pension_reform_eng

PENSION REFORM: CHALLENGE FOR UKRAINE

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Кyiv-2008

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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

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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.

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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

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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

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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

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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

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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.

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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.

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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.

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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.

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

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

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

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

Old system is kept to provide poverty alleviation

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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

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

Current and projected demographic structure and consequences for pension

systems

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

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.

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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

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.

Pension reforms are more advanced in new EU Members

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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

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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.

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

Get from the system what you have paid in plus interest

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and income, and, in turn, higher taxation needed to finance the same expenditure. The saving-

based 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 – 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 retire-ment

Working period,

years

Starting wage

Wage before

retirementUAH/month

Life expectancy at ret.age

Account value at ret.. age

Pension Benefits,

UAH/month

Replace-ment rate

55 35 1500 4221 22.7 354 547 1 813 0.43

60 40 1500 4893 18.7 469 733 2 766 0.57

65* 45 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 retire-ment

Working period,

years

Starting wage

Wage before

retirementUAH/month

Life expectancy at ret.age

Account value at ret.. age

Pension Benefits,

UAH/month

Replace-ment rate

60 40 1500 4893 14.1 469 733 3 445 0.7

65 45 1500 5672 11.6 612 618 5 276 0.93

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)

22

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

the way of its reform.

Unawareness and misunderstanding of reform options decelerate its progress

23

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

24

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

and Central European countries.

Table A. Life expectancy at statutory retirement age in selected countries

Statutory retirement age

Life expectancy at statutory retirement age Country

Male Female Male FemaleUkraine 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

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

Ukraine has the lowest retirement ageamong European countries

25

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 14.1 14

Female 19.7 18.5 18.4 18.2 18.5 18.9 18.9 19

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

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. n.a. n.a. 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

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

26

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

growth.

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

27

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

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.

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

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

Pension system is an institutional framework for intergenerational exchange

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

Increase contributions paid by the young or decrease pension benefits?

28

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

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

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.

C=T

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

29

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.

30

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

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

system requires developed institutions in other elements of the state.

The other elements needed:

well designed and executed property rights;

well developed (well designed rules and appropriate scale) financial markets;

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

Modern design of pension system requires developed institutions

31

well developed and independent supervision over financial markets;

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

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

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.

Business climate is important for ordinary people

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

32

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.

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

64

66

68

70

72

74

76

78

80

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

EUPolandEstoniaLithuaniaLatviaUkraineCIS

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 situation of Ukraine is similar to other European countries

33

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

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 11.1

Other pensioners (millions) 2.7 2.7 2.5

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

0.42 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


Projections, as presented in Table 2, suggest the changes in Ukrainian demography will be really

substantial.

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

34

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.

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

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

35

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

0

5

10

15

20

25

2006

2009

2012

2015

2018

2021

2024

2027

2030

2033

2036

2039

2042

2045

2048

2051

2054

mill

ions


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

36

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.

37

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 –

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

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).

Policies aiming at higher fertility rates cannot bring population structure back

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

38

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

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

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 effective.

Contributing to higher employment

Workers, or in a broader sense the economically active population, finance pensions. The

Retirement age is being increased everywhere throughout Europe

Ukrainians spend more years as pensioners than average in OECD countries

A policy aiming at later retirement is much more effective

39

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

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

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.

Only legal employment finance pension system

Higher indexation means higher pensions but also lower wages

40

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 needsto introduce a reform that goes beyond rationalisation

41

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.

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:

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;

channelling flows of contributions in a way that generates positive externalities for GDP growth, using financial markets;

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:

Individual accounts

Using financial markets for social security goals

Private management of pension services providers.

New design can contribute to strengthening effects off rationalisation

42

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

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

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

43

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

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:

C1 C2Aging population

C3Early retirement

C4 C5Diminishing the

number of employed

Increasing the number of unregistered workers

Contribution rate

Replacem

ent rate

L1 L2 L3 L4 L5

Z1

C

Z

O

44

aging population - line L1 is replaced by line L2, contribution c1 increases to c2;

granting early retirement – line L2 is replaced by L3, c2 increases to c3;

diminishing the number of employed line L3 is replaced by L4, c3 increases to c4;

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

45

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:

worker pays fixed part of his/her earning contribution to pension fund. It is collected on his/her individual account;

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

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.

46

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

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.

Individualisation does not mean participants have to rely only on themselves

47

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 non-financial 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

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.

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,

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

FDC– contributions to individual accounts channelled through pension funds

48

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 or even small

Not possible

FDCGDI Government Financial markets

r = rGDI Small GDPR/GDP increases due to higher taxes

FDCPFI Private sector

Financial markets

r = rPFI Very small GDPR/GDP increases due to higher asset prices

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.

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.

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.

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

49

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

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.

In Ukraine -NDC could be a main way to go

50

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 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 – 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.

The DC regime is considered superior due to self-adjustability and portability

51

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

52

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. 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.

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

53

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

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

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

Voluntary schemes work better in a well developed financial markets

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

54

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:

decision whether to participate or not

if yes

decision on the scale of participation (amount of contribution, frequency of payments);

decision on the method of income allocation (savings or insurance or a combination of the

two);

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)

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:

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;

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 non-universal 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

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

Privately managed does not mean privatisation

55

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 Public or private

Contracts Public Public or private Public or private

Claims Public Public or private Public or private

Assets Not defined Public Public or private

56

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:

absorption capacity (availability of assets) of financial markets at the

current level of their development in Ukraine;

development capacity of the markets (especially elasticity of supply of private sector

financial instruments);

possible diversification of assets that can be achieved through the markets in Ukraine;

expected profitability of investment in domestic financial markets;

openness of the general public in Ukraine for becoming partially exposed to financial

markets;

openness of the general public in Ukraine for becoming partially served by private firms

involved in social security;

readiness of institutions that would be involved in supervising financial market activities of

pension providers;

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

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

57

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 — at least for the time being - outside the area where the so-called

Maastricht criteria constraint government spending.

58

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 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

Deep reforms may be less politically difficult than rationalisation

59

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.

60

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

Focusing on the mandatory part of the pension system;

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);

Termination of the OA part of the previous system;

Creation of a new OA pension system, entirely based on individual accounts;

Accrual accounting within the OA system;

Splitting each person’s OA contributions between two accounts (first account – NDC, second

account – FDC);

Annuitisation of account values (NDC as well as FDC) at the moment of retirement;

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 Alternative approach (for instance the one applied in Poland)

Rationalised old system (redistribution; anonymous participation) „first pillar”

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

Splitting social security into OA* and NOA

Termination of the OA part of the old system

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

61

private asset managers „second pillar”

Contribution split between the old and the new system

Promotion of various forms of additional savings „third pillar”

retirement; no redistribution)

Contribution split between two accounts

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

Second account – financial; rate of return determined in financial markets; privately run

Annuitisation of account values (both accounts)

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.

62

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

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.

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

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

63

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

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�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 First pillar

individual acc. Second pillar individual acc.

Other elements of the system

OA 19.52 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”.

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