Pension Funds in Central Europe and Russia: Their Prospects and Potential Role in Corporate Governance

Abstract

The severe financial pressures on the social pension systems of transitional countries in Central Europe and Russia could be alleviated by downsizing and restructuring the public pillar of the system and by creating private pension funds. Private pension funds could help modernize capital markets and also help improve corporate governance. Social pension systems in most countries in Eastern Europe and the former Soviet Union face severe financial pressure. Aging populations are increasing that pressure, which stems mainly from design flaws and incompatible incentives in the systems. Vittas and Michelitsch describe the features of the pension systems that have led to the current dire predicament: A big discrepancy between system and demographic dependency ratios, unsustainable targeted replacement rates, the high contribution rates needed, growing evasion, and growing deficits. Radical basic reform is inevitable, they say, but may not be politically feasible or even advisable in the short run. After reviewing experience in other countries, they conclude that restructuring and downsizing the social pension system will leave adequate but affordable (thus sustainable) benefits and will allow for the creation and growth of private pension funds. The shortcomings of company-based defined benefit plans (limited portability, restricted vesting, inadequate funding) suggest that transitional economies should opt in the longer run for nonemployer, defined contribution plans based on individual capitalization accounts with full immediate vesting, full portability, and full funding. To cope with the need for a targeted replacement rate, such schemes could operate with variable contribution rates, reset each year in accord with the salary growth of each worker, the cumulative investment return on his/her account, and the targeted pension benefit. Once private pension funds are established, long-term financial resources should accumulate rapidly. They can then play a major role in modernizing securities markets, stimulating innovation, fostering better accounting and auditing standards, and promoting more disclosure of information. They could also greatly help improve corporate governance and the monitoring of corporate performance. Their voice in corporate affairs could be exercised more effectively through collective bodies. They could thus help create more robust structures of corporate governance, lower monitoring costs, and avoid the problems caused by free riding. This paper is a product of the Financial Sector Development Department. It is a slightly revised version of a paper presented at the Conference on Corporate Governance in Central Europe and Russia, December 15­16, 1994, organized by the World Bank and the Central European University Privatization Project.