International Conference on Pension Reforms Implementation 16-17 February, 2005 Sofia, Bulgaria

1. UKRAINE’S PENSION REFORMDEVELOPMENTS and CHALLENGESVladimir YatsenkoUSAID Mission for Ukraine, Belarus and Moldova International Conference on Pension Reforms Implementation16-17 February, 2005Sofia, Bulgaria

2. Multidimensional Impact of Pension System • Social well-being • Political landscape • Economic development

3. Social Implications • The main priority of any publicly established pension system should be poverty prevention in old age, during disability or upon the death of the family’s wage earner • Need to provide guaranteed and predictable benefits • Need to adjust pension system to changing demographic, social and economic environments • Ukraine has 14 million pensioners out of a total population of 47 million (30 per cent) • Ukraine’s current retirement age is still 60 for men and 55 for women, and pension system dependency ratio is 0.85

4. Political Implications • Different political structures require different reform processes • Pension reform is NOT a race, but a long-term process - the reform process may be slow because it has considerable risks for politicians and government bureaucrats • Politicians prefer that bad news be seen to arise through market outcomes rather than by their political decisions • Major reforms in a democracy require use of the political process to secure changes in social security legislation • Older workers and retirees form a strong political interest group (40% of Ukrainian voters) • Large and fiscally unsustainable increases in PAYG benefits just prior to 2004 Ukraine’s presidential election • PAYG & IRA advocates support different political philosophies, and which system is better is a controversial issue

5. Economic Implications • The difference between PAYG and funding is second order • Effect of pension financing on public deficit and debt • Labor market effects • National savings and investment • Domestic capital market • Liberty for the individual is great, just as long as the stock market goes up! What’s the cost of allowing choice?

6. Problems and Constraints of Ukraine’s Pension System (2000): • Inadequate and inequitable benefits • Benefit arrears of 2 - 8 months • Too many pensioners relative to contributors • Administrative inefficiency, poor compliance • Contributions and benefits often paid in-kind • Non-viable revenue systems and benefit levels – payroll tax of 34 % and benefits 30 % of poverty level • No capital markets for long-term capital investments

7. Demographic Tree, Ukraine, 2001

8. Impediments of Ukraine’s Pension Reform Process • Reaching a consensus on the reform has been going on for 8 years and is not finished • Lack of knowledge and experience at all levels(f.i. the demographic pressure has not become apparent for the public) • Lack of strong pressure groups without vested interests • High political risks (especially during 2004 presidential elections) • Lack of macroeconomic stability • Age distribution of the population • Agricultural sector contributions and payouts (split between rural and non-rural contributors/beneficiaries) • Weak financial sector and capital market (market capitalization is about 20% of GDP or just $15 billion; assets of 3 largest companies make up 48% and assets of 5 largest companies make up 64% of market capitalization) and its institutions, poor corporate governance. Ukraine’s long-term Fitch rating BB-, stable

9. The Ukraine’s Approach (2004): Tier 1. Traditional Social Security Benefit • Pay-as-you-go • Mandatory • Defined benefit • Government administered • Major source of benefits Tier 2. Mandatory Individual Retirement Savings (2007) • Fully funded, defined contribution • Mandatory, if more than 20 years to retirement • Administered by the 1st tier administrator • Investment of assets managed in private sector • Minor source of retirement income for lower income workers, moderately important for middle and upper income workers Tier 3. Voluntary Retirement Savings • Fully funded, defined contribution • Voluntary • Managed in private sector • Minor source of retirement income for lower and middle income workers, more important source for upper income workers

10. Required Preconditions for Creating the Mandatory Accumulation System (2007 or TBD) Country has experienced economic growth during last two consecutive years Special 2nd pillar law and other necessary legislation adopted It is ensured that PAYG system benefits are NOT less than the minimum subsistence level (Constitutional requirement) The PAYG State Pension Fund remains balanced according to international accounting standards It is ensured that the state budget will pay for transition costs Personified reporting and record-keeping system developed, tested and introduced by the State Pension Fund Regulator for the private pension system is operating properly Experience of operations in private pensions industry is available

11. Some Important Aspects of Ukraine’s 3rd pillar Law on Non-State Pensions: DC accounts within private pension funds (open, corporate and occupational), commercial banks and insurance companies 21 pension funds (16 open, 4 corporate and 1 occupational) and 47 investment managers licensed as of 01/01/2005 EET-type tax incentives for both employers and workers. Employers are able to treat contributions as business expenses, and the deductibility of the employer contribution is given priority. The total tax-deducted amount that may be contributed by or on behalf of an individual may not exceed 15% of the worker’s annual gross taxable income (up to 1.4 minimum subsistence level) Contributions are invested by professional asset managers Portability of pension assets is mandated Participants can take their funds not earlier than 10 years before and not later than 10 years after the normal retirement age (60m and 55f) as a life annuity, scheduled and lump sum payments (lump sum - in limited circumstances)

12. Ukraine: Investment Restrictions for the Voluntary 3rd pillar PPFs (up to): 50% government securities 20% municipal bonds 40% banking deposits and certificates (max 10% with one bank) 40% domestic corporate bonds 40% domestic equities 40% mortgage-backed securities 20% foreign securities 10% real estate 10% banking metals 5% other assets 5% in one issuer (except Government securities and bank deposits)

13. Ukraine: Investment Restrictions for the Mandatory 2nd pillar (up to): 50% government securities 20% municipal bonds 50% banking deposits and certificates (max 10% with one bank) 40% domestic corporate bonds 40% domestic equities 20% foreign securities 5% other assets 5% in a single issuer (except Government securities and bank deposits)

14. Key Problems in EE and CIS Countries Introducing Mandatory IRA System: • Limited time between passage of legislation and implementation, therefore not enough strategic planning and public education done • Coordinating among different government agencies and sharing of information • Conservative investment regimes. Lack of sound (firstly long-term) instruments in the domestic capital markets. High volatility and low liquidity of domestic capital markets. Lack of competition and high concentration of both capitalization and liquidity in a handful of stocks. Small size of voluntary third pillar • Knowledge gap between the sellers and buyers of financial services. No faith by the population in the private sector being able to ensure that the money will be there when they retire • Contributions compliance and data verification – i.e. reconciling records to cash. Assigning and administering individual identification numbers • Assuring consistency in accounting rules. Preventing marketing abuses. Appropriate asset valuation methods. Regulation of charges/fees and benefits modalities (annuity/capital)

15. ENDNOTES • Successful pension reform rests on two pillars - government capacity and private sector capacity • Miscalculations by Government are a reality, but the same is true for market failures • Social security privatization implemented thoughtlessly and mechanically, based on ideological considerations, increases poverty, inequality and impedes growth • “Everything on earth has its own time and its own season”(Bible, Ecclesiastes 3, Contemporary English Version)