New draft Russian law on investment of pension reserves

Russia, in common with many other European countries has a growing pensions crisis. This has been caused in part by an ageing population. It will be exacerbated in future years by the birth rate which has undergone a sharp decline during the sometimes painful transitions of the last 15 years. Along with many other transition countries, Russia has decided that it needs a system of funded pensions.

Russia already has a voluntary third pillar which consists mainly of employer sponsored pension funds. However, often these funds are provided not for the benefit of employees, but are instead used as vehicles to self invest back into the employing company and act as poison pills in the event of an hostile take-over. There are also many fundamental regulatory problems with the sector which still need to be addressed. Russia can also learn from the experience of other countries in the region, that where a system is purely voluntary, it is difficult to incentivise individuals to contribute and, in turn, accumulate substantial sums under management. Thus, Russia decided that it needed a second pillar. However, unlike many other central and eastern European countries, it chose not to follow the Chilean model of having a number of open competing pension funds. At first, the proposal was that the Pension Fund of Russia (which manages the pay-as-you-go system) would collect in money and then make transfers to asset managers. Under this model there would have been no element of individual choice. It was also suggested by some parties that this proposed method could be open to political manipulation.

The final draft of the law is now based on the model of individual choice and owes its inspiration to the Swedish second pillar model. In particular, it provides that the Pension Fund of Russia will still collect in money from employers in favour of individuals but will then allocate such money in bulk to a number of asset managers in accordance with the decisions made by those individuals. This is planned to start from 2004. The crucial difference between this model and the model implemented in countries such as Hungary, Croatia and Poland (which followed the Chilean approach) is that the asset manager should not, at least in theory, know the identity of the contributing individuals. It will not hold individual member records and will not enrol individual members. All record keeping will be undertaken by the Pension Fund of Russia. For potential market entrants, this means that there is no need to set up a nationwide distribution network or a complex record keeping system. The function which will have to be undertaken is pure asset management. This may make the market more attractive to international money managers and perhaps less attractive to some of the insurers that have entered the second pillar in other countries.

It is also important to note that, following lobbying by the non-state pension fund industry, an individual will be able to choose to have his/her account with a non-state pension fund instead of with an asset manager. However, much of the details of this opt out, which should be available from 2005, have yet to be sketched out.

So what does the new draft law contain? Set out below are the main provisions of the draft on the investment of pension reserves which has recently passed its third and final reading in the Duma.


The Pension Fund of Russia will perform an open tender in order to licence asset managers to participate in the second pillar. There is no limit on the number of licences which may be awarded. Licences are awarded for a period of five years but may be extended. New entrants may apply each year. The asset manager must be established in Russia and possess the necessary professional experience in respect of investment/mutual funds and NSPF’s. In particular, an asset manager must have a minimum level of assets under management, have a minimum level of capital and a certain number of clients. An asset manager must also demonstrate the professional qualifications of their employees and present a set of audited financial statements for the previous three years. The asset manager must not be a related party to a specialised depository or any of its related parties and the asset manager will have to draft, accept and approve (together with the Inspectorate) a code of professional ethics. The government may impose additional requirements in relation to asset managers.

Day to day functions

Asset managers will be required to use licensed brokers in order to carry out investment activities and shall be obliged to segregate pension reserves accumulated under the second pillar from other investments. The asset manager will also be required to report regularly to the Pension Fund of Russia and the Inspectorate on the investment of pension reserves and income received. According to the draft law, the asset manager will be required to purchase and sell assets at market prices. The current market value will be calculated in accordance with the rules set by the Federal Commission on Securities Markets and the asset manager is obliged to notify the Inspectorate of any transaction which deviates from the market price.

Investment of assets

The assets in which second pillar pension reserves can be invested include government securities, company bonds, mortgage securities and shares in open joint stock companies. These investments must be tradable on the Russian stock market. Further permitted investments include: shares or stakes in indexed investment funds which invest in securities of foreign countries and bonds and shares of other foreign issuers, subject to limits set out below. Cash may be placed with banks in RUR and also placed in banks in foreign currency accounts.

Pension reserves cannot be invested in any securities issued by either the asset manager, the brokers, the banks, the insurers, the specialised depository or the auditors with which service agreements have been entered into. Furthermore, pension reserves cannot be invested in the securities of companies which are currently under readjustment or subject to bankruptcy procedures.

Investment portfolio structure

In common with other pension fund laws in central and eastern Europe, the draft law has introduced limits for each type of investment which may be held in the portfolio. The maximum share of any one issuer (or a group of related issuers) in a portfolio should not exceed 5 percent, except in relation to government securities. Deposits held with a bank and securities issued by a bank should not exceed 10% and the maximum share of securities issued by related parties of the asset manager and specialised depository should not exceed 5 percent of the portfolio. The maximum share of any one issuer in the portfolio should not exceed 10 percent of its market capitalisation (effective from 1st January 2010). The maximum share of bonds of any one issuer in the portfolio should not exceed 10 percent of the total volume of bonds of that issuer that are traded on the market (except for government securities) and the maximum share of securities in one issuer in the portfolio should not exceed 30 percent of the total volume of securities which that issuer is trading on the market, except for government securities. The maximum share of cash accounts and deposits held with banks should not exceed 20 percent of the total portfolio.

If the structure of the portfolio is breached unintentionally (i.e. due to a change in the market price of the assets) the asset manager is obliged to adjust the portfolio within six months from the moment the breach is discovered. If there is an intentional breach, the asset manager is obliged to adjust the portfolio within 30 days of the discovery of the breach.

Investment in foreign securities

Investment in foreign securities can only be undertaken by the purchase of units in a foreign index investment fund. The list of permitted indices is set by the Inspectorate in agreement with the Federal Commission on Securities Markets. Pension reserves cannot be invested in indices which include bonds of foreign issuers that do not have an investment grade rating by a leading ratings agency. The list of rating agencies is established by the Inspectorate in agreement with the Federal Commission on Securities Markets.

To invest in foreign securities the asset manager must possess a licence which enables it to conduct fund management activity in relation to foreign securities. The asset manager must have experience of investment in at least one of the permitted stock indices for a period of at least five years. The asset manager must also have experience of providing fund management services to institutional investors (including pension funds) for a period of at least 10 years and comply with the capital adequacy requirements imposed on asset managers in EU countries. The asset manager is prohibited from investing in securities where the asset manager or the investment fund is registered in a tax haven and does not disclose the substance of its financial operations.

In any pension reform in the region one of the most contentious issues is the extent to which investment can be made abroad. In Russia, for the years 2004-2005 the level is set at 5 percent. For 2006-2007 it will be 10% and for 2008-2009 it will be 15 percent, eventually rising to 20 percent.

Obligatory insurance for operational liabilities of the asset manager

A controversial feature of the draft law is that the asset manager is obliged to insure its operational liabilities. The level of coverage should be not less than 5 percent of the total amount of assets under management where the total amount does not exceed 6 billion RUR or not less than 300 billion RUR if the total amount of the assets under management exceeds 6 billion RUR.

Fees and expenses

A charge for necessary expenses of the asset manager equal to up to 1.1 percent of the average net asset value can be deducted from contributions. Such money can only be used to meet costs of the specialised depository, auditors, insurers etc.

In addition, fees can be charged by asset managers but these must not exceed 10 percent of the total investment income received for the reporting year. No fees can be charged if the net assets have decreased in comparison with the previous year. This means that asset managers will be rewarded in the good times but not the bad times. It is also possible that competitive pressures will mean that asset managers will not be able to charge the full 10 percent. The fact that individuals can switch funds once a year, should keep continued pressure on costs.

Insured individuals

The insured individual has a number of options. He or she can opt for an investment portfolio with the asset manager or stay with the Pension Fund of Russia or even choose an account with NSPF. This latter option will only apply from a later date, probably in 2005. An individual can change an asset manager once a year. Where the insured individual does not make an election at the time he is first required to do so, the funds will be transferred by the Pension Fund of Russia to an asset manager appointed by the government. A transfer fee will be collected from the insured individual for the transfer of pension reserves from one asset manager to another. This will not apply to the first transfer from the asset manager appointed by the government to one selected by the insured individual.

Potential problems

Many of the countries in central and eastern Europe which have implemented second pension reform have run into problems with their IT systems. Russia faces similar problems. The pension fund of Russia will need to substantially develop its IT system in order to be able to manage tens of millions of individual accounts. There are also concerns about the licensing process, the timetable for which is not yet clear. Finally, there is concern about the ability to opt out into a non-state pension fund. Although, there are many reputable non-state pension funds, there are many which fail to come up to normal international standards.

Much of the devil lies in the detail. Over the coming months and years, the government will need to issue more regulations and provide further information on how tendering will start and individual Russian citizens will make their choice. We will keep you informed of developments in this area.

For further information please contact David Griston at or on 00 7 095 2585000