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For the fully funded pillar (FFP), a rough estimate for the potential longer-term replacement rate (Table A3) may be obtained in a similar manner. Assuming that the wage growth rate is equal to the interest rate (yield) in the economy85, the FFP replacement rate as of the date of retirement is proportional to the contribution rate and the number of years of service and inversely proportional to the average life expectancy after retirement86. Given the current maximum contribution rate for the funded pillar of 6 percent, prevailing values of both collection and regression factors, and working lives of 30-35 years, the FFP replacement rate will be about 8.5-10 percent (60.940.96(30-35)/19)87.

As a result, with the dependency ratio equal to 1, the combined (PAYG and FFP) longer-term potential replacement rate for the existing system would stay within the interval of 24-25.5 percent.

4.68 Table 4.10 provides a compressed summary of the expected trends in the replacement rate under the Group I scenarios. It suggests the following observations:

The current legislation provides that only 21 percent of pension contributions (6 percent out of 28 percent of payroll) will be directed to the funded pillar.

As mentioned above, the model uses the following estimates for these three parameters: 0.94, 0.94, and 0.respectively.

This is a standard assumption for this kind of model: if the interest rate is below the wage growth, the incentives for participation in a pension system weaken notably.

Currently, annuity has not yet been fixed for the funded pillar, and the model is using variable life expectancy with the same values as for the PAYG pillar (12-19 years depending on the year of projections).

This is an upward biased estimate because it does not account for several factors, such as e.g., administrative costs in the FFP.

Each cohort of the pensioners starts its retirement with quite a low real pension, and this relative value of pension at retirement is declining with time, i.e. each cohort is better off at the moment of retirement than those that follow.

The real value of pension for each cohort is growing with time, however this growth is concentrated in the second part of their retirement career.

Practically in all cases during the first part of retirement the average pension is less than one third of the average wage at retirement.

Table 4.10: Real pension as a percentage of the average wage at the time of retirement.

Year of 2002 2010 2020 2030 retirement Scenario 2 (12): Low growth 2002 31 34 41 - - 2010 - 26 31 48 - 2020 - - 20 31 Scenario 4 (14): High growth 2002 31 37 50 - - 2010 - 25 34 57 - 2020 - - 19 32 4.69 The dynamics of real replacement rate (Table A4.5), i.e. the replacement rate estimated as a ratio of the average pension to the full labor income (but not just to its taxable portion), shows much less variation than the conventional (nominal) replacement rate (Table A4.1). It suggests that, when one accounts for an expected decline in the share of informal wages in the total payroll, the overall trend in the relative size of the average pension is quite different. It shows modest growth for the period between 2005 and 2020 within the range of 24-27 percent, and after this it declines much more gradually that the conventional (nominal) replacement rate. Still, in none of the scenarios in Group I, the real replacement rate exceeds 26 percent in 2030.

4.70 At the same time, all scenarios in Group I show a gradual increase in the value of average pension relative to the subsistence minimum (Figure 4.10). The latter ratio is a better measure of absolute changes in pensioners standard of living than the replacement rate. It indicates that, even within the unreformed pension system, with economic growth the real incomes of pensioners will also grow steadily. However, there are two concerns with the patterns of this future growth: a) in the initial period till 2015, despite a low level of current pensions, this growth will be rather slow, and b) as reflected in the falling replacement rate, the growth in pensions will be lagging growth in real wages, which may become a politically sensitive issue.

4.71 In contrast to the replacement rate, the ratio between average pension and subsistence minimum shows a considerable variability depending on the growth rate in the economy, as well as growth in real average wages. By 2030, the difference in increases of this ratio across the scenarios is about 3 times, from 50 percent in Scenario 11 to 165 percent in Scenario (which is the scenario with the highest GDP growth rate).

4.72 The analysis also suggests that the existing pension indexation rules could be somewhat relaxed without compromising the stability of the pension system. In the expected environment of the high wage growth the existing indexation rules, which are primarily inflation based, are too restrictive and do not allow for utilization of the entire pension contributions. If the PAYG pensions are adjusted only for price inflation, and do not reflect real wage growth, the future average pensions would be much lower (Table A4.8) than those that the system could afford, and the pension system would generate considerable surpluses that would reach 1.8-2.7 percent of GDP by 2030 (Table A4.11). Comparison between the average pension, estimated for the inflation-only indexation rules, with the average pension that could be afforded by the pension system (i.e., with the zero balance of the PAYG pillar, (Table A4.1) shows that by 2020 the difference (measured by the replacement rate) amounts to 50 percent and it reaches 100 percent by 2050.

4.73 While under the existing indexation rules overall the PAYG system would generate considerable surpluses, they would be generated entirely by the base pension component (Table A4.9). The NDC component would have considerable deficits (Table A4.10 and Figure 4.11).

Figure 4.11: Balance in the Base and NDC Components of the Pension System, Group 1 Scenarios, % of GDP Balance in the base and NDC components of the pension system, Group 1 scenarios, % of GDP 3.Scenario 3.Scenario Scenario 2.Scenario 2009 2014 2019 2024 2029 2034 2039 2044 4.74 The inflation-only indexation rules would have a major effect on the real value of the base pension and could lead to a quick erosion of its value. If the real wages grow at percent, the replacement rate for the base pension will decline by factor of approximately 3 by 2025, and by factor of 18 by 2050. The share of the base pension in the total average pension benefit will decline from 30 percent in 2003, to 20 percent in 2025 and to only 5 percent in 2050.

4.75 Under the circumstances, it would make sense (probably after 2030) to convert the base pension into an instrument of social assistance, link its size to the minimum subsistence benefit, and respectively move the responsibility for its funding from the Pension Fund to the federal budget. This would be consistent with the nature of the basic pension, which aims to provide basic income security for the elderly (Hotzmann et al., 2004, pp. 10-11).88 This would cause an annual increase in government budget expenditures of about 1 percent of GDP in A similar suggestion was made by the Russian Union of Industrialists and Entrepreneurs (Concept of the Pension Reform. Employers Position, 2001). Hungary and Poland abolished their minimum pension and provide a minimum income support for the elderly from outside of the pension system (IMF, 2002, p. 30).

2030, but this amount would be declining quickly to less than 0.4 percent of GDP in 2050.

Accordingly, the same amount of pension fund resources could be freed and may be used for an increase in the PAYG pensions.

Impact of other specific factors on the replacement rate 4.76 The sensitivity of the results for future average pensions to changes in the interest rate proved to be quite high. An increase in yield by 1 p.p. leads to a 15-20 percent increase in the replacement rate for the fully funded component of the pension benefit. For 2050 this could bring about an additional 1.5 p.p. to the overall replacement rate in the system. However, for the period till 2030 the share of the fully funded component in the overall benefit remains low, and therefore changes in the interest rate have only a marginal impact on the real value of the overall pension benefit. Our baseline estimates assumed a rather conservative assumption regarding the interest rate, which is kept at 1 p.p. below the real wage growth, while usually these parameters are assumed to be equal in the longer term. Our choice of a lower interest rate relates to the fact that the baseline scenarios assume quite high real wage growth, and equalizing interest and wage growth under the circumstances may produce unrealistically high yields.

4.77 While the pension system may have potential financial reserves associated with an increase in the economic activity (labor market participation) of the population, as well as with declining unemployment, the possible impact of these two parameters seems to be low. It appears in our assumptions used for Scenario 14 (high growth with advanced reforms) that we have already accounted for most of the realistic reserves in these two areas.

4.78 An increase in the birth rate along with the effects of declining unemployment, growing economic activity, and higher net migration inflows in the base scenarios of Group I help to reduce the system dependency ratio by about 10 percent and, respectively, to increase the average pension benefit by 10 percent.

4.79 The above estimates for baseline trends in the replacement rate assume a considerable compression of the early retirement schemes as proposed by the Draft Law on Professional Pension Systems. Thus, there are no significant unaccounted reserves associated with this factor. We estimate that if the current draft Law becomes effective, this would reduce the number of early pensioners from about 3 million in 2002 to 2.25 million in 2030, and to million in 2050.89 Given that the total incremental annual payments to early retirees, as estimated, amount to about 4 percent of total Pension Fund spending on pension benefits, total savings due to the proposed reduction in this benefit would be modest from 1 percent of the total pension payments in 2030 to 2.7 percent in 2050.

4.80 The existing proposals for UST reforms also suggest considerable changes to the existing tax brackets, and also introduce a regular indexation of the tax brackets for the future.

If implemented, this would change both the average effective tax rate and the coefficient of regressivity (currently equal to 0.94) for the pension system. However, it is difficult to predict the magnitude of possible changes in the latter because we do not have data on actual distribution of wages within each group of contributors. More importantly, it is quite difficult to make longer-term projections for future changes in wage differentiation. We have therefore kept the coefficient of regressivity intact in our simulations and focused primarily on the impact of changes in the average contribution rates.

However, the number of early pensioners would increase till 2012 due to the grandfathering clauses.

Group II. UST reform: cuts in the pension contribution rates Modest rate cut of 4 percentage points 4.81 The pension system understandably is very sensitive to even modest cuts in the contribution rates. Scenarios of Group II were used to undertake a series of simulations that help evaluate the possible effects of cuts in the average UST rate on the overage benefit under the assumption that such a cut is not complimented by other reform efforts. In the base case, when there is no increase in the UST tax base relative to the baseline of 31 percent of GDP, the proposed rate cut is expected to cause by 2030 an additional decline in the average replacement rate by 6.5-7.5 p.p. This would bring the replacement rate to the level about percent, i.e. one quarter below the replacement rate that is likely to be generated in the system without the reforms (and 40 percent below the current replacement rate). This would represent a major compression of the real value of the pension benefit.

4.82 The ratio of the average pension and subsistence minimum in the latter scenario is about 20 percent below those in the Group I scenarios. It is worth noting, however, that it remains considerably higher than 1 (by 60-120 percent in 2030), which is a major improvement relative to the current situation.

4.83 In the optimistic case, despite an assumed considerable expansion in the tax base (See Section D), the average replacement rate would decline relative to the baseline in the Group I scenarios. By 2030 the decline would amount to 3.5-4 percentage points, which bring the replacement rate to the range of 22.7-23.8 percent (Figure 4.12). Along with this, potential fiscal costs of closing the gap in the pension system (measured against the replacement rate target of 30 percent) would increase from approximately 0.6-0.9 to 1.7-2.1 percent of GDP.

Figure 4.12: Pension Replacement Ratio, Comparisons of Scenarios in Group 1 and Group Pension Replacement Ratio, compariosons of scenarios in Group 1 and Group 2, % 2 (Gr1) 15.Scenario 2 (Gr2) Scenario 4 (Gr1) 10.Scenario 4 (Gr2) 5.0.2004 2009 2014 2019 2024 2029 2034 2039 2044 4.84 Due to a linear dependency among the parameters in the PAYG system, the above results may be used for generating rough estimates for potential alternative plans for cuts in the contribution rates in the PAYG pillar. On average 1 percentage point in reduction of the UST rate could be compensated for by an increase in the share of taxable payroll in GDP by 1.0-1.3 p.p. At the same time, a 1 p.p. cut in the UST tax rate could be compensated by 0.250.3 percent of GDP in additional external (budget) transfers to the pension system. Annex 4. presents additional results of sensitivity analysis: it helps to get the idea of the variation in real value of average pension for different pairs of UST contribution rate and payroll share in GDP.

Table 4.11: Some results of sensitivity analysis for 2030: equivalence table 1 p.p. in UST tax rate cut Could be compensated by an expansion in the UST tax base of 1.0 1.3 p.p.

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