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Looking Over the Border: The Pension Reform in Armenia

On the first of January, Armenia will adopt an entirely new pension system. This radical reform addresses two problems: widespread poverty among the elderly and a lack of capital in the economy. The very same problems also exist in Georgia, where the standard governmental pension currently is 150 lari, and where the economy is suffering from high capital costs due to notoriously low saving rates. So, it is worthwhile to have a look at what is going on in our neighboring country Armenia. Georgian decision makers may learn important lessons from their experiences.


THE REFORM IN A NUTSHELL

In January 2014, a mandatory funded pension component is implemented into the Armenian pension system. Everyone born after 1974 will obligatorily have to divert 10% of their gross salary to a pension fund, while people born before 1974 can join the new system voluntarily. The 10% of the gross salary, however, do not have to be paid in full by the future pension beneficiaries. In fact, most people have to pay only 5% of their salary, while the remaining 5% are thrown in by the government. The state’s contribution is capped at 25,000 dram ($62) per month, which is 5% of 500,000  dram. Hence, a person with a salary of more than 500,000 Armenian dram per month will receive a subsidy of less than 5%. For example, if the monthly salary is 600,000 dram ($1,480), the state will cover 25,000 dram ($62) and the individual will have to make up for the additional 35,000 dram ($86).

The government does not get tired to point out the advantages the new system yields to common Armenian residents. Unlike in the past, and unlike in Georgia, there will be a direct connection between a person’s lifetime salary and the pension. Whether or not this is fair is a matter of opinion; however, it smoothes the transition from work to pension age. Moreover, the pensions are expected to increase the living standards of elderly people considerably, and it is hoped that in future more elderly people can afford to live independently from their children. Currently, (adult) children often pay for their old parents, while in advanced countries it is rather the elderly who transfer money to the younger generation.

The state also emphasizes the safety of the accumulated capital, which is brought about by a government guarantee to pay back all money that was paid into the fund, compounded by the inflation factor. At the same time, the system allows people some flexibility to invest according to their own risk preferences. Each person can choose the percentage of “risky investments” from the available options of 0%, 25%, or 50%. By the governmental guarantee the potential losses are capped; hence, this scheme provides an incentive to go for riskier assets as one would normally do.


TOUGH RESISTANCE

The new system is rejected by a significant part of the population. Protesters are gathering every day in Yerevan, highlighting its alleged disadvantages.

One argument put forward against the reform is that 10% of the gross income is too large of an amount for a pension fund in a developing country. In Armenia, the average monthly gross wage is about 150,000 dram ($370). The income tax was recently raised to 24.4% for income below 120,000 dram ($296) and 26% above it. Thus, approximately 30% of the gross salary of a citizen will not turn into disposable income, a high percentage compared to neighboring Georgia. After taxes and pension payments were made, somebody who earns the average income will be left with just 105,000 dram ($259), hardly allowing to support a family. Therefore, the protesters suggest that the state should not only subsidize the accumulation of pension money, but pay the full 10% from the government budget.

A more fundamental concern is the mistrust of many people regarding the government’s willingness and capability to keep its promises. The collapse of the Soviet Union about 23 years ago was not only a political crisis, but also left most of the population without a cent, as ruble accounts held at Soviet banks were confiscated. Since the early 90’s, the Armenian government promises to refund those people who suffered from these losses, but nothing happened. This created a psychological barrier preventing people from trusting long-term projects in Armenia.

The main problem, however, is the highly volatile exchange rate of the Armenian dram (AMD) vis-à-vis the dollar (USD). Looking at the chart, one can hardly consider the dram to be a stable currency.

 

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As one can see, between 2000 and 2013 the nominal exchange rate was ranging between 300.73 and 591 dram per dollar. As much of the consumption basket of Armenians is comprised of imported goods, locals use to keep their deposits and cash in USD, even if there is a huge difference in the interest rates (currently, the deposit interest rate is 7% for dollar accounts and 14.5% for dram accounts p.a.). In future, people will be forced to save money for their retirement in dram. The government guarantees the return of at least the 10% of income plus inflation rate to each pensioner, but the exchange rate risk remains with the pensioners.

In the debate some politicians expressed their concerns that the new system would make it quite difficult for small and medium enterprises to pay competitive wages. The contributions paid to the pension fund are flowing back to the citizens when they retire, yet people are not aware of that or they do not trust the government to safeguard their claims. Therefore, employees mainly care about net income, and, so the argument goes, competing companies will be forced to reimburse their employees for the perceived loss of income. This however, is not a convincing argument, as all companies in Armenia are affected by this change, so that – given the low downward elasticity of labor supply in a market with unemployment – employers can shift the additional burden to their employees.

In summary, one has to acknowledge that the Armenian government is pushing a reform which is costly immediately but generates returns just in the long run. Such reforms are notoriously unpopular with the electorate, and hence it requires strong political will and determination to get them through in a democracy. If things turn out well, poverty among the elderly will be reduced. Moreover, a large share of the accumulated money will be invested in the Armenian economy (about 80%), improving the availability of capital. This capital is urgently needed for fueling Armenian economic growth.


 

About the authors: Aram Derdzyan holds an MA degree in economics from the International School of Economics at TSU (ISET).  He is head of the Young Researchers Organization Armenia (www.researchers.am) which provides assistance to university graduates who want to pursue an academic career. In addition, he is a teaching fellow of the CERGE-EI Foundation. Also Astghik Mkhitaryan is a teaching fellow of the CERGE-EI Foundation. She holds an MA in economics from the International School of Economics at TSU (ISET) and a Master’s degree in Business Management from Yerevan State University.

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Guest - Vardan on Friday, 20 December 2013 14:01

If it is true that 80% of funds are going to be invested in Armenia, I wonder how is the riskiness scale measured. At the same time, given there are almost no investment opportunities available on the financial market. Wouldn't we end up just lending longterm to the state, while the only way to invest in the local market would be to by government bonds? Finally, I cannot be sure how it is at the moment, but for many years Armenian banking sector had excess of liquidity preferring not to invest/lend due to what they claimed to be high risks. What if they (banks) are right and the pension fund is just a scheme to bypass prudence of banking sector and impose risks on the large part of population by applying this compulsory contribution approach.

If it is true that 80% of funds are going to be invested in Armenia, I wonder how is the riskiness scale measured. At the same time, given there are almost no investment opportunities available on the financial market. Wouldn't we end up just lending longterm to the state, while the only way to invest in the local market would be to by government bonds? Finally, I cannot be sure how it is at the moment, but for many years Armenian banking sector had excess of liquidity preferring not to invest/lend due to what they claimed to be high risks. What if they (banks) are right and the pension fund is just a scheme to bypass prudence of banking sector and impose risks on the large part of population by applying this compulsory contribution approach.
Guest - Lasha on Tuesday, 14 January 2014 14:04

I wonder what does government guarantee mean and how losses are capped, or what is "government" money.
It is very difficult reform that should consider political commitment and long term economic forecasts.

I wonder what does government guarantee mean and how losses are capped, or what is "government" money. It is very difficult reform that should consider political commitment and long term economic forecasts.
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