Why are pensions so low in Ukraine? And how can we make it “like in Europe”

We have asked Hanna Vakhitova, professor at Kyiv School of Economics, why Ukrainians have such low pensions and whether the situation can be improved.

State pensions are very low. Why is that so?

 

In order to explain this fact, one needs to understand that we have pay-as-you-go pension scheme. This means that people, currently working and making contributions to the Pension Fund, finance pensioners.

 

The demographic situation in Ukraine is such that the number of employed (16 million) and the number of pensioners (12 million) are fairly close, which implies the ratio of about 1.3 of employed per 1 pensioner (if we consider only those employed, who pay social contributions (12 million), then the ratio falls to 1:1).

 

So, for instance, an employed person makes a contribution of about UAH 2,000 (approximated) from his/her salary of 10,000 UAH . In addition to that, we have higher pensions for judges, academic researches etc, together with a desire to pay the least amount of taxes (that is, not from the whole salary, but solely from the minimum required sum). Therefore, one pensioneer gets only little amount of that money – the nominal 2,000 UAH become even less.

 

What is pay-as-you-go pension scheme?

 

This scheme was developed in the 19th century, when there were a lot of children and few pensioners. It works the same way as a financial pyramid: when many young people (the base) finance fewer pensioners (the top). Nowadays this doesn’t work anymore.

 

How the situation can be improved?

 

This question is very crucial for many countries with few children and aging population. For instance, European countries nowadays are switching to individual retirement arrangements, when everyone personally saves money to his/her future pension account. In case of a rapid switch to a such pension scheme, the following people will be affected:

 

  • those, who nowadays receive pensions at the expense of working people. They will no longer get money;
  • those, who work now, will get nothing for preceding years of work. They did make contributions, but this money has already been distributed among current pensioners.

 

What should Ukraine do?

 

Transition to individual retirement accounts in its pure form cannot be done, because old people won’t be able to switch to this scheme due to the fact that they usually don’t have permanent income to make contributions from; they have already lived through this time of life. Therefore, there is a need for the transition period: when the state partially finances pensioners, however people, currently making contribution to the Pension Fund, won’t be able to rely upon this state scheme anymore. They have to work and contribute to their individual pensions. Support of the current pensioners can be indirect, from other taxes (this is partially done today, when the deficit of the Pension Fund is financed directly from the budget).

 

Why is the pension age raised?

 

Generally, a pension is meant to be person’s savings for the age, when he/she is not able to earn money due to elderly age or poor health. All countries are raising pension age, as the span of active working age is constantly increasing because of scientific and medical improvements. That is why the increase in the pension age basically reflects the reality that a person remains productive for longer.

 

From financial point of view, there are several factors, which determine the balance of pension fund at any given time: number of employed, wage and deductible rates, which generate the fund’s incomes. Expenditures, in contrast, depend on the number of pensioners and amount of pension allowance. The raise of pension age increases the number of those who contribute and decrease the number of those who get. Thus, this measure allows paying pensions at some adequate level.

 

An alternative to the pension age increase includes economic and wage rate growth (which requires the labor force becoming more productive, in contrast to being just paid more for no reason).  Another alternative is unshadowing of wages (which is no easy to achieve either).

 

Why can’t we level off pensions?

 

It will not create a significant impact. There are 12 million pensioners in Ukraine nowadays, 400 thousand of whom (approximately 3%) receive special pensions. Even if we dismiss the allowances of privileged pensioners, it will not considerably improve the common pensions, as this effect is insignificant.

 

Why cannot one take money from the wealthy and give to the pensioners?

 

This is a “fairness against efficiency” question. No doubts, it would be fair to raise pensions, as today’s allowances are miserable. But, to give something out, it should be taken somewhere. If we start taking money from the rich (by increasing taxes, for example), we will end up with even worse poverty, because the business will sneak into shadow, decreasing tax revenue, or emigrate. For this reason we need to to be cautious in this fight against low pensions.

 

When is it time for us to switch from pay-as-you-go pension scheme to defined contributions pension system?

 

It should have been done in 2001, when this idea was brought up for the first time. Alternatively, it might have been implemented in 2004, when the respective legislation was adopted, but it did not happen.  But Ukrainian experience shows the further, the worse, as the number of pensioners rises up, while the number of employed falls down. This leads to an even more significant disequilibrium.

 

Considering the above mentioned, as a scientist I would suggest: the earlier we introduce the new system the better.

 

If you were a policy maker, how would you reform the system?

 

The principles were already announced in 2004:

  • transition to to the system of individual pension savings;
  • increase of the pension age.

 

I would personally add another point – investment into social sphere for pensioners (health care and social support).

 

Hanna Vakhitova was interviewed by a KSE student Valentin Litvinov

Translated by Maryna Shykun and Mykola Kravets, KSE students