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February 11, 2009

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Reference ID Created Released Classification Origin
09KYIV288 2009-02-11 15:09 2011-08-30 01:44 UNCLASSIFIED Embassy Kyiv

DE RUEHKV #0288/01 0421509
R 111509Z FEB 09

E.O. 12958: N/A 
REFS: A) KYIV 256 
      B) KYIV 228 
1. Summary: Ukraine's financially-unsustainable pay-as-you- 
go pension system is a leading contributor to the GOU's 
current budget crisis.  A special payroll tax is meant to 
finance this pension system, but, despite excessively 
burdensome tax rates, every year the government must pay 
more and more for pensions through regular budget revenues. 
The only immediate alternatives are to permit inflation to 
erode the real value of pensions or to fall into arrears. 
The Tymoshenko government exacerbated problems by 
significantly increasing pension payouts in recent years. 
The GOU is planning some changes to the system, like 
raising the retirement age, in order to economize, but such 
measures are unlikely to save what is essentially a sinking 
ship.  Efforts at long-term reform, to include a mandatory 
accumulation system that would ease pressure on the pay-as- 
you-go program, as well as voluntary private pension funds, 
have been halfhearted.  And while the budget crisis has 
awakened some political actors to the need for reform, 
unfortunately it will also delay the government's ability 
to actually implement the reforms.  End Summary. 
The Basic Pension System: Pay-As-You-Go... 
2. Ukraine's pension system has traditionally operated as a 
pay-as-you-go program whereby contributions of today's 
workers fund today's pensioners.  Retirement payouts are 
primarily determined by the individual's labor records and 
contributions, using a formula -- known as the "accrual 
rate" -- based the employee's average wage during the last 
five years of work.  Retirees receive a bonus in their 
payouts if they worked more than 25 years, and there are 
various other bonus payments as well.  The system is a 
social pension, as older Ukrainians who did not work or pay 
into the system still receive pensions.  The retirement age 
is currently 60 for men and 55 for women.  The Pension Fund 
of Ukraine, a quasi-independent body that reports to the 
Cabinet of Ministers and is managed by a Board with 
representatives from the government, labor unions, and 
employers, operates the system. 
3. Ukraine has a special payroll tax used to fund the 
pension system.  Employers shoulder the greatest burden, 
paying a 33.2 percent tax on their employees' wages, while 
workers contribute only 2 percent.  (Note: There are also 
some miscellaneous fees that help fund the pension system, 
but they are insignificant in comparison to this payroll 
tax.  End Note.)  While the payroll tax covers most 
workers' pensions, the government often must draw on 
regular budget money to meet shortfalls.  The government 
also uses normal budget funds to pay for social pensions 
(i.e. elderly people who did not work) and for some civil 
service and military pensions. 
... For as Long as You Can 
4. This pay-as-you-go pension system is financially 
unsustainable in the longer term.  Average nominal monthly 
pensions were UAH 751 in 2008, a 312 percent increase from 
2004 and a 57 percent increase from 2007.  Pension 
expenditures grew from 9.6 percent of GDP in 2003 to 15.5 
percent in 2008 and are expected to top 17 percent in 2009. 
The excessively high payroll tax rate for employers, at 
33.2 percent, exacerbates shortfalls in financing by 
encouraging substantial underreporting of wages.  A graying 
population also puts stress on the system; 42 percent of 
the population in 2008 was 45 years old or older (compared 
to 37 percent in 1990), and 16 percent was 65 years or 
older (compared to 12 percent in 1990).  The result is a 
growing need to bolster the system using revenues from the 
general government budget. 
5. The current Tymoshenko government exacerbated problems 
by increasing by 35 percent the accrual rate for retirement 
payments (i.e. by tinkering with the formula used to 
determine payments). 
Effect on Budget Crisis and Potential Remedies 
--------------------------------------------- - 
6. Total Pension Fund outlays in 2008 were UAH 147.9 
KYIV 00000288  002 OF 003 
billion (about $19 billion), equal to 68 percent of all 
non-pension expenditures of the state budget.  Of that 2008 
total, UAH 106.5 ($14 billion) was funded by the payroll 
tax, while UAH 41.4 billion ($5 billion) -- nearly 30 
percent of pension outlays and 16 percent of total state 
budget expenditures -- came from the state budget.  (Note: 
GOU accounting keeps funds provided for pensions through 
the payroll tax off the books of the state budget.  End 
note.)  Of that UAH 41.4 billion that came from the state 
budget, UAH 36.7 billion went to fund social pensions and 
civil/military service pensions, and UAH 4.7 billion went 
to cover shortfalls from the payroll tax for workers' 
pensions.  These figures indicate wha
t an unwieldy beast 
the pension system has become.  Preliminary planning 
foresees only a modest increase in pension funding from the 
state budget in 2009 from UAH 41.4 billion to UAH 44.2 
billion.  The government has not revealed specific 
estimates of how much will be required to cover payroll tax 
shortfalls, however, and with the government in the midst 
of a serious budget crisis (ref A) and payroll tax income 
expected to fall significantly, outlays to the pension 
system could break the bank this year. 
7. The IMF has identified Ukraine's bloated 2009 budget, 
and the budget gap caused by the pension system in 
particular, as a chief concern.  The GOU's draft 2009 
budget envisions a budget deficit of about three percent of 
GDP.  A balanced budget was a key conditionality of the 
$16.4 billion Stand-By Arrangement, but the IMF has already 
signaled flexibility, acknowledging that economic situation 
has deteriorated farther, and faster, than had been 
expected when the loan was approved last October.  While 
indicating a willingness to accept a certain deficit, the 
IMF is nonetheless expecting the GOU to address the sizable 
hole in the budget caused by the deficit at the pension 
8. The GOU is considering the following measures to reduce 
pension expenditures: 
-- Raising the retirement age to 62 for both men and women; 
-- Making it harder to work and receive a pension 
-- Gradually eliminating special pension regimes; and 
-- Replacing the flat contribution for farmers and the 
self-employed with a minimum contribution base. 
9. While these reforms, especially raising the retirement 
age, would help reduce expenditures, the potential savings 
are unlikely to balance the pension system's budget.  More 
aggressive moves, like repealing the recent 35 percent 
increase in the pension accrual rate, are politically 
unpalatable, especially with Presidential elections looming 
on the horizon (see ref B for PM Tymoshenko's recent 
comments).  Moreover, no mere tweaking of pension payments 
will be enough to provide long-term financial 
Real Pension Reform: Moving Away from Pay-As-You-Go 
--------------------------------------------- ------ 
10. The key to pension reform is to move away from the pay- 
as-you-go system. In 2004, Ukraine began a comprehensive 
reform program envisioning a three-pillar pension system: 
Pillar I, the pay-as-you-go system; Pillar II, a mandatory 
accumulation system; and Pillar III, a voluntary private 
pension system. 
11. Pillar II, the mandatory accumulation system, is the 
lynchpin of the reforms and would require all workers to 
contribute to a pre-funded, individual retirement account, 
which would eventually be managed by private sector pension 
funds.  Pillar II would reduce the pressure on Pillar I in 
the long-term and would generate substantial domestic 
savings to finance economic growth.  Pillar II requires 
that developed capital markets be in place to provide sound 
investment opportunities, however, and its introduction is 
therefore not expected before 2011.  The government's 
current fiscal crisis will likely delay introduction of 
Pillar II even further. 
12. Pillar III, voluntary private pension funds, actually 
began operations at the end of 2004.  These funds are the 
only effective, tax-favored method workers have to 
supplement their retirement income through voluntary 
KYIV 00000288  003 OF 003 
savings.  Since 2004 the number of private pension funds 
has grown rapidly, but they still remain a minor financial 
actor, with only some 450,000 participants and assets of 
under $100 million.  Pillar III is in a sense a training 
ground for Pillar II, as it is forcing the GOU to 
strengthen the legal and regulatory framework for private 
pension funds and is encouraging consolidation of the 
private pension fund industry. 
Comment: Crisis Inhibitor or Impetus of Reform? 
--------------------------------------------- -- 
13. Although pressure has been building on the system for 
years, the current budget crisis will help reveal the 
weaknesses of the current pension system and argue for 
reform.  Indeed, a USAID project working on pension reform 
reports that several political figures who previously 
opposed moving away from pay-as-you-go have now emerged as 
supporters.  On the other hand, however, the necessary 
pension reforms will cost more in the short-term, as there 
will be a period of overlap when the government has to 
fully finance the pay-as-you-go system at the same time 
that it begins pre-funding the new mandatory accumulation 
system.  In the current atmosphere, there is simply no 
fiscal space for such reform.  End Comment. 




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