Strategy Paper for Pension Policy in Ukraine

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United Nations Development Programme

Project “Support to the Social Sector Reform in Ukraine”

Strategy Paper for Pension Policy in Ukraine

Prepared by the European Centre for Social Welfare

Policy and Research

Commissioned by the UNDP in Ukraine

March 2012

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Content _____________________________________________________________

Preface ........................................................................................................................................................ 3

Introduction ............................................................................................................................................. 4

1. Identifying challenges and future pension policy goals ................................................10

2. Review of international experiences of pension policy reforms ...............................21

3. Pension reform scenarios for Ukraine ..................................................................................40

3.1. Short-term immediate measures, during the period 2012-2014 .....................40 3.2. Medium to longer term measures – beyond 2014 ...................................................42 3.3. Political feasibility of pension reform options ..........................................................45

4. A synthesizing discussion ...........................................................................................................48

Literature ................................................................................................................................................52

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Preface _________________________________________________________

The work reported here is funded by the UNDP in Ukraine.

This strategy paper has four-fold objectives:

to describe the current Ukrainian pension system (the 1st pillar) and in the process set the context for possible future reforms (Section 1);

to report on challenges faced by the Ukrainian pension system (with a focus on the 1st pillar) and identify future pension policy goals (Section 2);

to review and drawn lessons from experiences of pension reforms from other European countries and make specific recommendations for the future pension policy strategy in Ukraine (Section 3); and

In light of these analyses, to make recommendations for short-term immediate reform measures (during the period 2012-2014) and medium- and long-term reform measures (beyond 2014) for pension policy in Ukraine (Section 4).

A synthesizing concluding discussion is also provided at the end (Section 5).

The strategy paper is prepared by Asghar Zaidi. Alexandre Sidorenko contributed a full section (Section 4.3: Political Feasibility of Pension Reform Options) and also provided comments on the whole paper (during its various versions). Very useful and substantive support was received from Katerina Rybalchenko of the UNDP, Kyiv, not just in preparing this strategy paper but also in facilitating two very productive missions and in the interpretations of different views on pension policy in Ukraine. Useful comments from Bernd Marin and Eszter Zolyomi of the European Centre on the draft version of the paper are also gratefully acknowledged. Katrin Gasior of the European Centre provided valuable assistance in preparing the graphs included in the paper. Lydia Shuleva, Bernd Marin and Ella Libanova, and officials of the Ministry of Labour and Social Policy also contributed via the discussions during the two missions to Kiev. Written comments from Greg McTaggart (Senior international Pension Reform Adviser, USAID Financial Sector Development Project, FINREP), Marek Góra (Warsaw School of Economics), Natalia Goryuk (Senior Pension Lawyer, USAID in Ukraine) and Balázs Horváth (Poverty Reduction Practice Leader with the UNDP Bratislava Regional Centre) had been particularly useful and are gratefully acknowledged here. All remaining errors and interpretations remain the responsibility of the contractor: Asghar Zaidi.

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Introduction _________________________________________________________

Effective from 1st January 2004, Ukraine adopted the law "On Mandatory State Pension Insurance", introducing social insurance principles in its pension system. At the same time, supplementary non-state pensions were also legislated for and implemented. Together, the reformed system will provide a three-pillar pension system: the 1st pillar is a pay-as-you-go system of the mandatory state pension insurance; the 2nd pillar will be supplementary mandatory individual pension accounts; and the 3rd pillar is voluntary private pension insurance. Although the introduction of the 2nd pillar has since been postponed, the voluntary private pension insurance 3rd pillar had been in place since 2004.

These reforms established the basis of a mixed public/private and pay-as-you-go/funded pension system in Ukraine.1 Subsequently, there have also been several parametric reforms, the most recent one in September 2011, which have shaped the system into its current form. Below, we describe the 1st pillar of the Ukrainian pension system that has been in place until the 2011 reforms, so as to provide the necessary context for the most recent reforms and further reforms necessary. Next, the 2011 pension reforms are described, so as to highlight some of the necessary reform measures that have been undertaken recently.

The 1st pillar of the Ukrainian pension system

The 1st pillar of the Ukrainian pension system is based on the pay-as-you-go principle in which both the employer and the employee make contributions over the employee’s whole active career. The Ministry of Labour and Social Policy is responsible for the general coordination of the pension policy. The regional and local social protection departments administer the various social security schemes. The Pension Fund of Ukraine (hereafter PFU) administers all mandatory public insurance services (including pensions).

The insured worker contributes from 2% to 5% of earnings, depending on whether the worker contributes towards a special treatment within the same pension scheme.2 The maximum monthly earnings used to calculate contributions are 13,660 Hryvnias (June 2010). The employer pays 33.2% up to the same maximum as used for the employee.3 The state bears the cost of social benefits as well as provides the subsidies needed from central and local

1 Earlier, in 2000, the new information system were also put in place to document personified records of insurance contribution payments for each worker, mainly for the purpose of the functioning of the 1st pillar based on insurance principles. 2 Those who contribute 5% are “special pensioners”, mainly civil servants, and they draw different benefits from the same Fund. 3 Employer pays an additional 1.6% for unemployment, 1.5% for sickness and between 0.2% and 15% for work injury (depending upon the sector) insurances.

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governments to the PFU. The state also contributes as employer for public sector employees.

Within the 1st pillar, there are also special provisions for civil servants, military personnel, legislators, judges, National Bank employees, diplomats, journalists, scientists, local governors, war veterans and victims of the Chernobyl disaster. These special treatments are partly financed from the additional contributions from the same workers, and partly from the state subsidy. Within the same 1st pillar, there are also privileges for persons in the private sector who work in hazardous conditions (the so-called Lgotni pensii – the privileged pensions), allowing early retirement by 5 or 10 years for those categorised as List I and List II workers. These are funded by the employer meeting the cost of the privilege: full cost for List II workers, and almost full cost (by now 90%) of List I workers.

The current 1st pillar of the pension system can be seen to consist of four categories of pension schemes: (1). Old-age pensions, (2). Disability pensions, (3). Survivor pensions, (4). Service pensions. Then, there are also social pensions. The salient features of these schemes are described below.

Old-age pensions

Until the latest 2011 parametric pension reforms (see below for more details), the full pension has been payable at age 60 with at least 25 years of coverage for men or at age 55 with at least 20 years of coverage for women. These requirements were reduced for those workers who worked in arduous or hazardous occupations; for mothers of five or more children; for mothers who have children with disabilities; for war veterans with disabilities; and for some other categories of persons. The employment period in question could include years spent in the armed services, caring for persons with disabilities or children younger than age 3, or being unemployed and seeking a job, if contributions are paid for these periods. Partial pension has been payable at age 60 for men and at age 55 for women with at least 5 years of coverage – the monthly pension payments are then reduced in proportion to the number of years of coverage.

The pension benefit is calculated as a product of three parameters:

I. The average last wage of all insured workers, estimated as the average wage of which insurance contributions were paid during a preceding calendar year; (nb. recent parametric reforms made changes by which average wage of three last years will be used in the pension formula; instead of the wage of a single year preceding retirement);

II. The individual coefficient of relative wage, estimated as an average of coefficients for each month of service (a ratio of a person’s wage, of which contributions were paid in a particular month, to all-Ukraine average wage for the same month); and

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III. The individual coefficient of service, estimated as a sum of months of service, multiplied by the accrual rate (1.35% for each year since October 2008) and divided by twelve. A full month of service is counted under condition that a sum of paid contributions is not smaller than a minimum insurance contribution (based on a minimum wage and on contribution rate). Otherwise, service period is counted proportionally to the paid part of a minimum contribution.

The service period relevant for the calculation of pension income is established as 60 months before July 1, 2000, and all covered periods since July 1, 2000. Importantly, the inclusion of all period since July 2000 has made the pension income a function of the average lifetime salary, albeit gradually, for younger cohorts of workers.

Other important parameters are defined as:

Every year, beginning from March 2005, the pension income is expected to be raised by the index equal at least to 20% of the average annual wage growth. In practice, the ad hoc decisions had taken precedence over this rule.

Since 2008, the last year average wage, which is an important parameter in the pension formula, is the average salary per insured worker in Ukraine during 2006.

The accrual rate is 1.35% since October 2008 (it was 1% before January 2008). This change in 2008 made it possible to move away from a flat rate pension income (that existed earlier when pensions for most retirees were fixed at the subsistence level) and ensured a better link of pension income to contributions.

Until the latest reforms, in 2011, there has been no maximum limit for the pension income. The minimum pension is the minimum subsistence level defined for those unable to work i.e. pensioners.4 The pension is paid earlier to unemployed older workers from ages 58 and 6 months to 60 for men or ages 53 and 6 months to 55 for women, who meet the coverage requirements and who were working for an enterprise that was closed or reorganized. Such a pension stops if the beneficiary is reemployed.

The pension may also be deferred from 1 to 10 years after the normal retirement age, and the pension is increased by 3% to 85%, according to the number of months/years the pension is deferred after normal retirement age. For instance, pension benefit is raised by 3 percent for 1 additional year of work and by 85 percent higher for 10 additional years.5

4 The monthly minimum subsistence level is 784 Hryvnias, (October 2011); whereas the monthly minimum wage is 985 Hryvnias (October 2011). 5 The specified rates of pension income increase were changed in the 2011 reforms. Specifically, the Law now provides for 0.5% increase for each full month of later retirement for up to 60 months. If the

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The pension is payable abroad for 6 months in advance, beginning in the month the pensioner leaves the country; thereafter, only if there is a reciprocal agreement (there are currently 21 bilateral and multilateral agreements).

The old-age pension scheme is by far the most important since it benefits about 80% of all current pensioners in Ukraine.

Disability pensions

The disability pension is paid to three groups of persons with disabilities: Group I receives 100% of the old-age pension; Group II (90%) and Group III (50%). Whilst the disability pension is based on the old age pension, the criteria for getting the disability pension are based on age at which disability began and years of contributory service. Provided anyone satisfies the requirements, a reduced payment is payable if the insured has at least 2 to 5 years of coverage, depending on the age when the disability began (see below for the change of contributory requirements brought about in the 2011 pension reforms). The disability pension is payable abroad, something which may be considered highly problematic by experts (since social assistance and disability benefits are frequently awarded to residents only in the majority of European countries). A caregiver’s allowance is also paid to a caregiver of a person older than age 80 in Group I, provided the caregiver is not employed.

Survivor's pensions

The first step in determining a survivor’s pension is whether or not the survivor is disabled – if not then the survivor’s pension is not paid. If the person is not disabled and then subsequently becomes unemployed he/she would then gets the survivor’s pension. Eligible recipients of survivor’s pension can be a spouse, father, and mother of pensionable age. The surviving children younger than age 18 (age 23 if a student or an orphan, no limit if disabled before age 18) are also eligible.

The monthly survivor's pension is 50% of the deceased’s old-age pension for one survivor and 100% for two or more survivors. A supplement is paid if the survivor pension is less than 100% (for one survivor), 120% (for two survivors), or 150% (for three survivors) of the minimum subsistence level. Partial pension is paid if the insured had 5 to 24 years (men) or 5 to 19 years (women) of coverage.

Privileged pensions

These pensions are known as Lgotni pensii (the privileged pensions) and they are a special type of old-age pensions for workers in particular occupations (such as aviators, truck drivers, lumbermen, etc., but also teachers, medical

deferral is more than 60 months, the pension is increased by 0.75% for each full month of the deferral. Prior to the 2011 reforms, the amount of pension income increase was based on the number of years of the deferral, not the number of months.

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doctors, railway workers and pilots). These workers can retire at a younger age or with shorter duration of the contribution period. There are two types of early pensions: anticipated old-age pension and length-of-service pension. These pensions are assigned to people who have certain service length, particularly, in difficult or hazardous job conditions (according to the list of professions). Duration of service that gives the right to early retirement varies from 8 (for women)/12 (for men) to 20/25 years; bridge period (number of years before you can retire) varies from 5 to 15 years, depends on occupation or professional category, for those categorised as List I and List II workers. These are funded by the employers: full cost for List II, and almost full cost of List I.

Social pensions

Social pensions are under the Law “On Pensions”, not under the Mandatory Pension Insurance. A means-tested social old-age pension is paid to low-income citizens who are not working and not eligible for an old-age pension, starting at age 63 (men) or age 58 (women),6 at the level of the monthly minimum subsistence level. These social benefits are adjusted periodically according to changes in the national average wage and inflation. As in the case of other benefits, a supplement is added if the social pension is less than minimum subsistence.

The Pension reforms in 2011 put pension system on a sustainable path

On July 8th, 2011, the Verkhovna Rada adopted the Law "On Measures for Legislative Provision of the Pension System Reformation", which brought about the latest parametric pension reforms in Ukraine. These reforms are summarised as:

The Law raises the pension qualification age for women to 60 years (gradually, by six months each year).7

The service period required for full pension is raised to 30 years for women and to 35 years for men.

The minimum contributory service period to receive any pension has been raised from 5 to 15 years.

The statutory retirement age for male civil servants is raised to 62 years. The maximum monthly wage for contribution purposes is capped at 17

times the minimum subsistence level (in December 2011, UAH 17,068).

6 The principle applied is that such social benefits are made available 3 years after the statutory retirement age. 7 A three year transition period is set for women to opt for an old-age pension either under the old or new pension legislation, which, if the deferred retirement is chosen, provides for a bigger pension. Specifically, if the person defers her retirement the pension's increase will be 6 per cent for each of the first five years, and 9 per cent beginning from the sixth year.

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The maximum pension amount, adopted by the law, is now fixed at 10 times the minimum subsistence level (in December, UAH 8,000).

Pensions for civil servants will now be calculated to the amount of 80% of the salary instead of the present 90%. The pension for public employees will be calculated based on a salary of up to UAH 14,400. Also, the maximum pension will be limited to ten minimum incomes.

Changes for military personnel are also implemented making it necessary for them to contribute for a longer period of their working lives: the law gradually raises the length of service to 25 years for military personnel; moreover, each six months of studies in military high schools will qualify as one year of military service.

Parliamentary deputies will no longer enjoy higher pension benefits compared to other citizens. However, they will have the right to retire one and a half years before reaching the retirement age.

This pension reform has already come into force during 2011 (on October 1st, 2011), and will contribute to improving the financial sustainability of the 1st pillar pension and they will also be making the system more fair, with improved incentives to work and contribute in the formal sector. These reforms can be seen as a strong signal from the current government to bring about appropriate policy reforms in putting the pension system on a sustainable path.8

8 The reforms are even more remarkable given the fact that Article 22 of the Constitution bans any contraction of existing rights and freedoms by adopting new laws. In Ukraine, social sector reforms of these types require substantial legislative amendments, but nonetheless they can nonetheless be questioned in courts.

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Quotes from the Ukrainian President, Viktor Yanukovych

During his interview with the journalists in Warsaw, on September 30, 2011, the Ukrainian President Viktor Yanukovych, said: “First of all the pension reform should make all the pensions fair. It has been a request of the retirees and this problem needs to be solved”. He emphasized that increasing pensions still remains a priority for his government: “It is still a crucial problem that needs to be solved”.

He also underlined the fact that the deficit of the Pension Fund cannot forever be financed at the expense of the state budget: “The share of the budget for financing the Pension Fund should be limited. That is why we decided to increase the Pension Fund’s own revenues and implement a three-level pension system”.

He also stressed that such way of reforming the pension system had been chosen and successfully utilized by many developed countries: “Our objective today is to build such [a] system. And the sooner we do it, the faster we will reach our goal which is to improve the social welfare of elderly people”.

1. Identifying challenges and future pension policy goals ___________________________________________________________

This section highlights challenges that the current Ukrainian pension system

faces (with a focus on the 1st pillar) and, more significantly, outlines the policy

goals for future reforms. The priority for pension reforms, such as placing the

public pension system on a sustainable path, can be highlighted by the

statements of many high level policymakers in the current Ukrainian

government (see, for example, quotes from the Ukrainian President to

highlight the policy goals towards pension reforms and improve the social

welfare of older people). Note also that pension reform in Ukraine was one of

the main conditions for the disbursement by the International Monetary Fund

loans to the country (under the Stand-By Arrangement). Also, pension policy

reforms in Ukraine are now seen as a driving force for other social and

economic reforms, such as labour market policies towards reducing the

relative size of the shadow economy.

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The extraordinarily large public pension expenditures (16.2% of GDP in 2011) are among the most serious issues facing Ukraine today. A good management of the 1st pillar is not only a requirement for establishing a fiscally stable pension system in Ukraine but also a prerequisite for fulfilling Ukraine's economic development agenda. The high public pension expenditures have created a systemic risk to macroeconomic stability and threaten to slow down the economic reforms. Thus, strategic pension and labour market reforms are required, and some of them have already come about during 2011.

The most important and overarching policy goal for Ukraine should be that pension expenditures are brought under control and also revenues raised through increasing the retirement age for women (already happened in the 2011 reforms) and through labour market measures promoting the formalisation of employment.

1.1 Financial sustainability of the 1st pillar is a major policy priority

Since independence, Ukraine has undertaken very minimal reforms of the social sector. The current most serious concern is the extraordinarily large public pension expenditures (approximating to 16% of GDP, in 2010), which is almost twice as large as the average public pension expenditures in EU countries. Moreover, much of these funds are spent on relatively young and healthy people, who would not be entitled to pensions in other European countries. The PFU deficit (covered by the state budget) is forecasted to be 2.2% for 2012, having fallen significantly from 17.6% in 2011 and 26.6% in 2010.

It is the profound combination of parametric and systemic reforms of pensions that will the key to control pension expenditures over the long term. Raising taxes, or social insurance contributions, are other ways to deal with the deficit, however these are not viable options for Ukraine for reasons of keeping labour costs under control and promoting employment growth and such single measures in themselves cannot solve the financial sustainability of pension

system9.

9 See Independent International Expert Commission (2010). ‘Proposals for Ukraine: 2010 – Time for Reforms’ International Centre for Policy Studies, Kiev.

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1.2 Early retirement and low contribution period has been a common feature

Until now, the statutory retirement age in Ukraine has been 60 for men and 55 for women – lower than in almost all other European countries (see Table 1). The effective age of retirement is even lower for those workers who have provisions for privileged early retirement or they become entitled to disability pensions before the pensionable age.10

Many other European countries have also been facing the challenge of early retirement and have brought in pension and labour market policy changes to deal with the challenge (see below for a discussion on international experiences of reforms).

In Ukraine, the early retirement phenomenon is particularly notable for women, whose residual life expectancy at the time of retirement is 23.4 years, which is comparable to many other European countries of the world (for example, it is about 24 years in the UK, 25 years in Germany and Austria, 23 years in Poland, and 21 years in Slovakia at age 6011).12

The implication is that women in Ukraine work for a shorter period than women in many other countries and receive pension for a longer period. Thus, the equalisation of women’s retirement age with men to 60 in the 2011 pension reforms is the most appropriate policy measure.

The retirement age for both sexes should ultimately rise to a higher age in the future (age 65), after it has been equalised for men and women, and in the future it should be linked to developments in life expectancy.

10 Note that the number of workers eligible for privileged pensions has been dropping and also their impact on Pension Fund expenditure in Ukraine is not that high as the employer has to pay for these privileged pensions. 11 With the exception of Germany and Slovakia, age 60 can be taken as a proxy for the current statutory retirement age for women in these countries. 12 See Expert Note (2011), ‘Problems of Rising Retirement Age in Ukraine’, The Blue Ribbon Analytical and Advisory Centre, UNDP, Kiev.

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Table 1: Demographic indicators related to old-age pension schemes,

2010

Notes: In Poland the retirement mentioned is not a "statutory" age but the minimum one at which pension income can be claimed. In Sweden, full pension is obtained at 67, but part pension can be obtained from 61.

Men Women Men Women Men Women

Austria 17.6 78.2 83.2 21 25 65 60

Belgium 17.4 77.7 83.9 20 25 65 65

Bulgaria 17.6 70.9 77.7 16 20 63 60

Croatia 17.3 73.8 80.4 18 22 65 60

Cyprus 13.2 77.9 82.6 21 24 65 65

Czech Republic 15.3 74.3 80.3 18 22 62.2 60.7

Denmark 16.7 76.7 81.4 20 23 65 65

Estonia 17.1 68.9 79.3 16 22 63 61

Finland 17.2 77.2 83.6 20 25 65 65

France 17 78.6 85.1 22 27 60 60

Germany 20.5 77.8 83.1 20 25 65 65

Greece 18.3 77.7 82.5 21 23 65 60

Hungary 16.4 70.4 78.3 16 21 62 62

Ireland 11.4 78.1 82.9 20 24 65 65

Italy 20.4 78.6 84.6 22 26 65 60

Latvia 17.4 68.7 78.1 16 21 62 62

Lithuania 16.4 67 78.3 16 21 62.5 60

Luxembourg 14 77.8 82.8 20 24 65 65

Netherlands 15.4 78.5 82.6 21 24 65 65

Poland 13.5 72.3 80.4 17 23 65 60

Portugal 17.8 76.1 82.6 20 24 65 65

Russia 12.9 61.9 74.1 14 19 60 55

Slovak Republic 12.3 71.8 79.3 17 21 62 62

Slovenia 16.4 75.4 82.6 19 24 63 61

Spain 17.2 78.6 84.7 21 26 65 65

Sweden 18.3 79.6 83.6 21 25 67 67

Switzerland 17.3 80.2 84.7 22 26 65 64

Ukraine 15.6 63.9 74.3 14 19 60 55

United Kingdom 16.6 77.8 82.3 20 24 65 60

SOURCES: United Nations Population Division, DESA . World Population Prospects: The 2008 Revision

http://esa.un.org/unpp; HDR 2009.

Life expectancy at

birth

Statutory

pensionable ageCountry

Percentage

65 or older

Life expectancy at

age 60

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The situation for men is somewhat different because of their low life

expectancy; both at birth and at the time of retirement (see Table 1). The

relevant measure of life expectancy (for pensions) is indeed the life expectancy

at the age of retirement, which is also low: only 14 years, considerably lower

than that observed in the UK, Germany and Italy (18 years at age 65) and Czech

Republic and Slovakia (17.4 and 15.9, respectively, at age 62 in 2010), but

closer to Poland (15.1 at age 65).13

Moreover, the survival rate of Ukrainian men to the age of 65 is currently 52.6 per cent, while the same indicator for the countries of Western Europe is 84.9 per cent.14 Given this evidence, the retirement age for Ukrainian men should only rise if there are clear improvements in their life expectancy at 60. It can also be said that there should not be an increase in male retirement age until both men and women are equalized at age 60 which is still 10 years away.

The contribution period requirement for full pension (25 for men and 20 for women) had also been short in Ukraine until now – it should have been closer to the full period of working life or a close proxy for it. The 2011 reforms in increasing the contribution period (to 35 years for men, 30 years for women) is the most appropriate reform. The contributory requirements for women should rise further to 35 years, albeit gradually.

Many countries have recently extended the period over which lifetime earnings are taken into account instead of just basing the benefit on a limited number of final years or salaries of best years. For example, Finland, Poland, Portugal, the Slovak Republic and Sweden have all been moving to a lifetime average earnings measure. In fact, as a result of recent reforms, most OECD countries (17 out of the 22 with the relevant kinds of scheme) will use a lifetime earnings measure or a close proxy for it.

13 Data extracted from the Eurostat database, for the variable ‘Life expectancy by age and sex [demo_mlexpec] ‘. 14 UN (2010) ‘World Population Ageing 2009. Profiles of Ageing’. United Nations, New York.

The 2011 reforms in raising the retirement age for women (to 60) and also in increasing the contribution period (to 35 years for men, 30 years for women) is a good policy move and the current Government should be given credit for this parametric reform. It can be recommended that the contributory requirements for women should also rise to 35 years, gradually over the next 10 years. Also, subsequently, the future policy goal should be that changes in the statutory retirement age and contributory requirements for the full pension be linked to developments in the life expectancy.

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Increasing the pension system coverage by reducing the relative size

of the shadow economy is undoubtedly a major policy goal in

economic policy reforms in Ukraine. Useful lessons can be learned

from an in-depth study of similar issues in other Central and Eastern

European countries.

1.3 Formal registration of employment is low, and reporting of wages inaccurate

It is the formally registered employment that is relevant for pension fund purposes, as the contributions made then go towards financing the pension system. In most European countries, employment is almost synonymous to pension coverage. But, this is not the case in Ukraine, where those covered are only around 70% of total number of employees15 (some of the estimates of informal economy are close to 50%). Specific sectors, such as agricultural workers catering, and also urban self-employed, have a much lower coverage. Where there is coverage, it is often the case that employers only report a payment of the minimum wage.

In many other Central and Eastern European countries, the problem at the moment is less to do with the coverage, but that the majority of the self-employed pay contributions at the level of the minimum wage. This practice puts them at a high risk of receiving low pensions when they retire and hence they rely more often on social assistance benefits, which add a further financial burden on social benefit expenditures. Thus, strong measures are required in Ukraine to force employers in reporting employment and truthful wages.

In many cases, the defrauding of the system is done by employers in collusion with employees, but employees do not have many rights in the current labour market environment. The public policy reforms in Ukraine had already been brought about to encourage formal employment, e.g. pension system now requires 35 years of contributions to get the minimum pension, and there has also been an introduction of flat-tax. The removal of privileged schemes, and thus reducing employers’ burden of financing these schemes, should provide further incentives to employers to report employment and wages truthfully and reduce the size of the informal economy.

15 See UNDP (2008) ‘Pension Reform: A challenge for Ukraine’, The Blue Ribbon Analytical and Advisory Centre, Kiev.

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Strengthening of the contributory principles in the 1st pillar is another key policy goal, and such corrections are extremely important policy goals in making the public pension system sustainable over the long term. For this purpose, the actuarial basis of the 1st pillar pension scheme must improve.

It can be recommended to identify and separate out contribution-based pensions from social non-contributory pensions, the latter to be financed out of State subsidies. This is particularly important in order to promote incentives for work and savings (contributions) in various earnings-related pension schemes (1st and 3rd pillar at the moment).

1.4 Discretionary increases in minimum pensions compromise

contributory principles

Discretionary increases in minimum pensions have been common in Ukraine, and this has generated an additional burden on the PFU. For example, only months before the Presidential elections of early 2010, the Ukrainian parliament raised minimum wages and pensions by 20%, a policy move inconsistent with the overall fiscal austerity goals of the country to reduce public expenditures16 (particularly the deficit of the PFU).

Between 2002 and 2010, the minimum pensions increased by nine times in real terms, while average wage, which is a base for pension contributions, increased by only 3.4 times in real terms.17

As a result of these discretionary changes, pensions of many pensioners became lower than minimum pensions. So, many pensioners now receive pensions at the minimum level, undermining contributory links established in the social insurance based pension system that started in 2004. In fact, the 1st pillar pension has become largely a flat-rate pension, which is typically a pension of uniform amount independent of earnings. Such flat rate pensions are a feature of systems in the Netherlands, Ireland and the United Kingdom by design.

16 In 2008, the IMF extended a $16.4bn credit to Ukraine, but payments were frozen when the law raising minimum wages and pensions was passed. 17 See Betliy et al (2011).

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Comments from Balázs Horváth (Poverty Reduction Practice Leader with the UNDP Bratislava Regional Centre) emphasise this issue in the following way:

‘The above two recommendations are critical for a sound pension system. Linking pensions to contributions is a key prerequisite for changing incentives to encourage working in the formal sector; for discouraging early retirement; and for fairness in the pension system. There is also a need to enhance the non-contributory part, to strengthen social safety net, its separation from the PFU, because the measures to achieve this are very different from what is needed for the contributory 1st pillar component’.

Comments from Natalia Goryuk (Senior Pension Lawyer, USAID in Ukraine) also point to the importance of separation of non-contributory supplements from the contribution-based pension entitlements of the 1st pillar:

‘The Pension Fund of Ukraine is charged with financing supplements to pensions so that they would reach the subsistence level (minimal level). In Ukraine such supplementary payments are effected at the expense of insured persons’ contributions, but not at the expense of the State Budget, as it is done in Sweden. The PFU responsibility to finance supplementary payments to ensure that the amount of pensions is not lower than the minimum subsistence level income has increased the load on the PFU budget. This also contradicts the pension insurance principles, which require pension benefits to be based on insurance contributions. The inclusion of this issue in the Strategic Report would help the Ukrainian government decide what to do about the PFU deficit’.

1.5 Privileged pensions and their justifiability is a major issue

The financing of privileged pension provisions in Ukraine has been a burden on the PFU. A common opinion of experts is that these privileged pensions are a form of ‘structured corruption’ as none of these privileges in their current form can be fully justified. The labour market policy and collective agreements (between employees’ and employers’ unions) should be the instruments in dealing with any life expectancy differentials that arise because of arduous or hazardous work (but only to the extent that the life expectancy differentials can be proven by empirical scientific evidence).

In collective agreements, the optimal instrument for dealing with differences in working conditions and hazards is the adjustment in the wage level. This will lead to larger pensions through higher contributions paid within a sound pension system. Such a measure would be more suitable rather than distorting changes to pension rules that undermine the financial viability of the system and also create distortions in the labour market functioning for these sectors.

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The phasing out of pension privileges is indeed a daunting task. For the legislators, the issue is to overturn an experience that suggests that now the grant of a special pension allowance is seen as a right. The view of the (would-be) pensioner is that the preferential pension treatment has been an instrumental part of their choice of the profession in the first place. The task of persuading all sides to this argument of the need for reform is itself an arduous one!

We recommend that the Ukrainian government need to instigate a review process through a specially established expert commission. Moreover, a public information campaign is required, to be aimed at persuading the general public in the necessity of phasing out the privileges in the form of pensions. At the same time, there is a need to review employment categories in List I and List II that deserve to continue receiving privileged treatment for their pension entitlement. The question whether these schemes should continue to be financed by employers should also be looked at.

Employers in Ukraine contribute towards pensions for those professions that lead to shortening of life expectancy (with the exception of coal miners and those who were employed by bankrupt companies, whose pension subsidies for early retirement are still financed by the State budget subsidies to the PFU). The privileged pensions for coal miners had been a political decision, and the government need to acknowledge this as a separate cost to maintain coal industry (rather than mixing it with the state subsidy to the PFU).

Pensions for other professions, such as teachers, medical doctors, railway employees and airline pilots, are also still financed from the State subsidy. There are three other categories that benefit from legislated State subsidies in their pensions: Chernobyl accident victims; children of war (those who were under 18 on 2nd September 1945) and veterans of war. Given political sensitivity, the future of these categories has to be addressed with a particular caution.18

1.6 Introduction of the long-awaited 2nd pillar is the next important policy step

The 2nd pillar introduction is expected to bring positive benefits for younger employees to accumulate higher personal pensions than that possible just with the current 1st pillar pension scheme only. This is despite the fact that the introduction of the 2nd pillar, and the tax incentives implicit in it, benefit more

18 As part of annual budget laws, there is a possibility of a discretionary decision to not pay all of these privileges owing to the lack of sufficient budgetary funds. Thus, while these rights are set out in law, another law—the budget law—can be used to override them.

19

One of the major policy goals is to institute the 2nd pillar of Ukraine’s pension system, by 2013. A major requisite has been that the Pension Fund (the 1st pillar) is no longer running a deficit, which is now a major priority for the current Government.

"If last year the deficit of the Pension Fund amounted to 34.4 billion UAH (4,3 billion USD), this year we are planning to lower it down to 17.8 billion UAH (2,2 billion USD) and next year – to 2.2 billion UAH (0.3 billion USD). The Ministry has a goal to nullify this rate by 2013 in order to launch the second level of the pension reform",

The First Deputy Minister of the Social Policy of Ukraine, Vasyl Nadraga, on September 9, 2011.

often higher wage earners and would ultimately lead to furthering the pension income inequalities in the Ukrainian society.

The rate of return in the 2nd pillar schemes may surpass the rate of growth of the economy (inherently used in determining the benefit levels in the public PAYG schemes) – this can happen only if the pension funds are allowed to invest abroad and annual management costs of the funds are kept to the minimum. Thus, certain investment and management patterns and returns, and regulations, will be required to fully benefit from using this vehicle for private personal savings towards pensions. It can be said that the introduction of the 2nd pillar should be geared towards developing the public policy that lead to improving living standards of pensioners and not necessarily towards capital market development (as is often argued by experts in the context for the situation in other countries).

The benefits for the overall economy can nonetheless be noteworthy. The savings made can be considered forced savings,19 and it will provide funds for the growth of investments in the Ukrainian economy, thereby promoting growth of GDP. According to the calculations by the Ministry of Social Policy, the 2nd pillar pension funds are expected to have more than UAH 3.6 billion by 2013, which offers a large potential for domestic investment and should promote economic growth. If these funds are invested in government bonds, they will in effect finance the budget deficit, reducing the constraints on its possible size. Thus, these savings can either boost growth or just end up financing larger deficits, and the latter may or may not result in higher growth (depending on the composition and effectiveness of public spending).

19 If we assume pure additionality, i.e. if households are forced to save on one component, they may displace savings in other component, the net increment in overall savings will be negligible. This question requires further research within the context of Ukraine and other similar countries.

20

In drafting the law for the introduction of the 2nd pillar, it would be essential to establish guarantees to protect the contributions and the income generation process, as well as regulations of financial companies that will manage the funds.

It can be foreseen that the 2nd pillar funds are managed by the government in the first phase, but later on, based on the preferences of contributors, it could be managed by private pension funds, provided if they offer guarantees required and a reasonably low annual management cost. The question of guarantees in such 2nd pillar scheme has been a long and complicated one which many governments have so far rejected. Those very few countries that have got guarantees offer them at quite a high price.

The participation in the 2nd pillar pensions should be made compulsory only for young workers (for example, those who are age 30 or younger or those who enter employment for the first time). This will ensure provision of reasonably good average returns, despite variability of nominal returns over time. Over decades, it is indeed more likely that the average real returns will cumulatively be significant and positive. This cannot be said for a short period of, say, 5-10 years (which older workers would have before retirement) as the investment returns of past 5 years show.

1.7 PFU administration must show no negligence or misallocation to

win trust

Limited ‘formal’ employment and reporting of receipt of minimum wages by the majority lead generally to reduced levels of pension contributions, and these could be a sign of lack of trust in government and its institutions. Such mistrust is also triggered by inefficient, unreliable or non-transparent administrative routines, by low returns on pension contributions, or both, and it encourages employees into informal employment.

However, in Ukraine, it would be wrong to conclude that the informal economy stems from the PFU administration and an inefficient pension design. Incentives are stacked against formal jobs for a number of additional reasons, and one of the main reasons for the low level of accurate reporting of employment and wages by employers is the high rate of employers’ social insurance contributions. Most employers have to pay on average 40% as employers’ social insurance contributions, especially in risky occupations to fund for early retirement. The rise of informal economy has been a serious issue in many other Central and Eastern European countries, in particular in

21

The most important elements of improvements in the administrative structure in the context of Ukraine include the collection of contributions and the handling of the money with transparency (showing no negligence or misallocation). Thus, the PFU must have a goal of generating public trust for its operations, including through ensuring the transparency in the allocation of its resources and also through increasing the professionalism of its staff, particularly at the regional and local levels. Improvements in the PFU administration can also be expected by a unification of various different funds.

the CIS countries, and Ukraine can draw useful lessons from the policy experiences of other similar European countries.

2. Review of international experiences of pension policy reforms

___________________________________________________________

Having identified the policy goals in the previous section, the analyses included in this section will lead us to specific recommendations for policy reforms in Ukraine, drawn in the light of international experiences of pension policy reforms in the recent times (the shaded boxes are used to spell out the specific policy recommendations for Ukraine).

2.1 Development of benefit ratios and net replacement rates in EU countries

Evolution of the benefit ratio over time summarises the likely development of two measures: the relative value of the average pension (total public pension spending divided by number of pensioners) and the average wage (approximated by the GDP per hours worked). Ceteris paribus, a decline in the benefit ratio over time points to a fall in the generosity of public pensions (relative to contemporary wages). Such falls in the benefit ratio may also occur because the pension system has moved partly towards private pension schemes, reducing the expenditures (and also the revenues) of public pension schemes.

The results presented in Figure 1 are for EU countries, derived from the recently completed assessment of ageing related public expenditures by the

22

European Commission.20 They show that the projected benefit ratio will be declining in the majority of EU countries, over the next 50 years, though at a varying level. The decline in the benefit ratio is the highest for Poland (– 54%) and Sweden (–39%), where a stronger link between contributions and pension entitlements have come about because of their recent pension reforms.

Figure 1: Changes in the benefit ratio % (average public pensions relative

to average economy-wide wage) across 27 EU countries, for the period

2007-2060

There are also considerable declines in Austria (– 30%), Slovakia (– 27%) and France (– 25%). In Slovakia, this decline in public pension generosity will be offset by other mandatory private pension schemes, but there are no such private pension compensations possible in Austria. The magnitude of decline in the benefit ratio is also quite sound for Estonia and Latvia. In both these countries, the expected decline will be partially offset by the new private pensions, although an overall decline of about 18% is still expected in Estonia. In Greece, the benefit ratio remains among the highest in 2060, despite the fall observed during the period 2006-2060 – the graph produced during 2009 long before the strong cuts in pension benefits observed in Greece due to financial crisis.

Another pertinent indicator is the change that can be expected in the average first pension of future retirees as a proportion of the average wage as a consequence of pension reforms. The indicator in use here is the net

20 Economic Policy Committee, (2009a), The 2009 Ageing Report: Economic and Budgetary Projections for the EU-27 Member States (2008-2060), Joint Report prepared by the European Commission (DG ECFIN) and the Economic Policy Committee (AWG), European Economy 2|2009.

23

‘Theoretical Replacement Rate’ (TRR), and it is the change in the TRR that is adopted by EU member States to reflect the impact of pension reforms in the respective countries.21 The calculations for the TRR reported here cover pension entitlements from public pensions and mandatory private schemes as well as other private schemes with a significant role in the pension incomes of future retirees (such as occupational pension schemes in the Netherlands).

Figure 2: Changes in the theoretical replacement rate (net), for the period

2006-2046, for a stylised full career male worker on average wages

retiring at 65

Source: Updates of Current and Prospective Theoretical Pension Replacement Rates 2006-2046 (Annex Country fiches), December 8th, 2009. Notes: In the base case scenario, the TRR is calculated for a male worker entering into the labour market in 2006, staying in employment for a full career (40 contribution years), earning average wage, retiring at 65 and accumulating pension rights under the reformed pension system. The first pension income entitlement for this hypothetical worker is divided by the projected average wage in the immediate previous time period to calculate the TRR. This prospective TRR is then compared with the base TRR for someone who would have accumulated pension rights under the current pension policies and have retired in 2006. The change therefore approximates how pension reforms will affect future pension entitlements.

Figure 2 displays the change in the TRR from the current situation to the

prospective situation in 2046. There are wide variations across EU states. The

TRR (net) is projected to decline in twelve countries, and the most notable fall

is observed for the Czech Republic (– 21% percentage points, p.p.), Portugal (–

20 p.p.), and Poland (– 19 p.p.). Closely behind them are Sweden (– 13 p.p.),

Spain and Latvia (– 12 p.p.) and Ireland and Finland (– 11 p.p.). This decline in

21 Social Protection Committee (2009).

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Lessons drawn from this international experience are that the public pension spending (liability) is on the decline in many countries, particularly in the Central and Eastern bloc of EU countries. This is partly due to restrictions in early retirement and phasing out of other pension privileges, but mainly because of a shift towards private pension schemes. For instance, of the eight countries where a strong decline in the benefit ratio is expected, four of them (Estonia, Latvia, Poland and Sweden) have introduced individual pension accounts as a substitute for part of their previous public pensions. Italy is the other country with a strong decline in the benefit ratio, and it has introduced the system of notional accounts (as in Latvia, Poland and Sweden).

Poland offers a good example of such reforms and provides a clear path for pension reforms in Ukraine (as was the case for Bulgaria in its 2002 reforms). The new Polish pension system consists of public-private partnership: public (following the design of NDC and FDC schemes) and private. The public schemes are strongly regulated and participation is standardised, while the private schemes are left for workers to decide. NDC and FDC have the same social goal, namely income allocation over the life-cycle. When viewed in terms of a multi-pillar system, the Polish system has the 1st pillar, using Notional Defined-Contribution type social insurance principles, which is supplemented by the 2nd pillar in the form of a mandatory private individual pension accounts.

These reforms also point to greater risks of poverty in old age, especially if private pension schemes fail to deliver the returns (and protection) that will compensate for a smaller role of public pension incomes. Thus, it is recommended that the reformed system continue to provide a guaranteed minimum pension, to be paid if the total amount of pension from all different schemes (public and private) is less than the legal minimum old-age pension. Given the nature of reforms, and if the workers’ career is not extended, such guaranteed minimum pensions will be taken up by a large fraction of future retirees. However, If the current generation of workers will adjust their retirement behaviour to developments in longevity, they can be expected to receive higher pensions.

the TRR is a reflection of reforms that have taken place in these countries over

the recent past, which has lowered public pension benefits of future retirees.

For Poland, it is expected that some of the decline in the public pension income

will be compensated by an increase in private pension incomes.

An increase in the TRR is expected for eight EU states, and the most notable of them is Romania (+ 52 p.p.). Other significant increases are observed for Bulgaria (+ 15 p.p.), Cyprus (+ 14 p.p.) and Estonia (+ 12 p.p.). Notably, these are the countries where the base TRR (in 2006) was relatively low.

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2.2 The retirement age and bonus/malus incentives for working life extension

Majority of European countries have increased their statutory age for retirement, although in some of them (e.g. Portugal and Switzerland), only women’s pension age has risen. In the future, only two of the OECD member countries will have a pension age less than 65 for men. More importantly, there are seven countries that will have a pensionable age greater than 65. On December 22, 2011, Italy's parliament approved the new government's austerity and growth package (including pension reforms). In the growth package, an increase is announced in the retirement age, starting in 2012, from age 65 to 66 years for men and from age 60 to 62 for women and then gradually to age 66 in 2018. The retirement age in Italy will increase to 67 for all workers in 2022—4 years earlier than scheduled, and 2 years more, compared with the Law passed previously. In Poland, the current plan (as announced by the Prime Minister) is to increase retirement age for men and women to 67 - the increase from the current retirement age of 65 for men and 60 for women would come about incrementally, by three months each year. At this rate, men would retire at 67 in 2020 and women in 2040.

Many of these countries have also introduced measures to encourage extending working lives, by tightening the qualifying conditions for early retirement, by increasing the service period required and/or the minimum eligibility age (Austria, Belgium, Denmark, France, Greece, Hungary and Italy). For example, the Netherlands introduced changes by removing tax incentives for occupational early retirement schemes. Austria, Finland, France, Germany, Italy, Portugal and the Czech Republic increased (or introduced) the penalty in benefits (the malus) for early retirement, while bonus for late retirement were also introduced or enhanced in some countries (e.g. in Belgium, Finland, France, Spain, the Czech Republic, and the United Kingdom).22 In Belgium and Finland, there is even a bonus to people who work between 62 and 65 (in the form of a higher accrual rate).

The average penalty across OECD countries is 4.4% for each year of early retirement. The largest penalty (malus) for a European country is for Finland (in their Defined Benefit type scheme, 7%). However, larger adjustments can happen in the Czech Republic (close to 9%; for people who retire at the earliest possible ages) and in Spain (7.5%; for people with a smaller number of contribution years). In some cases – Belgium, France, Germany, Greece and Luxembourg – there is pension benefit penalty provided a certain number of years of contributions were paid.23

22 References: OECD (2009; 2011), Zaidi and Grech (2007); Martin and Whitehouse (2008); Whitehouse (2009a). Note here that NDC and FDC do not require any discretional adjustment as they automatically adjust the account value with the life expectancy at the time of retirement. 23 OECD (2011, pp. 112).

26

Majority of European countries now have age 65 as the statutory retirement age, equalised for men and women (prospectively in some countries). There are also countries that have introduced automatic linkage of future changes in pensionable age to life expectancy developments.

The 2011 reforms in Ukraine had already made a move towards equalisation of men and women’s retirement age. The automatic link to life expectancy improvements is the next reform Ukraine should consider. Also, in view of the international experience, the bonus/malus adjustments in pension benefits should at least be around 5 to 7% for each year for a deferral in retirement and for an early retirement, respectively.

The pension benefit bonus on offer is on average 4.8% per year of deferral in OCED countries. The United Kingdom offers one of the highest: 10.4% (and a lump-sum amount including deferred pension plus interest can now also be claimed instead of an increment in the pension annuity). The rules differ regarding whether people can combine work and also receive pensions after the statutory retirement age and thus people’s financial incentives to remain in work is combination of these two sets of rules. 24

2.3 Up-rating of pension incomes by price inflation only

The indexation reform is principally a choice between a lower initial pension combined with earnings indexation and a higher starting benefit combined with price indexation. In addition to changes in the benefit ratio and the net theoretical replacement rates (as outlined above), the indexation procedures have also changed in many pension systems in European countries.

In the majority of cases, a move towards a less generous method (of price indexation only) is made so as to improve financial sustainability of the public pension systems. A good example of changes that have happened is Hungary: pensions were indexed to earnings’ growth until 1990s, moved to a 50:50 split of earnings and price indexation in the reform of the late 1990s, and most recently moved to price indexation only.

Some countries (e.g. Austria, Greece, Italy and Portugal) offer an interesting policy of progressive indexation, under which higher pensions rise more slowly than lower pensions.25 For example, in Italy, smaller pensions are price indexed while larger benefits are increased by only 75% of price inflation. A detailed analysis using OECD pension models reveals that the impact of the progressive indexation on the overall public expenditure savings from this policy is tiny in Italy and Portugal (Whitehouse 2009b), although there are

24 Ibid. 25 See Whitehouse (2009b).

27

The most common international experience is price indexation, and it is (in some countries) supplemented by wage growth elements only in times of prosperity. As had been argued by OECD pension experts (Whitehouse 2009b, pp. 35), the price indexation of pensions can be seen to be most appropriate in developed OECD countries, not just for distributional reasons but also for the fact that it offers greater flexibility for pensioners. This is what we also recommended for Ukraine’s for its next pension policy reforms. In all circumstances, it is advisable to avoid discretionary higher levels

of indexation, as it puts pressure on public spending and compromises

the contributory principles of the 1st pillar public PAYG scheme.

It should not be ruled out that an income growth higher than price

inflation is offered in times of prosperity (say, in the period where

annual economic growth has reached 8-10% or more).

obvious political attractions in such policies. The impacts in Austria and Greece are somewhat larger.

However, as has been the case in Ukraine, discretionary policies overruled the legislated rules of annual indexation in many countries (in the majority of cases to satisfy demands of older pensioners and reduce their risk of poverty, but also to win political favours in times of elections).

Such ad-hoc adjustments, although more common in the periods of economic expansion, create an unnecessary burden on public expenditures – an example is Hungary where such handouts have been common in the recent years (until the public finance crisis of 2010/2011).

Moreover, some countries have introduced conditional indexation on the basis of demographic developments (e.g. Germany, Portugal and Sweden, where pension benefit level and growth can be lower in the case of a continued life expectancy gains), or use above-inflation rises in pension payments only if economic growth is rapid (e.g. Hungary and Portugal).

Table 2 summarises the indexation rules situation across EU member States.

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Table 2: Pension Indexation in EU Member States26

Variable EU Member State

Wage growth Denmark, Slovenia, and Sweden. Prices and wages Bulgaria, Cyprus, Estonia, Finland,

Luxembourg, Malta, Poland, Romania, Slovakia, and the Czech Republic.

Prices only Austria, Belgium, Hungary, France, Italy, Latvia, Spain, and the United Kingdom.

Prices and GDP growth (partially)

Portugal.

Discretionary Austria, Greece, Ireland and Lithuania. Progressive Austria, Greece, Italy, and Portugal.

Notes: Belgium: prices+partial adjustment to living standards. Hungary: prices+partial adjustment to net earnings growth in case of high GDP growth.

Notably, the indexation of pension incomes with prices only leads to an erosion of the value of pension income relative to wages. This would make sense only if the consumption needs of elderly suppose to decline. But, with healthcare costs soaring and increasingly becoming the responsibility of individuals, rather than the state, this will be an issue. Since women live longer than men, the erosion of the value of pensions during old age affects women more than men.

Results for 15 EU countries, presented in Figure 3, show that the age group of 75+ is worse off compared to the younger group aged 65-74, for both men and women.27 In all EU15 bloc of countries (except for the Netherlands), the subgroup of females aged 75 or above shows the highest poverty rate of the four groups considered. At 63%, the poverty rate for females aged 75+ is particularly high in Ireland (in 2003).

In addition, Austria, Finland, Greece, Portugal, and the UK show poverty rates of at least 30% for females aged 75+. Next to the Netherlands, Germany and Luxembourg show the lowest at-risk-of poverty rates in this group. For males aged 75+, poverty rates of 30% or more are only found in Greece, Ireland and Portugal, of which only Greece and Portugal also have high poverty rates for females aged 65-74 and only Greece has a poverty rate of 30% for males aged 65-74.

26 2009 Ageing Report, and Joint Report on Social Protection and Social Inclusion 2009. 27 Zaidi (2006).

29

Figure 3:

Proportion of elderly population at risk of poverty, using 60% of median income as the poverty line, by gender and age (in 15 European Union countries), during 2003

One significant policy development is that many countries have recently embarked on a further strengthening of their targeted minimum pension, state non-contributory pensions and social assistance benefits – this has a positive impact on the reduction of poverty amongst the elderly. The most notable result is observed for Ireland: it went through a drastic decline in the poverty risk for the elderly over the five years period 2004-2008. This trend is a direct

30

result of the fact that all forms of state pensions increased substantially over this period, in excess of growth in gross earnings. In particular, non-contributory and widowers’ pensions increased considerably, reaching close to 32% of average earnings in 2007 and closing the gap between the contributory and non-contributory pension to only about 4.5%.

Portugal also observed a notable decline in the poverty risk for the older population during the period 2004-2008: from 29% to 22%. This is partly due to the fact that a means-tested solidarity supplement to pensions (Complemento Solidário para idosos) was introduced during 2006. Belgium experienced a decline late in the same period, and this can be attributed to the fact that the minimum income guarantee for retirees (GRAPA – Garantie de revenue aux personnes agées) increased in 2007. 28

2.4 Phasing out privileged pensions and strengthening contributory principles

The privileged pension treatment in Ukraine is generally granted for three types of workers:

1. those who work in hazardous or arduous jobs and thus (likely to) experience lower life expectancy than the rest of the population (such as those who work in underground mining);

2. those who cannot be expected to serve for very long in their occupations (such as teachers; pilots); and

3. those with ‘special’ services to the nation (such as the war veterans, judges and civil servants).

These privileges result in such workers being made eligible for earlier (and/or more generous) access to pension benefits than otherwise available in that country’s general pension scheme. The pertinent questions are: how to define and justify objectively for the groups to enjoy privileged pension treatment, and how to fund these privileges and these issues have been addressed by many countries that currently have such schemes. Another pertinent question is to ask whether the pension system is the optimal policy instrument to deal with differences in occupations? Why is it not the wage, or mark-ups on wages, that can be used which would be a more direct approach and will leave the pension system undistorted.

Table 3 lists as many as 18 OECD member countries which have special pension schemes offering special privileged pensions.29 The most common form is that of a collective concession, where a whole sector (such as underground mine workers, sailors, airline workers and artists) had been granted a special treatment in the calculation of pensions and thus provisions towards earlier retirement.

28 Zaidi (2010). 29 Ibid, pp. 13

31

Table 3: Special privileged pension schemes across OECD countries

A number of broad conclusions emerge from experts’ opinions on this issue:

• These schemes are justified only for very narrowly defined subgroups of workers, who continue to face the risk of a premature mortality due to exposure to hazardous or arduous working conditions;

• In general, there is a weak case for maintaining such special pension schemes. The international experience is that the continuance of these schemes owes more to institutional resistance to change (and a strong lobby) rather than the usefulness of these schemes as a supplementary (and justifiable) public pension scheme.

• It can be argued that in cases where such work-related health risks are recognised, they can be better dealt with some well targeted conventional social policies, such as disability pensions or work-related sickness benefits (using a rigorous ability-to-work test), on case-by-case bases.

• If privileges of early retirement ought to be continued for some occupations or jobs, they should be financed based on contributions by

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Ukrainian government need to instigate a review process through a specially established expert commission, whose remit will be to look at each applicable special pension scheme on a case-by-case basis as well as examine their history and justifications. Such a review process should look into whether the current privileged schemes are indeed the best way to compensate for experiences in risk-bearing and arduous occupations or in rewarding special services. The conclusions should also be drawn about how such schemes are affecting the competitive functioning of certain sectors in the labour market. The review process should be inclusive in bringing together all social partners so as to seek a viable long-term solution.

It would be worth looking into what was proposed by the 2003 law that privileged pensions be transferred out of the 1st pillar into the 3rd pillar, with contributions paid by employers and employees. The real problem is that those employers in the sectors offering privileged pensions pay the contribution rate that is already very high – in some instances social insurance contribution rate is up around 60% for these employers. If an additional contribution burden is added to these employers, it will bankrupt many of these companies. The on-going reform process in France provides a good illustration of an attempted change and the difficulties encountered. A number of special public-sector schemes provided supplementary benefits to certain categories of workers recruited prior to 31st December 2008. As from 2009, the circumstances of such workers will be determined in negotiations by the social partners and on a case-by-case basis. For a detailed review of recent reform actions in other countries in phasing out the privileged pension, see OECD’s review ‘Should Pension Systems Recognise Hazardous and Arduous Work?’ (Zaidi and Whitehouse 2009).

employers and also employees. This is the direction many countries have moved (including Ukraine in making employers pay for early retirement in some of the sectors).

2.5 Pension contribution redistribution from employers to employees

The total contribution rate for old-age, disability and survivors’ pension in Ukraine is one of the highest among the European countries (as shown in Table 4). Most notably, for these schemes, the share of employers’ contribution is by far the largest in Ukraine than anywhere else (although in general higher employers’ contribution rates are the norms in the former socialist Central and Eastern European countries – see also Figure 4). The Netherlands offer the other polar position, where the pension contribution rate is much higher for the employees than for employers.

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Our recommendation is that the distribution between employees and employers in Ukraine should follow what is observed in Germany, i.e. a 50:50 division between employers and employees for pension contributions. Such a policy reform will have to be cost neutral to employers. Also, employers should be required to compensate employees with the equivalent amount to pay for higher employee contributions. The challenge will lie in the implementation of this policy reform. A collective agreement process (and/or a state legislation) may be required to ensure that the reform process of redistribution of pension contributions from employer to employees is implemented smoothly and is fair to both employers and employees.

Looking at the total contribution rate for all social security programmes (in Table 4), there are four countries in which the contribution rate is clearly higher than that observed for Ukraine (39.15%): they are the Czech Republic (45%), Hungary (44%), Austria (42.35%) and France (42.48%). The average contribution rate for all social security programmes in Ukraine (39.15%) is close to that observed for Germany (38.86%), but the distribution between employers and employees is drastically different (almost 50:50 for Germany, whereas in Ukraine 93% of all contributions come from the employer).

There are many strong arguments to prefer higher contributions from employees in comparison to contributions from employers. For example, a move towards higher employees’ contribution will make them appreciate better their pension rights that are accumulated by a ‘formal’ attachment with the labour market. Thus, it can be recommended that Ukraine should redistribute in favour of a higher contribution from employees, and follow what is observed in Germany, i.e. a 50:50 division between employers and employees for pension contributions.

Figure 4: Contribution rates for employers and employees for Old-age, disability, and survivors’ schemes, 2010

0

5

10

15

20

25

30

35

IE CY BG LU BE FR SK SE DE HR GR FI NO EE AT CH UK SI NL PL RU LT CZ ES IT LV HU UA PO

Employer

Employee

34

Table 4: Contribution rates for employers and employees for Old-age,

disability, and survivors schemes, and for all social security schemes,

2010 (in % of payroll)

Employee Employer Total Employee Employer Total

Austria 10.25 12.55 22.80 17.20 25.15 42.35

Belgium 7.50 8.86 16.36 13.07 24.77 37.84

Bulgaria 7.10 8.90 16.00 12.10 16.80 28.9 a

Croatia 20.00 0.00 20.00 20.00 16.70 36.7 a

Cyprus 6.80 6.80 13.60 6.80 6.80 13.6 a

Czech Republic 6.50 21.50 28.00 11.00 34 b 45 e

Estonia 2.00 20.00 22.00 2.60 33.30 35.9 a

Finland 4.50 17.10 21.60 7.10 20.38 27.48 a

France 6.65 c 9.9 c 16.55 c 9.80 32.68 b 42.48 b

Germany 9.95 9.95 19.90 19.25 19.61 38.86 a

Greece 6.67 13.33 20.00 11.55 22.10 33.65

Hungary 9.50 24.00 33.50 17.00 27.00 d 44.00 a,d

Ireland 4.00 8.50 12.50 4.00 8.50 12.5 e

Italy 9.19 23.81 33.00 9.19 30.17 39.36

Latvia 9.00 24.09 33.09 9.00 24.09 33.09 a

Lithuania 3.00 23.30 26.30 9.00 30.98 39.98

Luxembourg 8.00 8.00 16.00 12.35 11.40 23.75 a

Netherlands 19.00 5.70 24.70 22.5 d 17.50 40 a,h

Norway 7.80 14.10 21.90 7.80 14.10 21.9 a

Poland 11.26 14.26 25.52 22.71 17.61 40.32 a

Portugal 11.00 23.75 34.75 11.00 23.75 34.75

Russia 0.00 26.00 26.00 0.00 34.20 34.2 f

Slovak Republic 4.00 14.00 18.00 10.40 27.20 37.6 a

Slovenia 15.50 8.85 24.35 22.10 16.10 38.20 a

Spain 4.70 23.60 28.30 6.25 31.08 37.33 a

Sweden 7 c 11.91 18.91 7.00 23.43 l 30.43 a

Switzerland 11.90 11.90 23.80 13.05 13.15 b 26.20 b

Ukraine 2.00 32.20 34.20 2.85 36.30 39.15

United Kingdom 11.00 12.80 23.80 11.00 12.80 23.8 a

d. Plus flat-rate contributions for medical benefits.

e. Government pays for most of the cost of family allowance benefits.

CountryOld age, disability and survivors

programmesAll social security programmes

a. Government pays the total cost of family allowances

Notes: In many countries, the contributions are subject to a ceiling on some benefits.

b. Employers pay the total or most of the cost of work injury benefits.

c. Contributions finance old-age benefits only. Additional contributions are required for survivor

and disability benefits.

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2.6 Adjustment of pension contribution rates

In dealing with the challenges arising due to population ageing and the ensuing rising age-related public expenditures, policy makers must also make a choice between three options:

raising the pension contribution rate, provide incentives and the environment suitable to longer working

careers, or introduce cuts in retirement income generosity.

The second option will include the possibility of claiming pensions but also continuing to work, maybe part-time, and continue paying pension contribution. The third option would also include closing of alternative early retirement pathways.

Obviously, a combination of these three policy options could also be pursued, so as to meet the objectives of improving the long-term sustainability of pension systems and maintain the adequacy of pension incomes. The evidence presented above shows that many European countries have introduced reforms that have improved incentives for longer working lives and/or reduced public pension income generosity.

Figure 5 presents trends in the contribution rate for the old-age, disability and survivors programmes in European countries for the period 2002-2010. No change is observed during the whole decade of 2000s in eleven countries (out of 31 reported here): Austria, Belgium, France, Greece, Luxembourg, Malta, Norway, Portugal, Spain, Slovenia and Switzerland (bars shown in yellow). Such a trend is particularly notable for Belgium, France and Luxembourg, where the pension insurance rate is low relative to other countries. Another four countries show less than 1 p.p. change: Croatia, Finland, Germany and Italy. Cyprus and Lithuania and Slovakia observe a change by only 1 p.p.

Bulgaria stands out as the country where the largest fall in the contribution rate is observed: it had one of the highest rates during 2002 (31%), and a fall of 8 p.p. occurred during the 2002-2010 period. It is a special case, since a new system consisting of a social insurance first pillar plus a second pillar of individual accounts was implemented in January 2002 (coverage under the first pillar is universal, but the mandatory individual account system covers all employees born after December 31, 1959). For the individual account system, the insured person also has to bear 1% per year of accumulated funds as annual administrative fees. Such additional costs (mainly to the insured person) are also observed in other countries where the individual account system had been introduced (e.g. Slovakia and Poland).

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Recent trends observed in the European countries suggest that many countries have opted to limit any rise in the pension contribution rates. This policy choice has its merits, as it leads to a higher scope for the individual choice in determining the most appropriate level of pension insurance for individuals concerned. Moreover, pension contribution rate rises are also politically difficult to implement as they are termed equivalent to a rising taxes.

Given already high contribution rate, no further increases in pension contribution rate are recommended for Ukraine. When feasible given the deficit situation in the Pension Fund, Ukraine should consider reducing the pension contribution rates, so as to reduce labour costs, improve competitiveness and employment growth.

Figure 5: Changes in the pension contribution rates, between 2002 and 2010, in European countries

Notes: Includes Old-age, Disability, and Survivors; Sickness and Maternity; Work

Injury; Unemployment; and Family Allowances. In some countries, the rate may not

cover all of these programs. In some cases, only certain groups, such as wage

earners, are represented. The contribution rate in most instances is flat rate. In

other cases, it varies with the wage class. When the contribution rate varies, either

the average or the lowest rate in the range is used. They refer to the contribution

rate by employees; however, the self-employed may have to contribute at a higher

rate than employees, thereby making up for the employer’s share.

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2.7 Measures in de-shadowing informal labour market

It is estimated that the economic activity in the informal shadow economy approximates in excess of one-third of GDP in Ukraine, and the issue is particularly serious in some sectors, e.g. extractive industry; catering; real-estate and manufacturing.30 The experience of other countries with respect to the problem of shadow economy shows that the shadow economy in Ukraine as a share of GDP is one of the largest among transition economies.31

From the experience of other countries, Ehrke et al. (2011) point out that there are three factors responsible for a high informal labour market in Ukraine:

1. The social insurance contributions are high, and they outweigh the positive effect of the low 15% flat-rate personal income tax;

2. Non-professional functioning, including corruption, of social security administration in enforcing penalties for the ‘cheats’ prevents benefits from any recent labour market reforms to improve reporting of employment; and

3. Lack of trust and low provisions of public goods lead to low motivation to contribute to public sector initiatives.

It is beyond the scope of this study to address all these issues, so we point to the considerations under the 1st point only. High pension contributions by the employer are indeed one of the major elements in raising costs of labour in Ukraine. High labour costs encourage informal employment in which a large share of wages is paid in shadow. Even when employment is reported, contributions are paid for minimum wages for the majority of workers. These two aspects subsequently undermine revenues of the PFU.

Also, by linking pension levels to actual contributions paid, the incentive for formal work would be raised. In the context of a global shift (also seen in Ukraine) of “responsibility” for generating income in old age from the state to individuals, this can be a particularly powerful channel for lowering the relative share of the informal economy and for moving away from paying contributions at a reported income of minimum wage only.

However, the generous indexation of minimum pensions guarantee have reduced work incentives for employees, as most people expect to receive the guaranteed minimum pension after retirement (currently 65% of pensioners). The pension receipts have become a flat rate benefit, and thus there is no strong relationship between the levels of contribution and expected benefits. Also, employees do not benefit from demanding ‘official wages’ for their work, especially since the official wages are likely to be lower than those paid in the under-the-table transactions.

30 See Ehrke et al (2011). 31 See Schneider et al. (2009).

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A move towards reducing overall social security contributions, and also moving the contribution burden away from employer to employees, is recommended for Ukraine. It will achieve the desired objective of reducing labour costs and also improving incentives to employees to participate in the formal work.

We agree with experts’ opinion on this topic, viz. Ehrke et al. (2011), that ‘no quick victory over the shadow economy is possible. Policymakers can realistically expect only a gradual reduction of the problem. But, given the enormous dimension [and significance] of the problem, also gradual improvements count a lot.’

2.8 Coverage and treatment of self-employed (including agricultural

workers)

An efficient and effective social insurance servicing of self-employed and agricultural workers will include not just coverage by an appropriate pension scheme but also providing them with advice and activities in the prevention of occupational injuries and appropriate health care and rehabilitation services in case of sickness or disability. Broadly speaking, two kinds of social insurance services are required:

(1) Old-age Pension Insurance; and

(2) Accident, Health and Maternity Insurance.

These services should cover not just the principal person (e.g. the farmer, who is using his/her own land for the agricultural production), but also all co-workers (whether family members or others). Here, we address issues concerning old-age pension insurance only.

The basic requirement for the coverage is: reporting of an accurate income and wages generated from the activities, for all workers, irrespective of its level in a single period. A suitable incentive structure should be in place, so that the insurers could see the advantage in participating in the system. The penalty structure should enable the threat so as to minimize the cheating with the system.

Poland offers a good example in the social insurance treatment of agricultural workers.32 The Agricultural Social Insurance Fund (KRUS) is established as an institution to realize and implement all tasks connected with social insurance of agricultural farmers (such as contributions collection, allocation and payment of insurance benefits and their supplements). It is an independent, specialized organization which serves as a real manager of farmers' social insurance. The corresponding Law provides two forms of coverage: the covering by insurance takes place either on the strength of a law (obligatorily)

32 Information reported here is drawn from http://www.krus.gov.pl.

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or on demand (voluntarily). The obligation of payment of contributions must be fulfilled by the owner of the farm who conducts the agricultural activity on his own account.

The following persons are covered in the obligatorily scheme of farmers' social insurance:

The owner of the farm (the farmer), possessing above 1 hectare of arable land (or a special section of agricultural production, according to the interpretation of tax regulations);

The farmer's spouse who works continuously on the farm, or keeps the house which is directly connected with a farm;

A household member, who is at least 16 years old, remains a farmer in the common household or lives on the farm or in the neighbourhood, works constantly on the farm and is not employed by a farmer as a worker, and if those persons are not covered by other social insurance and do not have right to old-age pension or disability pension from the farmers' social insurance or other social insurance.

There are some exceptions to this rule for those who conduct agricultural activity or work on the farm and at the same time conduct non-agricultural economic activity. The pension income drawn from this insurance includes:

old-age pension (or disability pension in case of inability to work);

farmer training pension;

survivors' pension;

pensions from the farmers' social insurance for private farmers and

their families; and

some pension supplements (such as supplement for orphans in

survivor’s pension; and cash supplement for the soldiers from

supplementary military service who had been forced to work in coal-

mines, quarries and uranium ores-mines).

There is a separate fund within KRUS, the Pension Fund, which is created from pension insurance contributions and also financed by supplementary subsidies from the national budget. The Fund finances pension benefits, pension from other social insurance, paid together with benefits of pension insurance and supplements. The farmers own contribution cover about 10% of expenditures on benefits and the rest is covered by the national budget subsidies.

The United Kingdom has recently introduced, and then changed33, the way employers and employees arrange their pensions. In a bid to encourage better coverage, a new law introduces ‘auto-enrolment’, where employers have to sign their employees up to a pension, unless the employee opts out of it, rather than the other way around. Now, employees are entitled to an automatic

33 The new compulsory scheme, NEST, is due to start in 2012. The change made is the UK government has deferred enrolment in NEST for employers of under 50 employees only.

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Ukraine should initiate a special expert committee to understand and resolve the issues involved in registering and covering the self-employmed as well as rural agricultural workers in the public social insurance system. Important lessons can be drawn from other countries, in particular Poland and the UK.

Ukraine should consider adopting the automatic enrolment principle for pension schemes, in registering all self-employed and agricultural workers for a minimal level of employment, wages and contributions. The interaction between entitlement to minimum pensions and the social assistance should also be analysed.

pension scheme if they work for three months, and they earn £10,000 or more (per annum). The implication of a high threshold is that the casual workers will be excluded from the coverage.

3. Pension reform scenarios for Ukraine ___________________________________________________________

3.1. Short-term immediate measures, during the period 2012-2014

Setting up an independent expert commission to review special pension

schemes

An immediate action is required in devising the best possible way to phase out the pension privileges available to many workers within the 1st pillar. Our recommendation is that the Ukrainian Government should, without delay, instigate a review process through a specially established commission consisting of independent experts. The remit of such a commission will be to review each applicable privileged pension (eligible for List I and List II workers) on a case-by-case basis while keeping the systemic implications in mind, as well as examine their historical origin and possible justifications.

The Commission should look into whether the current privileged pensions are indeed the best way to compensate for experiences in risk-bearing and arduous occupations (or in rewarding special services). The Commission should involve social partners and come up with a viable long-term solution. The Commission should also contract a study for a detailed review of reforms of such type in other European countries, in particular in CIS and EU countries. It should provide a costing of how much privileged pensions cost in Ukraine. A template of such a study is provided by OECD’s 2009 study ‘Should Pension Systems Recognise Hazardous and Arduous Work?’

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Reducing pension contribution and changing its distribution while

maintaining wages

Currently Ukraine has one of the highest social insurance rates in the European countries. In the first instance, Ukraine should consider reducing the overall pension contribution burden, provided there is a fiscal space for it. Bulgaria offers an example where the largest fall in the contribution rate is observed in recent times: it had one of the highest rates during 2002 (31%), and a fall of 8 p.p. occurred during the 2002-2010 period.

The Ukrainian Government should also modify the distribution between employees and employers for their pension contribution. We recommend that Ukraine should adopt the model observed in Germany (and also in Switzerland, and (approximately) in Poland and the UK), i.e. a 50:50 division between employers and employees for pension contribution. Such reform should start immediately (in 2012/2013), albeit the change towards the ultimate 50:50 division will have to be implemented gradually, to be completed by 2020.

Most important element of this reform would be that the employers will be required to compensate employees with the equivalent amount to pay for higher employee contributions, so that the take-home wages could be maintained at their current levels. The reform will also be required to be cost neutral for employers. Experience of Kazakhstan for example was that employers in public sector passed on the wage increase but not in private sector.

Thus, the challenge lies in the implementation of this policy. A state legislation, along with a collective agreement between employers and trade unions, will be required to ensure that the reform process of redistribution of pension contributions from employer to employees is implemented efficiently and fairly. Also, the purpose of this reform is the signal to employees that the future pension entitlements are linked to one’s own lifetime contributions – if such a signal would be missing, the impact of changes in the contribution distribution between employees and employers would not have its desired effects.

Improving coverage and de-shadowing the labour market

A move towards reducing overall social security contributions, and also moving the contribution burden away from employer to employees, is the recommended path for the pension policy in Ukraine – it should start during 2012/2013. Such a policy change will achieve the desired objective of improving incentives to employees to participate in the formal work.

The model followed in Bulgaria, in improving the formal participation of workers across different sectors, is recommended. This involves defining minimum wages that are different for different sectors, and thus higher minimum wages are expected for workers of certain types (e.g. professionals). We understand that the implementation of such a policy has already started – the Government should aim to implement this over the short run. Such policy reforms can bring a gradual reduction of the problem (although the results

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obtained in Bulgaria had been impressive!), but given the enormous significance of the problem, this gradual improvement should be a satisfactory outcome over the short run. The Ukrainian government would want to watch out that this approach may open the door to all kinds of creative interpretations of “professions”. Also, it may not be sufficient to stop at inter-profession differentiation only, but also to look into the possibility of applying a regional differentiation.

Improving procedures of pension income up-rating

The inflation only up-rating of pensions is viewed by experts as the most appropriate form of adjustment of retirement incomes, particularly in view of the budgetary pressures of current times. This ‘price-indexation’ policy is also our recommendation for Ukraine, subject to a revision (say) after 2015.

In all circumstances, it is advisable to avoid discretionary higher levels of indexation, as it puts pressure on public spending and compromises the contributory principles of the 1st pillar public PAYG scheme. It should not be ruled out that an income growth higher than price inflation is offered in times of prosperity (say, in the period where annual economic growth has reached 8-10% or more).

Given the policy of higher-than-price growth of pension income in the past decade or so, the Ukrainian authorities should also consider the policy of no growth in pension incomes for a single year (if at all allowed by the law!). This policy option will undoubtedly hurt income adequacy of current pensioners, and should only be considered if it is absolutely essential in bringing down the deficit of the 1st pillar public PAYG scheme considerably (e.g. down to the levels that set up the conditions for the launch of the 2nd pillar).

It is also worth considering the policy of age-specific pension indexation, so that relatively young retirees will get lower pension increases than the most elderly pensioners. Such a policy instrument would help deal with the high risk of poverty among oldest old pensioners, especially women.

3.2 Medium to longer term measures – beyond 2014

Over the medium to long term, Ukraine should aim to strengthen its multi-pillar system, as was envisaged in the 2004 pension reforms. The launch of a mandatory 2nd pillar, along the lines of the 2nd pillar of the new pension system in Poland, would reinvigorate the pension system (as was already envisaged in the 2004 reforms in Ukraine).

The most important effect of these reforms is the diversification of mechanisms (and risks) of pension provision, between public and private schemes and between PAYG and funded pension schemes. Thus, the new Polish pension system (as well as selected features of the reformed Swedish, Latvian and Italian and Austrian and German pension systems), and the pension reforms processes that led to their current form, offer a good model for Ukraine.

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First pillar to become a defined contribution type PAYG scheme

In our recommendation, the 1st pillar of Ukrainian pension system should implement changes to adopt the social insurance principles of the Notional Defined Contribution (NDC) type PAYG schemes.34 Indeed, as argued in detail in Whitehouse (2010), changes in the conventional PAYG can achieve the desired objectives, but without necessarily adopting a notional accounts system. Four countries (Italy, Latvia, Poland and Sweden) have introduced NDC schemes in their 1st pillar, and they provide insights about what should be suitable parametric adjustments for the 1st pillar in Ukraine.35 The pension system design followed in Austria and Germany also offer useful insights on how to adjust the classical PAYG system so as to mimic the good principles of the NDC system.

Four desirable features of the NDC can be highlighted here:

1. The pension income entitlements are based on average ‘lifetime’ wages, rather than a subset of best or final years’ wages;

2. Benefits are adjusted for early or deferred retirement on the basis of actuarial fairness;

3. Benefits are adjusted as life expectancy increases, so as to reflect the longer duration for which benefits would be paid; and

4. The recognition of periods outside employment (such as unemployment, periods of maternity and parental leave) is achieved by crediting notional personal accounts with additional contributions paid from general public revenues on annual basis.

For Ukraine, the main reform element would be the factors determining the pension annuity calculations at the time of retirement. The pension formula currently in use in Ukraine has three parameters (as outlined in Section 1): (i) The average last wage of all insured workers; (ii). The individual coefficient of the relative wage, and (iii). The individual coefficient of service.

To mimic the social insurance principles of the NDC type scheme, an adjustment in the first parameter is required. The assessment period, used in the second and third parameter, has gradually been extended towards the whole working lifetime, (given the fact that the full service period since July 1, 2000 will be taken into the calculations for a new retiree).

Four parametric reforms are recommended here:

1. An adjustment is recommended in the parameter: the average last wage of all insured workers, which is applied to adjust the wage for pension calculation purposes (used specifically to in order to adjust the wage as of the date of pension awarding). Already, an appropriate change has happened by which average wage of three last years will be included in

34 See Góra and Palmer (2004) for a description of distinctions between NDC and FDC pension schemes. 35 See, for example, Palmer et al. (2009).

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the formula (instead of one last working year wage before retirement). However, in our view, this period will need to become even longer: the most preferred option would be to use the average wage for the whole assessment period. This adjustment is necessary, in our view, despite the fact the 2nd parameter of the pension formula, individual coefficient of relative wage (which is a ratio of a person’s wage, of which contributions were paid in a particular month, to all-Ukraine average wage for the same month), will start using the full working-life assessment period (currently only circa 199 months).

2. An additional issue is how pensions will be adjusted by improvements in life expectancy in the future. A first sustainability factor should be introduced by which retirement age and contributory period requirements will be adjusted as a result of rising life expectancy. Such adjustment in the pension system should not be subject to a political process; rather it should be an automatic trigger.

3. Also, a second sustainability factor should seek to further improve the economic sustainability of the system, by linking the pension annuity calculations income to the equalization of the present value of streams of all future contributions and pension income liabilities (so as to keep the sustainability gap to the zero). This sustainability factor would in addition account for changes in the dependency ratio and any other large exogenous shocks that affect the long-term viability of the pension system, even inefficiencies in the actual administration of the system.

4. Furthermore, the pension income adjustments for early and deferred retirement should be made in line with the actuarial fairness principles. Our recommendation is that the malus/bonus adjustments for early/deferred retirement should be should be significant, leading to actuarially fair adjustments.

We believe that these changes in the pension income formula would make the 1st pillar PAYG system in Ukraine get closer to the good contributory principles of a defined-contribution type system (and thus improve the financial sustainability and social fairness of the system).

Changes in the statutory retirement age

The 2011 reform in Ukraine that had brought about changes in the equalisation of men and women’s retirement age is the right policy move. In our view, no further changes in the retirement age should be necessary in the immediate future (until both men and women retirement age is equalised at 60). However, over the longer term, Ukraine should also introduce an automatic link to life expectancy in determining the statutory retirement age.

Launch of the 2nd pillar mandatory personal pension accounts

The 1st pillar must be supplemented by the 2nd pillar mandatory personal pension accounts in Ukraine (over the medium and long term), and this pillar

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was originally envisaged in the 2003/04 reforms. Our view is that the 2nd pillar should be offered in the form of a mandatory individual account pension scheme, which has inherent tax incentives for people to participate in a Financial Defined Contribution (hereafter FDC) type scheme.

One of the most important measures in this respect would be to keep the administrative costs and charges to the minimum and Poland and Slovak Republic offer useful examples in this respect (Palmer 2011 provides a detailed account of various options). Strict regulations will have to be put in place to ensure protection of workers’ contributions and the continuity in the income generation process. The 2nd pillar funds can be managed by the government in the 1st phase, but later on, based on the preferences of contributors, it could be managed by private pension funds, provided if they offer guarantees required and a reasonably low annual management cost. Lessons should be drawn from the administrative problems encountered by Poland in its introduction of the 2nd pillar in 1999.

The participation in this scheme should be made compulsory for young workers and for anyone to enter employment for the first time. The age threshold for a young worker could be set at 30 or 35 (following examples in other countries) or, preferably, base this choice on the empirical evidence that is more suitable in the context of Ukraine. Older age groups could be allowed to opt for either the old or the new system, and the entry could be restricted for only those very close to the retirement age. It might be that the mandatory savings of the 2nd pillar would displace savings made in the 3rd pillar.

Guaranteed minimum pensions should be maintained

The Ukrainian system must continue to provide as now a guaranteed minimum pension, as is the case in Poland and Sweden, to be paid if, at the time of statutory retirement age, the total amount of pension from all different schemes (public and private) is less than the legal minimum old-age pension.

At the moment, the PFU is responsible for financing supplements to reach the subsistence level. These supplementary payments are therefore effected at the expense of insured persons’ contributions, and not directly linked to state budget subsidies (as is the case in Sweden). This responsibility of the PFU has increased the load on the PFU budget and contradicts the contributory principles of the pension system. Thus, a separation of the guaranteed minimum pension scheme from the financing of the 1st and 2nd pillar will help improve the contributory principles, and the sustainability of the pension system in Ukraine.

3.3. Political feasibility of pension reform options

The central political task of the pension reform is to ensure sustainability of the corresponding policy process and its continuity beyond the length of the electoral cycle. The continuity and consistency of the pension system are among the major challenges of the reform and, at the same time, present major

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opportunities. Two most important contingencies can be identified for Ukraine at this juncture: the ending of the electoral cycle in 2012 and the on-going and possibly continuing global economic crisis. Both can potentially eliminate the pension reform from the national political agenda or at least demote its standing.

To safeguard continuity and consistency, a two-pronged approach is needed consisting of simultaneous and interlinked efforts aimed at sustaining political consensus and ensuring public support for the reform process. The essential prerequisites of continuity and consistency include political will; evidence informed policy; and participation of major stakeholders. In practical terms, the reform process should have in place support mechanisms (instruments) that can remain functional beyond the length and independent of the electoral cycle. Such mechanisms have to exist both within and outside the government and involve major stakeholders of the reform process: government office(s); legislature (Verkhovna Rada); research and academic community; and civil society. Several support mechanisms for promoting the above essentials can be considered.

Well established and actively functioning links within the Government

The links within the Ministry of Social Policy (MSP) and between MSP and other government offices of Ukraine are particularly important for monitoring and analysing the practical experience of the reform process. So far, the reform process has benefited from the leadership of the Minister who is simultaneously occupies the post of Deputy Prime Minister. Building on this, it is advisable to establish an inter-ministerial coordinating body that would be led by a high ranking government official (Deputy Prime Minister) and acquire responsibilities for coordinating the reform of the pension system, perhaps along with other on-going and forthcoming reforms in the social sector of Ukraine – a Committee for Social Reforms. Such a body would facilitate inter-ministerial coordination and might prevent interruption of the reform process owing to government reshuffles, particularly at the beginning of an electoral cycle. Another option for better coordination of the reform process would be adjusting the structure and functions of the already existing Presidential Committee for Economic Reforms. This would be a better option than creating another committee; but there could be offsetting considerations. The Committee that has advisory/consultative role should expand and deepen its coverage of social sector reforms. Such an adjustment would help to better coordinate the economic and social dimensions of the reform processes in the country and also demonstrate the priority given to the social needs of people. As a more practical recommendation, we would suggest to modify the website of the Presidential Committee (www.president.gov.ua/content/ker.html), so that it would include, in addition to official documents, more specific, better structured and easy understandable information on the achievements and obstacles of the reform process.

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Strong leader in government authority

The availability of a strong leader in the government mobilizes and motivates the staff of the Ministry in continuing and spearheading the reform. Moreover, a strong leader is necessary for influencing the policy process within the entire government, as well as in legislature and also vis-à-vis general public. Equally important is that such a leader has a support of a powerful political authority.

Until this point in time, the reforming of pension system, as well as several other crucial socio-economic reforms in Ukraine, has been headed by a dedicated leader in the face of the Minister of Social Policy. His high position in the government, as one of the three Deputy Prime Ministers, and an evident support by the President has helped to advance the reform process. It is essential that he retains his post in the foreseeable future and will not be scapegoated for the short-term political costs.

Credible evidence-base essential to sustain the reform process

Availability of credible, and timely, analytical data produced in a scientific, technical way preferably by domestic research institutions is an essential prerequisite for the policy reforms. Strong evidence basis ensures comprehensiveness of all phases of the reform process. Moreover, it can give strong arguments to organizers of the reform information campaign in promoting consensus among major stakeholders and facilitating public support for the reform measures. Both quantitative and qualitative information should be collected and analysed.

This appears to be one of the strongest dimensions of the reform process in Ukraine as the country has a well-established network of research institutions, particularly within the National Academy of Sciences, such as the Institute of Demography and Social Studies. These institutions can be involved in forming an advisory body attached to the Ministry. Such an advisory body should include experts (not bureaucrats) from government, research/academic institutions, and non-governmental organizations. Moreover, one of the research institutions can be given a responsibility of independent monitoring of the reform process.

In addition to research information on the social and economic aspects of the reform, it is of utmost importance to collect and analyse information concerning its political aspects, including analytical information on availability of support for the reform process within the government and by the legislature. Equally important is to have timely and reliable information about the public views of the on-going and forthcoming policy measures. This type of information would allow foreseeing the adverse public reaction and preventing it through well designed public information campaigns and fine tuning of the planned policy actions.

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Participation of civil society and other stakeholders

Participatory, bottom-up component has been one of the weakest components of the Ukrainian reform process as the involvement of the stakeholders outside the government has been sporadic with corresponding activities of “too little, too late” nature. Two practical measures can be recommended to fill this gap: first, establishing of an advisory body, as outlined in the part (3) above; and, second, promoting dialogue between government and civil society during all stages of the policy process, including designing and monitoring the essential policy actions. The latter measure can be facilitated through the already existing Public Council of the Ministry of Social Policy. The work of the Council has to be organized in the way that would provide a feedback communication channel between the Ministry and civil society organization. The suitable models of similar bodies exist in various European countries, for instance in Austria the Federal Senior Citizens Advisory Council promotes the principle of a policy which is not for but with older people (www.bmask.gv.at/cms/siteEN/liste.html?channel=CH0773). The Federal Senior Citizens Council is based in the Ministry of Labour, Social Affairs and Consumer Protection and is employed as an active control mechanism of senior citizens' and generations policy in Austria.

A nucleus of a feedback communication between government and general public also exists in Ukraine in the form of the website on pension reform (http://pension.kiev.ua/index.php?option=com_content&task=blogcategory&id=22&Itemid=123). While it allows for visitors to post their comments, it is unclear whether any further analysis of the posted views is being undertaken. It would therefore be advisable to amend the functioning of this website by adding a forum or a blog features.

4. A synthesizing discussion ___________________________________________________________

In the 2011 pension reforms, the Ukrainian government has shown a strong promise in taking appropriate steps towards reforming its pension system and putting it to a sustainable path. This strategy paper has listed recommendations for further pension reforms, over the short-term (during 2012-2014) and over medium and longer-term (beyond 2014), on the basis of review of pension reform experiences in European countries. Three key messages stand out from this review for future pension policy reforms in Ukraine:

Link individual pension entitlements to the contributory period; Link statutory retirement age and contributory period requirements to

developments in life expectancy;

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Link pension income calculations to a second sustainability factor that would seek to equalise the future stream of pension system’s assets and liabilities; and

Strengthen equal-treatment, fairness and transparency principles in pension provision to diverse population and occupation groups.

Such principles had been the major factors behind successful reforms in

Sweden (since 1994), Italy (since 1995), Latvia (1996), Poland (1998) and

Bulgaria (2000).

For labour market measures, the importance of the de-shadowing of employment in Ukraine cannot possibly be overstated. The key message from our review of literature is that the pension design itself provides strong incentives to employees (especially the young ones) and employers to choose ‘formality’ over ‘informality’ for employment (these arguments stem from Palmer 2011). In this context, simultaneously reforming the healthcare sector to reinforce such incentives could result in a synergistic effect on incentives.

Our recommendations towards reducing pension contribution burden, and a redistribution of pension contribution from employers to employees, as well as the launch of the 2nd pillar, would offer incentive signals to workers to formally participate in the labour market. The changes recommended in the pension formula will also improve the link between contributions made and pension received.

Figure 4: The vision for the future pension system in Ukraine – a three

pillar public-private PAYG-Funded combination of pension schemes with

a social protection floor of guaranteed minimum pension

Earnings-related

schemes

Guaranteed minimum

pension

1st

pillar

Man

2nd

pillar

Man

3rd

pillar Volu

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Thus, the proposals made for Ukraine is to have a three pillar pension system (as depicted in Figure 4; and as was legislated in the 2004 reforms):

The 1st pillar will continue to be a public mandatory pension schemes, based on pay-as-you-go principles and mimicking the good features of a defined contribution system (particularly going along the notional defined-contribution system as in Sweden, Italy, Poland and Latvia). Already, the system contains the features of lifetime service period (to come into effect gradually over the next 30 years), but some other parametric adjustments are still required, as recommended in this paper.

The 2nd pillar will be a mandatory individual account scheme, on the principles of the FDC system (as in Poland, Latvia and Slovakia). State regulations will have to be put in place to ensure protection of workers’ contributions and the continuity in the income generation process. Also, measures should be put in place to keep the administration costs to the minimum. The 2nd pillar funds can be managed by the government in the 1st phase, but later on, based on the preferences of contributors, it could be managed by private pension funds, provided if they offer guarantees required and a reasonably low annual management cost. The participation in this scheme should be made compulsory for younger workers than 30 and for anyone to enter employment for the first time. Older age groups could be allowed to opt for either the old or the new system.

The 3rd pillar will remain as it currently is: a private voluntary scheme, to continue using the principles of the FDC, and providing tax incentives for additional pension savings. However, it can be expected that the contributions towards this type of schemes will be lower after the introduction of the mandatory 2nd pillar.

From the social and political point of view, it is necessary to also provide the guaranteed minimum pension at the statutory retirement age – such a social protection floor for all pensioners in the future will warrant poverty reduction among older people. It is useful to reiterate here the important point elaborated earlier that non-contributory components should be kept separate from the PFU so as to keep it a ‘cleaner’ system.

The pension system as proposed above will disperse risks and also ensure fairness across generations and will improve economic sustainability. The government will have the window of opportunity to introduce these reforms soon after the election in 2012. The additional domestic savings generated via a smooth functioning of 2nd and 3rd pillar will contribute to the economic growth, particularly the growth of the financial sector in Ukraine.

One of the key questions in our consultation with MSP has been: to identify the ‘pressure points’ in the current Ukrainian pension system.

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Firstly, on the basis of the principles alone, the most imperative reform will have to be the phasing away of the privileged pensions and restrict early retirement provision, so as to improve the contributory aspects of the 1st pillar. For this purpose, a special expert commission should be established to review each applicable special pension scheme on a case-by-case basis, consult social partners and come up with a viable long-term solution.

Secondly, under labour market measures, the de-shadowing of the labour market will be the most important policy reform, in improving the fiscal situation of the 1st pillar Ukrainian pension system.

We believe that the move towards the DC-type system (for the 1st pillar), and the introduction of the 2nd pillar FDC for supplementary pensions, will contribute strongly in providing incentives to workers to formal employment, thus helping to address one of the greatest challenges of the ageing Ukrainian society – the accelerated ageing and depletion of its labour force.

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