The Multipillar Pension System in the Russian Federation: Completing the Reform Moscow, November 1, 2011 Heinz P. Rudolph

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

3 The framework of the 2 nd pillar in the Russian Federation is one of the best around the world, comparable to Scandinavian countries, but there are serious flaws in the implementation of the reform

The Russians have spoken, but what are they saying? 4 Allocation of Contributors to 2 nd Pillar by Type of Institution

The Russians have spoken, but what are they saying?  About 85% says that they do not understand what the government is trying to do or do not have the parameters for making an informed decision about asset allocation.  Financial literacy is low  About 12% says that they trust their employers  Do they have an option?  Syndicates are strong in large companies /conglomerates  About 3% says that at least they want to have a different portfolio option 5

Our Interpretation There is a Strong Demand for Guidance  Different policy conclusions:  Financial Education?  Forcing the Selection of a Pension Fund Management Company?  Benchmarking! 6

2 nd Pillar in the Russian Federation  Lack of understanding and passive response of contributors to the pension reform is the only outcome that can be expected.  Finding the portfolio that optimize individual’s future pensions is too difficult for the average contributor  Russia’s experience Is no different than Australia, Sweden, Denmark, Chile, Peru.  These findings are documented in the behavioral economics literature. But the literature adds that poorer individuals are the ones more affected by the lack of a good default option.  Lack of capacity to understand it is not an argument for not having funded pillar, but an argument for:  Educating the population?... long-term result and not proven results  Creating a default option that optimizes the future pensions of individuals 7

Lessons from the Reform in Sweden and Denmark Sweden  Government’s initial efforts for encouraging active selection of contributors for 2 nd pillar contributions have proven to be expensive and did not encouraged informed decisions.  Initial active selection ($$$), about 70% of contributors  Current active selection 5% of contributors  In 2010 PPM improved the default option (lifecycle) Denmark  Danish SP system, gave 3 options:  Default Option  Assisted Choice Option  Active selection  About 99% of the Danish population followed the default option.  The default option was a lifecycle strategy, derived from an optimal strategy. 8

Implications on Investments: Default Option  As it is the one with highest coverage, it should be the one with the best investment strategy  No point in having a default portfolio that promises a real rate of return of zero percent  In funded systems the bulk of the pensions come from interest earned  Designing a low cost strategy that optimizes the pensions of individuals at retirement age, that invest in well diversified portfolio with equity and bonds along the lifecycle of individuals.  International diversification should be encouraged through ETFs and index funds 9

Parametric Changes (1 st Pillar)  Move to price indexation  Generous pension increase will have high fiscal costs  While inflation is likely to remain high, it preserve the purchasing power of the pensions (avoid poverty)  Typically public finances are hedged to inflation risk  Wages in countries with Dutch Disease grow faster than prices  Retirement age needs to be increased, especially for women  Linking the retirement age with the life expectancy of individuals  Voluntary retirement age typically do not work  Frontloading the 2 nd pillar benefits as an incentive is counterproductive 10

The Payout Phase: Pensioner and Provider Risks  Pensioner risks: complex and pointing in opposite directions (longevity v bequests, investment v liquidity).  Provider risks opposite to those of pensioners.  General lack of adequate instruments to hedge longevity and inflation risks.  Risk sharing through variable participating annuities but complex regulatory and supervisory issues.

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Menu of Retirement Options in Five Countries Lump- Sums Term Annuities Lifetime PWs Fixed Nominal Life Annuities Fixed Indexed Life Annuities Variable Annuities AustraliaYes NoYes Chile No *NoYesNoYesYes, not implemented Denmark (1) No (2) No * (1) No (2) Yes (1) No (2) Yes No No guaranteed benefit only No conditional bonus only Yes Yes Sweden (1) No (2) No (1) No (2) Yes (1) No (2) Yes No No guaranteed benefit only No conditional bonus only Yes Yes Switzerland Yes *No YesNo Conditional No * Restrictions apply; either regulatory or at the plan level

Product Shortcomings  Nominal annuities cover investment and longevity risks but are exposed to inflation risk.  Real annuities cover all three risks but require access to inflation-linked securities, issued by both the public and private sectors.  All fixed annuities are exposed to annuitization risk.  Variable annuities avoid annuitization risk but may be exposed to high investment and inflation risks.  Phased withdrawals are exposed to longevity, investment and inflation risks.

Main Conclusions on Products and Options  Policy makers should target an adequate level of annuitization but avoid excessive annuitization.  Lump-sum distributions should be subject to reasonable restrictions.  Policy makers should favor a combination of payout options, covering different products at a particular point in time as well as different payout options over time.  A default option should always be specified.

Main Conclusions on Market Structure  Advantages of centralized administration and risk pooling with decentralized asset management.  Decentralized structures require vigilance over growing oligopolies.  Need to regulate marketing through centralized quotation systems.  Need to regulate risk management through maintenance of adequate reserves and prudent use of hedging instruments.

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