market development, possible contribution to an increase of savings in economy and so on. That externalities can appear in FDC only if using financial markets they invest contributions in private instruments. If they just buy government bonds the positive externalities are weak or none, while managing cost of that type of FDC is still high. This is why distinguishing three types of individual accounts may be useful for discussion. Table 3 provides key information on types of individual accounts. Table 3. Three types of individual accounts Type of individual accounts

Liability of:

Returns financed through:

Rate of return

Political risk: manipulation

Economic risk: What happens if r > g

NDC

Government Real economy

r≡g

Moderate even small

FDCGDI

Government Financial markets

r = rGDI

Small

GDPR/GDP increases due to higher taxes

FDCPFI

Private sector

r = rPFI

Very small

GDPR/GDP increases due to higher asset prices

Financial markets

or Not possible

In the table: g – GDP growth rate; r – pension system rate of return; GDPR/GDP – share of GDP spent on pensions; GDI – government debt instruments; PFI – private financial instruments. Typically FDC based on government bonds and FDC based on private sector instruments are managed together. Moreover, FDCGDI usually dominates or even strongly dominates the combination FDCGDI/FDCPFI. The latter can be caused by various reasons or their combination, such as: high government debt, hence high returns on debt instruments it issues, preference for avoiding fluctuations of value of portfolio, low supply of private sector instruments. 9 The NDC type of pension system is the easiest to implement (no costs, no fiscal problems). After maturation NDC divides GDP between generations in a stable proportion. NDC is neutral (fair for generations) by definition. 9 FDCGDI is more difficult for implementation (no costs, some fiscal problems). If for any reason government debt interest on government debt is larger than GDP growth rate (r > g) then the pension system may contribute to an increase in taxation. A benefit is that this type of account contributes to the development of the financial markets. 9 FDCPFI is the most difficult for implementation (some (minor) costs, fiscal problems). FDCPFI generates positive externalities for growth, such as increased investment. In the case of this

type of account it is also possible that is larger than GDP growth rate (r > g). However, this problem can be solved by the reduction of the contribution rate, which will offset the increase of the scale of allocation of GDP to the retired generation. Advantages and disadvantages of each type of individual accounts suggest that choosing a combination of the accounts seems to be a rational option in general. In the case of Ukraine, taking into account existing constraints, NDC could be a way to go. It is worth realising that NDC type individual accounts create large parts

In Ukraine NDC could be a main way to go

of the new systems in Poland as well as in Sweden. The two countries strongly differ from each other; different history, different institutions, different income per capita. At the same time both countries successfully implemented similar arrangements based on the same theoretical approach. This suggests NDC is a pretty universal approach. It can probably be applied also as a leading (basic) type of individual accounts in Ukraine.

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Can financial markets work for social security? Financial markets play important role in economy. Well developed they contribute to economic growth. It is not commonly known they were used by social security schemes in the past (before the Second World War) in some countries (for instance in Germany). However, traditional social security systems did not use them at all in the second half of the twenties century. According to common perception financial markets and social security systems became entirely separated, which applies not only to methods they use but also to concepts they are based on. Nowadays financial markets come back to social security. Following the example of Chile many countries have started their new systems with a larger or smaller component using financial markets, which is commonly called funded schemes. However, the use of financial markets in the past and nowadays differs. The key factor behind is pension regime used. In the past it was only the so-called defined benefit (DB) regime, which does not use individual accounts in a way typical for saving. Benefit (pension) is

The DC regime is considered superior due to selfadjustability and portability

guaranteed as a proportion to previous wages (usually a formula is used for calculating that) no matter what were the individual contributions and earned interest on them. The modern version of using financial markets employs a regime called defined contribution (DC) based on individual accounts. Individual pension is calculated on the basis of individual contributions and earned interest. Theoretically both regimes should lead to the same aggregated outcomes. The DC regime is now considered superior to DB since the former has two features that are important nowadays. These are: self-adjustability and portability. Portability â&#x20AC;&#x201C; ability to preserve the rights to pension by employee when he/she changes a job. Self-adjustability means that DC pension systems do not generate actuarial deficits by definition while to achieve the same outcome DB systems need to be externally regulated. If not they can run a deficit, which in turn creates costs for the people whose product is the only source of financing that deficit. DC regime is cheaper from that viewpoint. Portability means that labour mobility is easier. This is why DC schemes are now dominating in private voluntary schemes, while in the past DB schemes did. Nowadays labour is much more mobile and complications created by DB schemes are more painful for workers. The same applies to universal pension systems. DC regime is getting more popular for that reason as well. Both pension regimes, namely DB and DC, can be used irrespective to whether a pension system uses or not financial markets. Though, that holds only in universal systems since only in that systems an objective explicit rate of return can be define for systems not using financial markets.

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However, neither using financial markets nor using the DC regime is contrary to the nature of social security. Using markets and DC is a part of method applied not the system itself. Social security defines goals, while methods are not social or not. They need to be just effective. The longer ineffective methods are used within social security, the higher is risk one day goals will be given up. Effective methods contribute to systems ability to reach its goals even in difficult times after the demographic transition when the financial pyramid does not generate “miraculous” revenues. Employing financial markets for social security can also be promoted as a method to solve social security sustainability problems. This needs a piece of explanation. First, financial markets – the same as traditional social security – cannot create miracles. The rationale for using financial markets is different. They contribute to growth of modern economies since they generate positive externalities. Channelling through financial markets the flow of money going from workers to retirees (contributions) multiplies effects of the positive externalities these markets generate, which in turn contributes to stronger economic growth. Contributing to an increase of savings in the economy when pension money flows go through financial markets is usually mentioned in discussion on pension reforms. It is usually assumed the additional flow of money finance investment in the real economy. However, if the pension system just spend contributions on purchasing government bonds then this is not necessary the case since governments usually spend that money on current consumption rather than on investment. So the argument for using financial markets by the pension system holds but that needs investment in the private sector. Consequently, privatisation of the economy is needed in order to use the potential of the effect of the pension reform. On the other hand, privatisation is easier when the additional flow of money comes to financial markets. The two desired processes, namely implementation of a new pension system and privatisation need each other and support each other. On the top of typically discussed positive externalities we would like to mention an additional one not so commonly perceived, which is contributing to public education. Social security covers entire population, everybody or almost everybody is covered. Only a small fraction of that people know something on financial markets, which is one of the reasons for relatively little scale of that markets in majority of countries. Ordinary workers being passive financial market users get some knowledge on them and may become less afraid of becoming their active users, which will lead to more individual welfare of that people and stronger growth of the economy. Not only financial markets but also social security is rather weakly known by the people. Although social security – contrary to financial markets – is used by majority of population, people usually do not know much on social security much more than just the level of benefits and some criteria required to get them. Using financial markets within social security will contribute to public

education on how social security works, what can be achieved within social security systems and what is the cost for the society generated by attempts to reach certain goals. Altogether, it is really the good idea to use financial markets within social security. In Ukraine positive effects of that development could be strong. However, it is worth repeating here once again. Successful implementation off methods employing financial markets in social security strongly require additional efforts focused on improvement of the institutional structure, especially property rights, financial markets independent supervision, availability of information, and so on.

It is possible to reform the pension system not using financial markets

It is possible to reform the pension system not using financial markets. However, using them can accelerate both the pension reform itself, as well as other reforms and changes going on in other parts of the state.

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Public versus private pensions Many of those who are not satisfied with traditional pension arrangements promote the idea of voluntary additional pension schemes created on the top of the universal traditional one. The idea is based mostly on Anglo-Saxon tradition and current experience. Indeed voluntary schemes work pretty well in the UK or in the US. However, they supplement small mandatory pension systems and work in a very well developed financial markets. They are large, easy accessible, well regulated, relatively cheap in use and additionally fuelled

Voluntary schemes work better in a well developed financial markets

by tax incentives. These conditions are hardly existing in continental Europe. This observation is even stronger in Central and Eastern Europe that has the history of non-existing financial markets. The Anglo-Saxon approach being interesting point of reference for continental Europe does not really fit – at least in our opinion – to continental situation. Continental Europe is characterised by large scale of mandatory systems, smaller financial markets, and also people and firms are less used to use financial markets. However, additional voluntary schemes of various shape are interesting and important for countries reforming their traditional pension systems. In the World Bank’s so-called three-pillar approach these schemes are called the “third pillar”, in typical European classification both “second pillar” and “third pillar” name is used. Voluntary schemes – even if they work well – cannot fix problems of large and inefficient traditional mandatory systems. Although partial exchanging unreformed universal systems for non-universal voluntary schemes is a good idea it is difficult to implement since unreformed traditional universal systems commonly need an increase of contributions, so their reduction is extremely difficult. This leads to a conclusion saying that expansion of non-universal schemes needs a reform of universal systems which would stop their ever increasing “hunger” for higher revenues. So deep reforms within traditional universal systems are needed not only for avoiding bankruptcy of these systems but also for expansion of additional voluntary schemes that can bring more

Reforms needed for avoiding bankruptcy of traditional systems and expansion of voluntary schemes

flexibility to income allocation as well as open the possibility to increase the overall scale of income allocation. The “third pillar” has become a new element of pension panorama in Ukraine. Additional voluntary schemes are still very limited both in terms of the number of people participating as well as in terms of assets. Hopefully these schemes will grow in both terms. Their existence matters even now, when they are small, since it helps people to understand and step by step accept new perspective on pensions being not only state-provided but also being dependent on

individual responsibility. Non-universal systems are supposed to be based on free market. Similarly to the discussion on solidarity in pension systems the issue of free market also needs a piece of discussion. Free market assumes free choice. In voluntary schemes the choice means: 9 decision whether to participate or not if yes 9 decision on the scale of participation (amount of contribution, frequency of payments); 9 decision on the method of income allocation (savings or insurance or a combination of the two); 9 decision whether to use an intermediary financial institution (the alternative is doing the job by the person allocating income himself/herself); if yes (in the latter bullet) 9 decision on which institution to choose. Typically in universal systems none of these decisions is left for choice. In some systems only the last decision of the listed above can be left for full or partial choice. Actually, the absence of free choice is not a disadvantage of universal systems – it is a part of their nature, since choice within universal arrangements can lead to uncontrolled and in many cases undesired outcomes, for example. people outside any pension system or with too small contributions in their activity period to support their pensions even at a minimum level. It is convenient to divide pension systems into two classes: 9 universal mandatory, in which the need to decide is limited but at the same time responsibility for future outcomes of that decision is spread over the entire population; 9 non-universal (voluntary, additional),when individual decision is crucial and responsibility for its outcomes is on individual person. A universal system can be perceived as and called a public scheme, while nonuniversal schemes can be called private. This classification of systems does not imply public/private ownership of institutions running pension systems. In particular a private firm can manage a part of the public pension system. This is a special case of the public-private partnership implemented within social security. This

Privately managed does not mean privatisation

is the case in some newly designed pension systems (for instance in the new Polish pension system). Within this approach a reform based on implementation of “fully-funded” privately managed pension funds does not mean privatisation of social security. It means, only

managing old-age part of social security is contracted out to the private sector. In other words, it is not true that a part of social security is privatised. Contrary, the private sector enters social security taking a role in providing people with social security. Table 4. Characteristics of pension system versions Indexes

Traditional

NDC

FDC

Management

Public

Public or private

Contracts

Public

Public or private

Claims

Public

Public or private

Assets

Not defined

Public

Public or private

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Financial markets in Ukraine A number of professional assessments of financial markets in Ukraine, their scale, regulatory structure, and so on have been prepared by various institutions. Financial markets are being developed step by step. However, that development started from the very low level. They were virtually nonexistent some 10-15 years ago. So even if the markets grow very strongly their scale is limited. Assuming they would quickly adjust to new needs caused by channelling pension contributions through them would be over-optimistic. On the other hand assuming that existence of well developed large financial markets is a precondition to implementation a pension system using them is over-pessimistic. The latter would just lead to loosing the chance for Ukrainian pension system as well as for further development of that markets. A part of pension flows could and should be channelled through financial markets in Ukraine. A rational decision on the scale of that part needs an analysis of a number of factors, among them: 9 absorption capacity (availability of assets) of financial markets at the current level of their development in Ukraine;

A part of pension flows could/should be channelled through financial markets

9 development capacity of the markets (especially elasticity of supply of private sector financial instruments); 9 possible diversification of assets that can be achieved through the markets in Ukraine; 9 expected profitability of investment in domestic financial markets; 9 openness of the general public in Ukraine for becoming partially exposed to financial markets; 9 openness of the general public in Ukraine for becoming partially served by private firms involved in social security; 9 readiness of institutions that would be involved in supervising financial market activities of pension providers; 9 possibility to open the pension system for international investment. Using financial markets will be the real challenge for both the pension system and the markets. Actually, developing financial markets (their scale and regulations) in Ukraine is a part of the pension reform. Using financial markets in social security causes an additional problem that goes beyond

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economic and social issues. This is the problem of accounting. According to standard accounting procedures social security flows are not accounted. These flows are very large but in national accounts only a deficit or surplus (this does not happen nowadays) is accounted. However, if the same flows of their part go through financial markets, then they are accounted as if additional money was spent. We discuss that later in this brochure. Here we only mention that the decision on choosing the channel for passing money from the workers to the retirees matters for perception of the financial situation of countries reforming their pension systems. This is not a crucial factor, especially for countries staying â&#x20AC;&#x201D; at least for the time being - outside the area where the so-called Maastricht criteria constraint government spending.

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Transition to a new system Rationalisation does not create costs. Just the opposite. It let governments to bring into pension systems some, usually much too little, stability. Rationalisation is needed but it is used only if there is no chance to avoid it. The reason is political cost which is huge. Reforming pension system, which means either a deep change or even exchanging the old system for a new one – paradoxically – may

Deep reforms may be less politically difficult than rationalisation

let avoid large political problems. Deep reforms for governments – which mean changing rules for the future – may be less dangerous than rationalisation – which is adjusting the rules for now (reducing pension system generosity). Pension reform is not costless, however. The cost has already been mentioned. That is the public finance liquidity problem called “transition cost”. This is not real cost in economic terms since the reform it is rechanneling pension flows not creating them. Workers keep paying unchanged sum of contributions; retirees receive the same sum of benefits. Not creating a cost the reform creates the problem. Transition to a new system using financial markets means uncovering previously hidden flow of money in the economy. Accounting that flow government shows higher deficit in the budget. Shall that be perceived as the problem? There is no direct economic cost. However, indirect costs may appear. Higher deficit, and consequently also public debt, change perception of countries where that development is observed. This is another paradox in the area of pensions. Countries reforming their pension systems, hence, improving their situation may be perceived the same as countries worsening their situation due to irresponsible fiscal policy. Typically countries care about their perception in international financial markets, so reforming their pension systems that countries try to keep the “transition cost” relatively low. This can be achieved either by going for only partial reform (a small fraction of contributions are rechannelled to financial markets) or spreading implementation of the reform for a long period. Also a combination of the two is possible. Actuarial projections based on various sets of assumptions let us know what can be financial consequences of the transition pension system from traditional to a new one. What matters it is not only the entire “cost” but also its time characteristic. Normally that type of “costs” is spread over many decades. The question is to what extent public finance can absorb that “cost” without loosing control over the budget. An answer to this policy question creates important constraint for pension reforms. The scale and pace of the reform matter. In Ukraine actuarial projections can be run for a large

variety of assumptions thanks to a model created in the Institute for Demography and Social Studies. This model is similar to models used in other countries working on pension reforms. It offers very reliable answers to policy questions. This is the important asset Ukrainian reformers have since it is very important to convince experts, politicians and the entire public that all options discussed can be tested and the reform plan is under control. Introducing a reform that goes beyond current rationalisation will provide Ukraine with a chance to solve the pension problem, not only to postpone it. The reform understood as changing the way in which the system operates creates a promising option especially for younger part of population for whom opening new prospects can be an interesting option. As already mentioned, there are two types of individual accounts that can work within the mandatory pension system. These are NDC and FDC arrangements. In the case of the former – contributions are turned into quasi-government bonds - one the problem discussed above, namely the “transition cost” does not apply. Being slightly illogical that gives a very useful opportunity to implement a deep reform not facing the “transition cost”. NDC is a good idea itself but it can be also perceived as a path towards FDC in the future. This really matters to start a reform as soon as possible in Ukraine. Waiting for the developments projected to come in some 5-10 years, namely to projected sharp and constant decrease of employment (see Figure 7 again), would lead to difficult problems. The sooner the reform is implemented the cheaper. The concept called NDC provides the chance to do that even if more radical step that is implementation of FDC is impossible or can create undesired problems. So after deciding on the desired scale of FDC designing of a new pension system is not necessary completed. The rest of the old-age part of social security or at least a part of it can be transformed into NDC. This is the way Poland and Sweden reformed their systems.

An example of a successful reform – Specific features of the Swedish/Polish approach As mentioned above, pension systems need reforms virtually everywhere. Countries try to do at least something. Some have already decided to go for reforms, some try to rationalise systems not implementing deep reforms yet. So on the top of economic knowledge, there is also already a lot of experience based on practical implementation of changes. The following bullets help in grasping the essence of the concept of the new Polish system design (Box 4). The Swedish approach is very similar. Also Latvia and Italy go along similar way. Box 4. Polish approach to pension reforms 9 Focusing on the mandatory part of the pension system; 9 Separation of the old-age part of social security (OA) from the non-old-age parts of social security (NOA); and segmenting the flows of revenue (contributions are separated); 9 Termination of the OA part of the previous system; 9 Creation of a new OA pension system, entirely based on individual accounts; 9 Accrual accounting within the OA system; 9 Splitting each person’s OA contributions between two accounts (first account – NDC, second account – FDC); 9 Annuitisation of account values (NDC as well as FDC) at the moment of retirement; 9 Minimum pension supplement on the top of both annuities if their sum is below certain level (financed out of the state budget). (see Annex also) The Polish approach has a number of similarities to reforms remaining within the general concept called “three pillar reform”. However, there is also a number of substantial differences. Table 4 provides some hints on how the Polish approach differs from the pillar reform. Table 4. Alternative approaches to pension reform Typical “three pillar” approach

¾ Rationalised old (redistribution; participation) „first pillar”

Alternative approach (for instance the one applied in Poland)

system ¾ Splitting social security into OA* and NOA anonymous ¾ Termination of the OA part of the old system

¾ New part of the system based on financial individual accounts run by

¾ Creation of entirely new OA part of the system (individual accounts of two types; annuitisation on

private asset managers „second pillar”

retirement; no redistribution)

¾ Contribution split between the old ¾ and the new system ¾ ¾ Promotion of various forms of additional savings „third pillar”

Contribution split between two accounts First account – non- financial; rate of return determined by GDP growth; publicly run (possible privatisation)

¾ Second account – financial; rate of return determined in financial markets; privately run ¾ Annuitisation of account values (both accounts) ¾ Promotion of various forms of additional savings * OA – old age part of social security; NOA – the rest of social security. Experience of other countries provides experience that can help in designing a new pension system for Ukraine. It is impossible, however, just to copy design of any reform implemented in other countries. Each country has to choose its way.

A look into the future New pension systems are needed in many countries since their traditional systems permanently ceased to work properly due the change of population structure. Although various “tricks” applied in the past can still bring some improvement of sustainability of the systems, that tricks are insufficient. They can bring no more than temporal improvement of the situation. However, the real challenge is not to push the problem to the future but to solve it. There is no way to escape the demographic problem other than designing and

A way to escape the demographic problem is designing and implementing a new system

implementing a new system that can work in the situation after the demographic transition. The same demographic pressure exists and causes similar outcomes in Ukraine. Since doing a reform will eventually be the must and since social, economic and political costs of the reform are increasing, the sooner the system is reformed, the cheaper for Ukraine and the Ukrainians. Ukraine can implement a good pension reform. There is no constraint that is in Ukraine harder with that respect than in other countries. However, it makes sense to put things strait forward. The reform should be implemented soon in order to see results in a number of years. Effects will not appear immediately. That is impossible. Pensions it is the long-term business. Some positive outcomes will come in a couple of years, some after a decade. Not implementing the reform would lead to worsening of the current situation and if nothing is done in longer perspective than a catastrophe may come. It is better not to test this scenario. Motivation to go for the reform gets stronger when we realise that young Ukrainian workers who now enter labour market will be around retirement age in 2050. Not only short-term goals but also their interest should be respected. The reform is needed in order to reduce the cost of the pension system to be born by the current and future workers. The reform is needed in order to provide them with a simple, easy and cheap pension system that will let them to allocate income over their life cycles in the optimal way.

Reform is needed in order to reduce the cost of the pension system for current and future workers

Annex Polish approach

The new Polish mandatory old-age pension system started on 1 January 1999. For people born after 31 December 1948, it replaced the previous system that was terminated the day before. The new system has a lot of similarities with reforms being implemented in other countries However, both the reform design and phasing-in process are – to a large extent – different from pension reforms implemented in other countries. New system key features The pension reform implemented in Poland is focused on the mandatory part of the system. Additional voluntary schemes are very important for the new system but even if they are well developed they do not solve the problem of lack of financial sustainability of the mandatory system. The key method applied in Poland to solve that problem is introduction of individual accounts in the entire old-age (OA) part of social security. That part was separated within social security. The reform, however, have not reduced the scale or change goals of that system. Private providers of services related to OA pensions have appeared in course of the reform. They play a very important role However, in Poland their involvement does not mean privatisation of social security. Other way round, private providers have been invited into social security to run a part of it. The system has been designed in the way that makes it possible and internally consistent. What matters in the new Polish OA system the most is not ownership but function of each element of the system. If we applied “pillar” terminology then instead of common opposition: first pillar versus second and third pillars – in Poland the opposition is between mandatory OA system, namely “first” and “second pillar” together versus additional voluntary arrangements called the third pillar. The first and second OA “pillars” play exactly the same role. There are – of course – differences in the way each of them generates resources for future pensions. The mandatory system is designed in the way that links its two parts closely to each other. They are both based on individual accounts, participants receive similar statements from both accounts, retirement age is the same, both accounts are annuitised at the day of retirement, minimum guarantee is based on the sum of annuities paid from both parts of the system. Differences between them are still substantial. The most important of them is the way of generating the rate of return. The NDC part does not use financial markets, while FDC does. It is also worth mentioning that non-old-age (NOA) elements of social security remain outside the new mandatory old-age system. Due to the “bottle” shape of the demographic “pyramid” the OA part of social security in the pre-retirement period has the nature of savings irrespective to particular arrangements applied. The arrangement applied in Poland, namely individual accounts causes that interest earned by the money paid into the OA system is equal for all participants since there is no redistribution in the system. Insurance starts after retirement when savings are annuitised. Box 1. Polish pension reform approach Focusing on the mandatory part of the system Separation of old-age and non-old-age parts of social security Old-age part of the previous system has been terminated The sole social goal of the entire new old-age system is providing people with safe and efficient way of allocation of income over life cycle The old-age system is sub-divided into parts (accounts) Non-old-age part of social security is outside the structure for providing old-age pensions Two parts of the mandatory system are newly born “twins” having very little in common with the previous system

Entire new OA system based on individual retirement accounts – old-age contributions are divided between two accounts Both accounts are annuitised at the day of retirement Minimum guarantee on the top of the sum of annuities paid out from the two parts of the system (financed by the state budget) Although the two parts of the OA system are designed in the way that makes them very similar to each other, the two pillars are not identical. Similarity refers to individual perception of people covered by the OA system. People pay contributions in, money goes to their individual accounts, when the people retire they get back what they paid in plus interest, the entire amount is annuitised. What is different and crucial for the OA pension system it is the way in which the interest is generated. Contributions paid to the social security system are first divided into OA and NOA and afterwards the OA part is divided between the accounts (see Table […]). Table 1. Old-age and non-old-age social security contributions as a percent of wage Total OA

19.52

First pillar Second pillar Other elements individual acc. individual acc. of the system -12.22 7.3

NOA

17.07a

17.07

The OA contributions are divided between two accounts in order to provide people with risk diversification. Short-term rate of return in the NDC part depends mostly on labour market performance, while in the FDC part the rate of return depends on financial markets’ performance. The difference is really substantial but in the long-run it should narrow. In the short-run risk diversification between two markets, namely the labour market and the capital market helps in reducing effects of fluctuations in each of the markets. The aim reached at the starting date of the new system was to exchange the previous unsustainable defined benefit system for entirely new defined contribution system. One part of the system works along the so-called non-financial defined contribution (NDC) regime. Contributions paid into the accounts have a nature of public debt. They are not spent on financial instruments traded in markets. The rate of return is generated through an increase of contribution base due to demographic growth and increasing productivity (similar to government debt instruments). In the long-term this rate of return converges to the GDP growth rate. Another part of the system generates rate of return using regular financial instruments. In the long-term this also has to converge to the GDP growth rate. So in the long-term both parts of the system lead to similar effect. Two methods of reaching the same long-term goal are used since their short-term outcomes can be different or has different time profile. So using two methods instead of one brings additional security to the system. This is why the Polish reform had the name “Security through Diversity”.