By the book

Russia's five-year old third pillar pension system started to expand just as the financial crisis swept across the globe - and a deadly combination of high inflation and low government bond yields leaves the sector facing a risk management conundrum. Aaron Woolner reports

The violent swings in equity values and interest rates during the past 18 months have brought a variety of regulatory responses. For example, the Dutch regulator gave schemes an additional two years to complete their recovery, while its Danish and Swedish counterparts both adjusted their methods of calculating funds' liabilities.

For the Federal Financial Markets Service (FFMS), which regulates Russia's nascent third pillar pension sector, however, the solution to the problem of asset values plummeting by as much as 40% was simple - suspend market consistency. Instead of announcing the actual 2008 return figures, schemes could simply post the book value of their assets.

A culture of opacity within the Russian pension sector makes it very difficult for an outsider to offer an objective opinion on the effect of this tactic. Schemes are only obliged to publish their results 100 days after the year-end and even then as one industry insider says, "schemes may publish the information - but it is another question as to whether it is possible to access it".

The temporary suspension of market consistency might appear cavalier to more developed pension sectors based in countries that have not experienced the type of equity market volatility that is present in Russia. For example, in 2005 the country's benchmark Russian Trading System index jumped by 51% (see chart 1).

But according to Andrey Kulapov, business development manager at Aviva Insurance Company, one of only two non-state pension funds in Russia that are backed with foreign capital, the rationale behind the FFMS's move is simple - it takes an optimistic view of the future path of the Russian stock market.

"When the pension funds declare the book value of most of their assets they will receive positive investment return and the FFMS's decision was made in the hope that the market will rebound."

The key point in the FFMS's decision is the existence of a non negative return guarantee. When annual asset figures are published every March they must at a minimum be equal to the previous year's figures, plus the total contributions made in the intervening period.

For Russian pension scheme members, such a guarantee must seem extremely attractive. The financial chaos following the collapse of communism, which climaxed in the country defaulting on its international obligations in the Russian bond crisis of 1998, left a vivid impression on international investors. But for Russians who saw their life savings evaporate in a series of banking collapses, and a precipitous fall in the value of the rouble, trust in the financial system is all but non-existent.

A 2007 report published by the Russian arm of Dutch insurer ING said the three Ds of, "devaluation, denomination and default (meant) the people's trust in long-term savings and benefits dropped to zero".

But while Russian investors might yearn for the happy predictability of slow, steady investment returns, the main source of stability in the financial system is the regularity of its double-digit inflation rates. The current official inflation rate stands at close to 15% - far in excess of the yield available on government bonds. This situation leaves Russian pension managers with a conundrum - how is it possible to construct a strategy that produces an above-inflation return without running foul of the non-negative investment return guarantee?

Period of transition

The Russian pension sector, in common with most post-communist states, spent the 1990s in a state of transition. The - relatively - generous defined contribution (DC) state-backed pension schemes (typical replacement rates stood at around 75% of previous income) were no longer either financially, or ideologically, viable. An issue that was worsened by the climax of a demographic transition which saw the numbers of workers supporting each pensioner fall from six to every retiree in the 1970s, to 1.6 to one, by 2008 according to Raiffeisen non-state pension fund (NSPF).

As the Russian state grappled with its deteriorating finances in 2002, it sought to offload some of its liabilities to its citizens by reforming the country's second pillar pension sector. This shifted responsibility for pension provision from state employers to their employees by moving to a DC approach.

At the same time it created a third pillar pension structure that would be administered either by NSPFs, non-profit organisations, which are attached to large-scale companies such as Gazprom, or insurance companies.

The NSPFs attached to companies are usually closed to employees only and while it is possible for individuals to take out their own private pension plans, this has not proved popular, with the ING report stating that by 2007 the amount saved in this form was "not material".

Indeed, according to FFMS, despite Russia's working age population standing at nearly 90 million, by 2008 the total amount of third pillar pension assets stood at EUR18 billion (£15.5 billion). In comparison, the UK's Pension Protection Fund calculated that the deficit on the UK's 7,400 defined benefit plans alone stood at £158.1 billion at the end of July 2009.

The vast majority of these assets - more than 85%, according to Aviva Russia - belong to the captive pension sector, but the insurer sees potential in the market for growth. So much so that it purchased ING's Russia pension business earlier this year for an undisclosed sum.

According to Marketa Vylitova, a senior associate at consultant Mercer, who has responsibility for Russia from her office in Prague, this figure for the size of the Russian pensions sector hides the fact that it has experienced rapid expansion. "There has been significant growth - when we looked at the sector in 2003 there were very few third pillar providers. Pensions were provided either via book reserve plans, or offshore vehicles. Currently around one-third of companies provide pension plans - either via non-state pension funds or insurers."

According to Vylitova, Russian companies up till now have focused on providing immediate benefits - medical care and life assurance were a top priority, with pensions running a distant third. "But this has started to change - a process that has been accelerated by the financial crisis - the FFMS is predicting third pillar pension assets will reach EUR38 billion by 2012".

Consistent returns

For the sector to expand on such a scale will require a consistent level of returns - and the development of a risk culture. But, according to one senior figure from the Russian insurance sector, risk awareness has not yet been embedded into the DNA of the Russian pension industry.

He recounts a story of meeting the pension regulator several years ago who told him that the only reason a pension fund makes a loss is because it does not have enough expertise at managing its portfolio: "The regulator didn't take seriously the chances of the market to fall in the way that is happening now."

In common with most emerging economies, Russia imposed strict investment rules when the third pillar system was constructed which emphasised the role of government and municipal bonds while restricting equity investment to a 40% ceiling. According to Aviva's Kulapov, after several years of rampant growth on the domestic stock market, in 2007, these rules were relaxed to allow up to 70% of their funds in equities - a decision that could not have been taken at a worse time.

Kulapov says: "But nobody really knew that was going to happen because in 2005 the Russian stock market grew by 80% and by 50% in 2006. In 2007 legislation was passed increasing the amount of equities schemes could invest in. It is clear what the intention behind this move was - the NSPFs were actively lobbying for this move. So the legislation relaxes a bit and allows for more investment in stock - however, the result in 2008 was bad news."

According to the senior figure in the Russian insurance sector, this "bad news" was that pension funds were left facing some losses - in the region of 20-40% of the market value of those funds.

Kulapov says Aviva's reliance on an ultra-conservative investment strategy of only government bonds, municipal bonds and bank deposits meant it didn't suffer losses on this scale. Although he declined to discuss exact figures, he confirmed that the Moscow-based fund was in no danger of breaching its non-negative guarantee.

If returns falls below the level of the no negative return guarantee level, there is a fallback position - Russian legislation requires all NSPFs to hold a 5% reserve fund which is explicitly for the payment of pension liabilities. For captive funds this can only come from additional contributions, while schemes backed by insurers can seed the reserve fund by using shareholders' capital.

Even so with declines of 40% estimated for many in the captive market, the 5% reserves can only go part of the way to making up the shortfall - meaning the FFMS's decision to suspend mark-to-market accounting has potentially serious implications for the pension sector's sustainability in the near future.

The route of this financial quicksand is, however, visible. While the no-negative return figures are calculated on an annual basis, any customer lapsing their policy prior to this date will be credited with returns at market, rather than book, value. And with 2009 witnessing a modest improvement in the fortunes of the Russian stock market, Kulapov argues that the country's pension funds can realistically expect to be at the minimum 0% return level when figures are calculated in March 2010.

"Basically the idea of this letter was that the market will bounce back quickly - and it partially did. So the funds can regain the value they have lost and once people start lapsing their agreements, the shortfall will be made up more quickly.

"When they declare the book value, most of the funds will receive positive investment return and this decision was made in the hope that the market will rebound."

Lack of faith

"And this appears to be the case - naturally there is a lack of information, so it is not possible to compare other funds' performance to Aviva's, but the unofficial news is that most of the NSPFs have recovered their 2008 losses and some have even made a positive return by this point on 2009," says Kulapov.

For long term investors, not losing cash - while welcome - is not the primary aim, and the need for decent returns leaves Russian pension providers in another bind. How will they ensure decent enough returns in a high interest-rate environment? Aviva targets a return of inflation plus between one and two percent - a tough call in Russia's 15% inflation environment (see chart 2).

The concern over the inflation level is further exhibited by a lack of faith in the government figures used to calculate inflation. "There are two inflation rates - an official one from the government and an unofficial one, which is usually much higher. For example, last year the official figure was around 13% and the unofficial was around 18%," says Kulapov.

"This brings you to the second and more intractable problem - matching either of these rates. Switzerland has government bonds that pay around 2.5% - or at least they used to - and the inflation rate was around 2.3%, so if a scheme just invests in government bonds it would receive a return of just above inflation. But this is not true of Russian government bonds (see chart 3). They pay 8% whereas the inflation rate is around 13%, so when we invest in government bonds we do not always have enough returns to cover inflation," he says.

And Russia's relatively shallow capital markets make it almost impossible for pension schemes to attempt to hedge their way out of problems with changes in interest, or inflation, rates. According to the senior figure, legislation permits derivatives use only within strict parameters. There is very little potential to use such instruments: "The scheme must demonstrate clearly to the regulator the position being hedged. It should be on the surface - it should be obvious. So, for example, you have bought derivatives to hedge the risk.

"But it is simply not possible to hedge either inflation or interest. There are no inflation or interest rate-linked instruments - only equity-linked derivatives. There was talk a few years ago that the government would issue inflation-linked bonds, but nothing has happened so far. Currently the only risk management tools open to a Russian pension scheme are bonds, equities, deposits and the way you move in and out of each asset class."

In more developed pension systems, companies that consistently produced returns that are clearly below the inflation rate would quickly find themselves short of customers. But according to Mercer's Vylitova the nature of Russia's recent experience with financial services means customers are wary of providers which promise sky-high returns: "The Russian economy experienced two financial crises in the 1990s. Many people lost all their savings, so it may be detrimental from a marketing perspective if a pension fund says it wants to invest in more high-risk assets, as this might hamper the number of people willing to join."