UKRAINE'S PENSION SYSTEM: A TICKING TIME BOMB

UNCLAS SECTION 01 OF 03 KYIV 000288

SIPDIS

STATE FOR EUR/UMB AND EEB/OMA
USDOC FOR 4201/DOC/ITA/MAC/BISNIS
USDOC FOR 4231/ITA/OEENIS/NISD/CLUCYCK

E.O. 12958: N/A
TAGS: ELAB EFIN ECON UP
SUBJECT: UKRAINE'S PENSION SYSTEM: A TICKING TIME BOMB
APPROACHING ZERO?

REFS: A) KYIV 256
B) KYIV 228


1. Summary: Ukraine's financially-unsustainable pay-as-you-
go pension system is a leading contributor to the GOU's
current budget crisis. A special payroll tax is meant to
finance this pension system, but, despite excessively
burdensome tax rates, every year the government must pay
more and more for pensions through regular budget revenues.
The only immediate alternatives are to permit inflation to
erode the real value of pensions or to fall into arrears.
The Tymoshenko government exacerbated problems by
significantly increasing pension payouts in recent years.
The GOU is planning some changes to the system, like
raising the retirement age, in order to economize, but such
measures are unlikely to save what is essentially a sinking
ship. Efforts at long-term reform, to include a mandatory
accumulation system that would ease pressure on the pay-as-
you-go program, as well as voluntary private pension funds,
have been halfhearted. And while the budget crisis has
awakened some political actors to the need for reform,
unfortunately it will also delay the government's ability
to actually implement the reforms. End Summary.

The Basic Pension System: Pay-As-You-Go...
--------------


2. Ukraine's pension system has traditionally operated as a
pay-as-you-go program whereby contributions of today's
workers fund today's pensioners. Retirement payouts are
primarily determined by the individual's labor records and
contributions, using a formula -- known as the "accrual
rate" -- based the employee's average wage during the last
five years of work. Retirees receive a bonus in their
payouts if they worked more than 25 years, and there are
various other bonus payments as well. The system is a
social pension, as older Ukrainians who did not work or pay
into the system still receive pensions. The retirement age
is currently 60 for men and 55 for women. The Pension Fund
of Ukraine, a quasi-independent body that reports to the
Cabinet of Ministers and is managed by a Board with
representatives from the government, labor unions, and
employers, operates the system.


3. Ukraine has a special payroll tax used to fund the
pension system. Employers shoulder the greatest burden,
paying a 33.2 percent tax on their employees' wages, while
workers contribute only 2 percent. (Note: There are also
some miscellaneous fees that help fund the pension system,
but they are insignificant in comparison to this payroll
tax. End Note.) While the payroll tax covers most
workers' pensions, the government often must draw on
regular budget money to meet shortfalls. The government
also uses normal budget funds to pay for social pensions
(i.e. elderly people who did not work) and for some civil
service and military pensions.

... For as Long as You Can
--------------


4. This pay-as-you-go pension system is financially
unsustainable in the longer term. Average nominal monthly
pensions were UAH 751 in 2008, a 312 percent increase from
2004 and a 57 percent increase from 2007. Pension
expenditures grew from 9.6 percent of GDP in 2003 to 15.5
percent in 2008 and are expected to top 17 percent in 2009.
The excessively high payroll tax rate for employers, at
33.2 percent, exacerbates shortfalls in financing by
encouraging substantial underreporting of wages. A graying
population also puts stress on the system; 42 percent of
the population in 2008 was 45 years old or older (compared
to 37 percent in 1990),and 16 percent was 65 years or
older (compared to 12 percent in 1990). The result is a
growing need to bolster the system using revenues from the
general government budget.


5. The current Tymoshenko government exacerbated problems
by increasing by 35 percent the accrual rate for retirement
payments (i.e. by tinkering with the formula used to
determine payments).

Effect on Budget Crisis and Potential Remedies
-------------- -


6. Total Pension Fund outlays in 2008 were UAH 147.9

KYIV 00000288 002 OF 003


billion (about $19 billion),equal to 68 percent of all
non-pension expenditures of the state budget. Of that 2008
total, UAH 106.5 ($14 billion) was funded by the payroll
tax, while UAH 41.4 billion ($5 billion) -- nearly 30
percent of pension outlays and 16 percent of total state
budget expenditures -- came from the state budget. (Note:
GOU accounting keeps funds provided for pensions through
the payroll tax off the books of the state budget. End
note.) Of that UAH 41.4 billion that came from the state
budget, UAH 36.7 billion went to fund social pensions and
civil/military service pensions, and UAH 4.7 billion went
to cover shortfalls from the payroll tax for workers'
pensions. These figures indicate what an unwieldy beast
the pension system has become. Preliminary planning
foresees only a modest increase in pension funding from the
state budget in 2009 from UAH 41.4 billion to UAH 44.2
billion. The government has not revealed specific
estimates of how much will be required to cover payroll tax
shortfalls, however, and with the government in the midst
of a serious budget crisis (ref A) and payroll tax income
expected to fall significantly, outlays to the pension
system could break the bank this year.


7. The IMF has identified Ukraine's bloated 2009 budget,
and the budget gap caused by the pension system in
particular, as a chief concern. The GOU's draft 2009
budget envisions a budget deficit of about three percent of
GDP. A balanced budget was a key conditionality of the
$16.4 billion Stand-By Arrangement, but the IMF has already
signaled flexibility, acknowledging that economic situation
has deteriorated farther, and faster, than had been
expected when the loan was approved last October. While
indicating a willingness to accept a certain deficit, the
IMF is nonetheless expecting the GOU to address the sizable
hole in the budget caused by the deficit at the pension
fund.


8. The GOU is considering the following measures to reduce
pension expenditures:

-- Raising the retirement age to 62 for both men and women;
-- Making it harder to work and receive a pension
simultaneously;
-- Gradually eliminating special pension regimes; and
-- Replacing the flat contribution for farmers and the
self-employed with a minimum contribution base.


9. While these reforms, especially raising the retirement
age, would help reduce expenditures, the potential savings
are unlikely to balance the pension system's budget. More
aggressive moves, like repealing the recent 35 percent
increase in the pension accrual rate, are politically
unpalatable, especially with Presidential elections looming
on the horizon (see ref B for PM Tymoshenko's recent
comments). Moreover, no mere tweaking of pension payments
will be enough to provide long-term financial
sustainability.

Real Pension Reform: Moving Away from Pay-As-You-Go
-------------- --------------


10. The key to pension reform is to move away from the pay-
as-you-go system. In 2004, Ukraine began a comprehensive
reform program envisioning a three-pillar pension system:
Pillar I, the pay-as-you-go system; Pillar II, a mandatory
accumulation system; and Pillar III, a voluntary private
pension system.


11. Pillar II, the mandatory accumulation system, is the
lynchpin of the reforms and would require all workers to
contribute to a pre-funded, individual retirement account,
which would eventually be managed by private sector pension
funds. Pillar II would reduce the pressure on Pillar I in
the long-term and would generate substantial domestic
savings to finance economic growth. Pillar II requires
that developed capital markets be in place to provide sound
investment opportunities, however, and its introduction is
therefore not expected before 2011. The government's
current fiscal crisis will likely delay introduction of
Pillar II even further.


12. Pillar III, voluntary private pension funds, actually
began operations at the end of 2004. These funds are the
only effective, tax-favored method workers have to
supplement their retirement income through voluntary

KYIV 00000288 003 OF 003


savings. Since 2004 the number of private pension funds
has grown rapidly, but they still remain a minor financial
actor, with only some 450,000 participants and assets of
under $100 million. Pillar III is in a sense a training
ground for Pillar II, as it is forcing the GOU to
strengthen the legal and regulatory framework for private
pension funds and is encouraging consolidation of the
private pension fund industry.

Comment: Crisis Inhibitor or Impetus of Reform?
-------------- --


13. Although pressure has been building on the system for
years, the current budget crisis will help reveal the
weaknesses of the current pension system and argue for
reform. Indeed, a USAID project working on pension reform
reports that several political figures who previously
opposed moving away from pay-as-you-go have now emerged as
supporters. On the other hand, however, the necessary
pension reforms will cost more in the short-term, as there
will be a period of overlap when the government has to
fully finance the pay-as-you-go system at the same time
that it begins pre-funding the new mandatory accumulation
system. In the current atmosphere, there is simply no
fiscal space for such reform. End Comment.

TAYLOR