Attachment 8 - Annex 1.doc

ANNEX I

Country Background and Donor Assistance to Armenia

1.

ARMENIA:

COUNTRY, MACROECONOMIC AND FISCAL BACKGROUND

Armenia is one of the most ethnically homogenous countries in the world with an estimated population of about 3 million people of whom 64% were urban residents and 36% - rural, and each third Armenian citizen lives in the capital Yerevan. It is bordered by Georgia, Azerbaijan, Iran, and Turkey. It is land-locked and about 29,800 sq. km in size. Administratively, it has 10 regions (marzes) plus its capital city, Yerevan.

In 2008, 19.7% of the population was under age 15, 69.5% was between the ages of 15 and 64, and 10.8% was over age 65. Males were 48.3% of the population and females were 51.7%. Average life expectancy at birth in Armenia is the highest among the Commonwealth of Independent States (CIS) countries, 73.5 years for the total population, 70.2 years for males and 76.6 years for females (2007).

During the 1970s and 1980s Armenia was a highly industrialized Soviet republic where industry accounted for more than two-thirds of net material product and employed half a million workers. A major setback to the industrial sector occurred as a result of a 1988 earthquake, which resulted in a loss of nearly 40 % of the country’s productive capacity. The subsequent breakup of the Soviet Union combined with the collapse of its trade and financial system, dealt another crippling blow to Armenia’s industrial capacity and jobs crisis.

In 1994 a cease-fire was declared between Armenia and Azerbaijan in their war over the ethnic Armenian enclave of Nagorno-Karabakh (NK). Armenia’s borders have remained closed with Turkey (which sides with Azerbaijan on the NK issue) and Azerbaijan since 1989, forcing to import energy supplies, raw materials and food from other countries. Land trade routes through Georgia and Iran are either inadequate or unreliable.

The recent conflict between neighboring Georgia and Russia has demonstrated Armenia’s vulnerability to disruptions in transport (70 percent of Armenian imports are shipped through Georgia), temporary fuel shortages and trade interruptions, but had limited impact on production, consumer confidence, and domestic prices.

The GOAM began ambitious economic reforms following the ceasefire. Since then, the Armenian economy has performed strongly by most macroeconomic criteria, particularly since 2000. Prudent monetary and fiscal policies, together with a flexible exchange rate regime, delivered double digit growth and low inflation, and a notable reduction in poverty. Armenia has been one of the fastest-growing transition economies in the past decade, reaching an average annual rate of 11.8 percent between 2001 and 2008. This strong performance was underpinned by sustained macroeconomic discipline, but also reflected a favorable global environment, and large-scale foreign exchange inflows (remittances, FDI and international donor assistance). But economic diversification was limited as growth performance remained narrowly based on remittances and construction boom.

Whereas the overall poverty rate has continued the downward trend begun in the late 1990s, falling from 51 percent in 2001 to 25 percent in 2007, it is still high and more progress is needed to reach the Millennium Development Goals. Suppression of extreme poverty remains a big challenge, with 3.8 % households living in extreme poverty (2007). The extremely poor did not gain from economic growth. Wages for minimum-wage earners do not cover basic needs, with 36.4 % of the poor being “working poor”.

Armenia’s state budget revenues have not kept pace with the country’s double digit economic growth. Tax revenue buoyancy is very low compared with other CIS countries. The tax-to-GDP ratio grew to a less-than-targeted 14.5 percent by 2006 and reached 16.4 percent by 2008, reflecting limited progress in reforming revenue administration even though total public spending decreased by 0.7 percent of GDP during 2003–07.

Tax policy deficiencies, such as exemptions and weaknesses in tax and customs administration, continue to hinder efficient and transparent revenue mobilization. As a result, the expenditure side of the budget remains constrained. The level of social expenditures and public investment spending (10.3% and 4.5% of GDP respectively in 2008) is very low by international standards, thereby limiting much-needed progress on the social front. To deliver social protection benefits and services efficiently, GOAM needs to develop institutions with the appropriate level of administrative capacity, while at the same time promoting NGO involvement to help households increase their livelihoods and individuals increase their human capital development.

Armenia has taken great strides to improve its economic and social framework, but the progress with structural reforms has been uneven. For example: reforms in the financial area, where ownership was strong, were more successful than in tax policy and tax/customs administration, where vested interests resisted the comprehensive approach necessary to create an efficient and fair tax system. The policy mix of sound fiscal and monetary policies combined with exchange rate flexibility has been measured. However, macroeconomic imbalances are growing. As such, the IMF is encouraging GOAM to continue (i) increasing budget allocations for social services in order to ensure that salaries and infrastructure are adequate to provide quality services and (ii) improving the efficiency and equity of social spending.

In early 2008, a new government was formed in Armenia under President Serzh Sargsyan with a mandate to reform tax policy and administration. A comprehensive and well-targeted plan for modernizing the tax administration has been adopted in conjunction with the merger (August 2008) of tax and customs administrations in a single State Revenue Committee (SRC) that is expected to yield efficiency gains in administrative and management systems, such as Information Communication Technology (ICT) systems, provided that reforms are implemented vigorously.

The started overhaul in tax and customs administration is a major step to butters competitiveness by enhancing the business climate, since it should contribute to scaling down the shadow economy and discouraging tax evasion (thus promoting financial deepening), while creating room for productivity-enhancing infrastructure, capital investments and pension reform. GOAM will need to balance the need to boost social spending to meet Poverty Reduction Strategy objectives with the need to limit the fiscal impulse in order to control inflation, which mostly affects the poor. Strengthened tax collection and strong revenue performance are crucial to the financial sustainability, fiscal affordability, and adequacy of the reformed social protection system. However, lack of political support and the current economic downturn could jeopardize the government’s ambitious reform programs, particularly the pension and tax collection reforms.

Monetary and fiscal policies improvement would require a sustained revenue effort and better spending prioritization to make room for infrastructure and social needs, especially in view of prospects for lower grants and GDP growth rates in the medium term. However, plans to increase pension outlays, introduce a funded pension pillar, and build a new nuclear power plant are expected to put pressure on the budget in the coming years.

As most low income and emerging economies, Armenia has been significantly affected by the deepening global financial and economic crisis. Events originated outside the region, combined with shortcomings in policy and institutions within it, now pose major economic risks of instability and recession. The implications of global downturn on Armenia’s economy result from : (1) slowdown in remittances flows, (2) reduction in trade and investment, (3) problems originating from the financial sector, and (4) reduction in official assistance.

The financial crisis, with the attendant slowdown of world economic growth, has reduced demand for Armenia’s exports. The concentrated structure of Armenia’s exports—six countries account for nearly 70 percent of the country’s exports—increases the country’s vulnerability to a negative impact arising from a shock to a major trading partner.

The production base is undiversified, and the economy continues to be heavily dependent on remittances to finance its large and growing trade deficit. A collapse in world oil prices has lead to a protracted downturn in Russia and a significant reduction of remittances , private transfers, and foreign direct investment (FDI) inflows to Armenia from Russia. Depressed economic activity and growth prospects could easily trigger heightened tensions as severe economic and social consequences mount.

The global economic downturn seriously threatens the robust poverty reduction that Armenia enjoyed in recent years. According to the World Bank, the overall poverty incidence in Armenia could increase by about 5.2 percent between 2008 and 2010 - from 23 percent in 2008 to 28 percent in 2010 affecting about 900,000 people. This assumption is based on a protracted crisis scenario, with the economy contracting by 8 percent in 2009 and by 2 percent in 2010. According to the National Statistical Service (NSS), in 2004 the poverty level in Armenia was 34.6%, in 2005 - 29.8%, in 2006 - 26.5%, in 2007 - 24.9%, in 2008 - 22.7%. The increase in extreme poverty and poverty gap could be more pronounced as the already poor become poorer, and the extreme poverty level may increase from 3.2% in 2008 to 8.7% in 2010, reaching up to 300,000 people.

According to the Ministry of Labor and Social Affairs, the poverty threshold for 2009 is set at 25,964 AMD per capita ($69 at 375AMD per $1USD exchange rate) and the extreme poverty threshold for 2009 is 17,225 AMD ($46).

There are multiple channels through which the economic crisis could affect household welfare and poverty in Armenia. The overall slowdown in growth and the inefficient labor market are the main channels for transmitting the impact of the economic crisis to households, accounting for two thirds of the increase in overall and extreme poverty between 2008 and 2010. The projected decline in remittances accounts for 20 percent of the poverty increase. Remittances in Armenia have three specific distinctions: they mostly come from one country (Russia), they are often paid to persons other than immediate family members, and they are often used for investment. Since about 80 percent of Armenia’s migrant workers work in Russia, which is facing a severe economic slowdown, the impact on households depending on remittances would be very large. The remaining is attributed to price changes due to exchange rate adjustment and utility tariffs increase from April 1, 2009.

Banking sector in Armenia remains relatively unimportant, in terms of its contribution to GDP and employment, and also in terms of its ties with the households through borrowing and lending. Finally, banks have limited capacity to secure long-term funding for lending, particularly in the current uncertain global environment. GOAM and the CBA have pressed ahead with reforms to strengthen the financial sector infrastructure, to improve financial sector transparency and consumer protection. A comprehensive program of securities market development has been launched by the CBA and the new stock market operator NASDAQ-OMX. An insurance registry has been established at the CBA.

While Armenia has made significant strides in financial sector reform, additional efforts are needed to boost competitiveness, notably by improving the business environment and the usage of modern ICT. While some progress has been made, the cost of doing business in Armenia remains high, and a large part of economic activity remains underground. The World Bank’s “Doing Business 2009” report shows a slight deterioration in Armenia’s position (from 41st to 44th rank), notably in categories such as ‘starting a business’ and ‘trading across borders.’ Yet, ‘paying taxes’ remains the worst category by far, with Armenia slipping from 147th to 150th place. The ICT sector’s competitiveness rating is also very low - Armenia is ranked just 106 out of 127 countries for the ICT network readiness. This low ranking is due to an outdated ICT infrastructure and regulatory environment, as well as poor government readiness and usage of ICT.

Armenia’s weak business environment discourages economic diversification, hinders export growth, and accentuates Armenia’s dependence on foreign exchange inflows and its vulnerability to external shocks. The government’s intention to press ahead with overdue reforms is a welcome step towards making the economy more resilient to future economic and trade shocks and disruptions in foreign exchange inflows.

2.

OTHER DONORS AND INTERNATIONAL COLLABORATORS IN PENSION AND LABOR MARKET REFORMS

USAID is the major donor in the social protection domain and meets regularly with other donors and international agencies to coordinate and maximize resources. Although the MLSA does not yet convene regular donor roundtables, the Ministry does encourage donors to meet and share information, and arranges and participates in such meetings. Particularly, USAID coordinated its pension and other social protection reform efforts with other donors such as World Bank, IMF, UNDP, EU, SIDA, ILO and others. In the pension reform area, USAID has been a major donor providing technical assistance in close coordination with the World Bank and the IMF. Regarding labor market reform interventions, USAID coordinates its activities with the World Bank, EU, UNDP, ILO and SIDA.

The World Bank The development objective of current World Bank three-year $5.15 million Armenia Social Protection Administration (SPA) Project is to improve performance (efficiency, effectiveness and quality) in providing social services to the population. The SPA project has been aimed to improve the administration of public sector social protection programs through human resource and institutional capacity development, including the installation of information technology networks nation-wide, by working in four technical components: (1) general support to the social protection sector, including the development of management information systems (MIS); (2) improving labor and employment by increasing the efficiency and effectiveness of the State Employment Service Agency in labor market intermediation and support labor reform; (3) modernization of pension system administration, including operational improvements in key business processes related to the management of the central register, and improving general and financial management in the State Social Security Service ; (4) social assistance refinement to improve poverty targeting by supporting community-focused household surveys and developing in-depth monitoring and evaluation system.

In addition, in 2006-2008, the World Bank conducted studies on Armenian Labor Market Dynamics and Teachers Displacement Program (available at http://www.worldbank.org.am), and provided significant support to GOAM’s Pension Reform Working Group through the short-term technical assistance consultants groups. In November 2008 the Bank provided detailed comments on Armenia Pension White Paper (November-2008).

International Monetary Fund (IMF) IMF provides regular Poverty Reduction Strategy Paper reviews under the Poverty Reduction and Growth Facility (PRGF) 3-year arrangement. According to its latest Staff Report, under the 2005-08 PRGF-supported program, Armenia achieved a marked reduction in poverty within a high-growth and low-inflation macroeconomic environment . The new (low-access) IMF/PRGF-supported program builds on these achievements and addresses unfinished reform issues. In addition, IMF provided valuable comments on the Pension Reform White Paper.

UNDP

In 2006-2008, UNDP provided technical assistance to 27 VET institutions in Yerevan and marzes through its Modernization of Vocational Education and Training Project that had two main objectives: (1) creation of proper physical infrastructure in vocational training institutions through rehabilitating facilities and providing new equipment in the selected institutions; and (2) ensuring sustainable VET system development by initiating policy dialogue to meet labor markets demand.

In 2009, UNDP launched a new three-year, $2.7 million project (funded by the Government of Denmark) to continue its support to vocational education modernization in Armenia. The project incorporates six main components: 1) development of state qualification standards, (2) strengthening linkages with the labor market, (3) acquisition of laboratory equipment for 12 pilot colleges, (4) development of teaching materials, (5) conducting VET faculty training, and (6) capacity building for the Ministry of Education and Science as well as the National Center for VET development (www.undp.am; www.vet.am). The UNDP VET reform project supports the implementation of a preliminary and middle professional education strategy in Armenia as part of an assistance package aimed at pro-poor rural development through business and trade skills development. The project also seeks to increase youth employability for VET graduates in occupations relevant to the country’s economic growth with special emphasis on regional labor market demands.

The European Union (EU)

Before 2007 the EU provided technical assistance to Armenia under the former EU-TACIS program that focused on continued support for institutional, legal and administrative reforms as well as on support to address the social consequences of transition, including essential assistance to implement the Poverty Reduction Strategy (PRS). In 2007, the EU adopted its new technical assistance Action Plan for Armenia for 2007-2013 under the European Neighborhood and Partnership Instrument (ENPI). The EU/ENPI assistance is going to address the key issues of poverty reduction, economic growth, and the reduction of social inequality, concentrating especially on comprehensive actions at regional and local levels (e.g. enhanced access to and quality of social services, in particular education and vocational training).

The EU-supported €15 million, four-year (2009-2012) Vocational Education and Training (VET) Modernization Program in Armenia is focused on non-targeted budget support to: (1) introduce a competency-based vocational education and training standards; (2) modernize quality monitoring mechanisms; (3) create technical support and quality assurance infrastructure; (4) improve cost efficiency and educational outcomes; (5) optimize VET system financing; and (6) build national capacity for VET modernization implementation and monitoring. Consequently, the EU is a major player in the VET system reform.

International Labor Organization (ILO)

The GOAM signed a technical cooperation agreement with the ILO in November 2004. Priorities for the cooperation between the ILO and Armenia for 2007-2011 were formulated in a Decent Work Country Program (DWCP) signed in March 2007 by the ILO and the tripartite partners - GOAM, employers’ and workers organizations. The program outlines policies, strategies, and expected results necessary to progress towards decent work and aims to assist the social partners to use labor market analysis effectively in formulating and implementing labor market policies. The ILO is providing technical advice and capacity building assistance to help the GOAM improve its laws and practices concerning the recruitment, oversight, and protection of migrant workers. The ILO has also helped to set up the State Labor Inspectorate (SLI) in 2005 with more than 140 inspectors covering all regions of the country, draft a Labor Inspection Law and the new Labor Code, and it is continuing its support to improve the national occupational safety and health (OSH) system under the DWCP. Further development assistance regarding improving the legal basis for social partnerships and social dialogue, including sector and enterprise level collective bargaining and the promotion of bipartite and tripartite commissions (public authorities, employer’ and workers’ organizations), is anticipated.

The Swedish International Development Agency (SIDA) SIDA has been funding a joint Swedish-Lithuanian labor market reform program since 1999 to strengthen overall administration of the central SESA office and its two regional employment centers in Yerevan, Gyumri and Vanadzor (SEK 24,035,000 or $2.64 million to date). Main technical assistance has been provided to establish a flexible and well-functioning labor market by providing short-term trainings for SESA’s staff in 18 local offices and study tours for MLSA and SESA. The project will be phased out in June 2009.

Annex 2 - GOAM Pension Reform Program 12-23-2008

Government of the Republic of Armenia

Decree N 1487-N

13 November, 2008

On Approving the RA Pension Reform Program and Pension Reform Implementation Schedule The Government of the Republic of Armenia, decides:

1. To accept the report of the working group formed by the RA Prime-Minister’s Decree N 599-A of August 4, 2006 on “Establishment of the Pension System Reform Working Group” (no longer in force by the Prime-Minister’s Decree N 618-A of August 15, 2008).

2. To approve:

1) the RA Pension Reform Program (hereinafter, program) as per Appendix N 1,

2) the schedule of events ensuring pension reform implementation (hereinafter, schedule) as per Appendix N 2.

3. To give tasks to the RA Minister of Labor and Social Issues, RA Minister of Finance, RA Minister of Economy, RA SRC head and propose to RA Chairman of Central Bank to take measures to ensure the implementation of the reform program within planned schedule by submitting suggestions for increasing the efficiency of work done, if needed.

4. To recognize the Decree of RA Government N 796-N of May 26, 2006 on “Approval of RA Pension System Reform Concept” no longer in force.

5. This Decree comes into force starting the day following official publicity.

December 23, 2008

Yerevan

Appendix N 1 of RA Government Decree N 1487-N of November 13, 2008

PENSION REFORM PROGRAM

OF THE REPUBLIC OF ARMENIA

The Program of the RA Government approved by the National Assembly has inscribed the political decision of authorities to introduce a multi-pillar pension system in Armenia. In order to execute this decision, implementation of the pension reform is anticipated in the 2008-2012 Government Action Plan which is targeted at the achievement of the following crucial outcomes:

1) Annual increase of the pension sizes thereby ensuring pensions equivalent to the minimal consumer basket, by ensuring the average occupational (insurance) pension amount.

2) Establishment of a link between the income of the individual and amount of the pension by introducing the mandatory funded pension system.

Problems of Existing Pension System of Armenia (situation analysis and findings)

Current Situation

1. Currently a PAYG pension system is operational in the Republic of Armenia. Before January 2008 it is financed from current contributions paid by employed citizens and the mandatory social insurance contributions of their employers. Mandatory social contributions accrue on the account of the Social Insurance (Pension) Fund and are fully used for payment of current pensions. The principle of “financial equilibrium of the Fund” is followed which implies that the payable pensions should be equivalent to the collected social contributions. This means that existing employees secure the payment of current pensions to persons of non-working age.

3. In 2008 pension expenditures will be 4.3% of the GDP thus constituting the largest component of social sector expenditures of the consolidated State budget which exceeds the expenditures for the health sector 3 times and those for the education sector 1.6 times. Even this level of pension expenditures is not adequate for ensuring an average pension which is equivalent to the minimum consumption basket. The upward adjustment of pension sizes can be feasible either by increasing the rate of mandatory social contributions or by other tax revenues. The commitment of ensuring the fiscal sustainability of the pension system is a constraining factor for increasing pensions significantly solely at the cost of collected mandatory social contributions not increasing their rates. Therefore, based on the Government Decree, in January 2008 the State Social Insurance Fund was reorganized as a service operating in the governance field of RA Ministry of Labor and Social Issues. The mandatory social insurance budget was taken away and mandatory social insurance contributions were included in the general revenues of the state budget which made it possible for a 60 percent increase in pensions which allowed a at the expense of general revenues of the budget. Obviously, further upward adjustment of pensions and their long-term subsistence will be a “heavy burden” for the State budget.

4. The situation will aggravate in tandem with the unfavorable demographic trends which are linked to the reduction of the birth rate, increase of the average life expectancy.

One of the reasons for the aggravation of the projected situation in the pension system is also the “birth boom” following World War II. It is the generation born during the “birth rate boom” period that will retire over the coming years. This will be complemented by the phenomena which occurred during the last 20 years, namely, the decrease of birth rate, increase of average life expectancy and extensive emigration of working age individuals in the 1990s. As a consequence, like in many countries of the world, aging of population is also recorded in Armenia.

5. In addition to the above described problems, the existing PAYG system faces the problem related to the absence of any direct link between paid contributions and pension sizes. Employees are not motivated to make pension contributions to a system. Employers also avoid paying mandatory social contributions and tend to conceal the actual number of their employees and to underreport the amounts of actually paid salaries.

6. Thus like other transition countries, Republic of Armenia faces three socio-economic challenges:

1) Demographic problems (“aging of population”),

2) Existence of a large informal economy,

3) Rapid and increased recovery of incomes.

The impact of these challenges on the pension system is demonstrated by a decline in the financial sustainability and measures of pension adequacy (replacement ratio), as well as deterioration of other pension system indicators.

Problems of Financial Sustainability of the System

7. The issue of financial sustainability of the pension system is crucial for any country facing the problem of aging population. Demographic analysis projections for Armenia also testify about serious shifts in the age structure of its population. Thus, compared to 1990, at the beginning of 2008 the proportion of children aged 0-14 in the overall population number decreased 1.6 times while the proportion of individuals aged 65+ increased 2.1 times. The financial sustainability of the pension system is directly dependent on these indicators because the quantitative potential of contributors to the system declines, and this is accompanied by an increase in the number of individuals “feeding” on the system. In fact, the dependency ration of the system is higher as in addition to the old-age pensioners the system also covers persons of non-retirement age (persons with disabilities, survivors, recipients of privileged pensions, etc.).

8. A key factor which influences the financial sustainability of the system is the number of contributors which are nearly 5 times lower than the indicators of working age (15-63) population. The analysis of the Armenian labor market shows that the gap between these two indicators is due to the fact that the real unemployment rate is around 3 times higher than the official rate, informal employment sector is large, and part of the formal employees do not pay social contributions (in terms of payment of social contributions, farmers are also “informal” workers since they are exempt from payment of mandatory social contributions.). As a result, the pension burden is distributed among a smaller number of working age population which in turn predetermines the trend of worsening the dependency ratio of the pension system. This ratio was close to 1 in 2008, i.e., one pensioner per contributor.

9. Expert estimations have shown that a system can be financially sustainable if this ratio equals at least 3:1. Actuarial calculations show that through 2050 the dependency ratio of the pension system will be in the range of 1.0-1.1 which means that the system will appear in a situation of “lasting financial crisis”, and over the period from 2050 to 2065 a financial collapse of the system is expected (If the share of shadow and informal economy to GDP remains unchanged, then the number of pensioners will be above the number of contributors as early as in 2011. However, in view of the measures anticipated under the 2008-2012 Government Program which are aimed to increase formal employment and reduction of shadow economy, the number of contribution payers will increase by 100000 persons). The major reason for this situation is, perhaps, the ratio of pensioners to contributors as a result of which the pension costs will significantly exceed the revenues from social insurance contributions.

10. The financial sustainability of the system is also dependent on the level of average salary and contribution rate calculated thereof. The higher the average salary rate, the broader the opportunities for financing the system. At the same time the question about which salary groups are the main payers of social contributions is important. Thus, analysis shows that in 2000-2008 more than 2/3 of contributors are concentrated within the group of workers whose salary is below the average salary. Furthermore, around 1/3 of contributors belong to the group of workers who are paid minimal salary. These data witness of the fact that the phenomenon of underreporting salaries by employers is rather common.

11. On the other hand, actuarial calculations show that regardless of the growth rate of average salary, if the dependency ratio of the pension system is close to 1 while the social contribution rate is 25-26%, then the average pension size in the country should not exceed 22-23 percent of the average salary in order to maintain the financial sustainability of the system. In view of deterioration of the dependency ratio any of the below actions should be taken:

1) Maintain the rate along with reducing the replacement ration( The replacement ratio expresses the ratio of average pension to average salary), or

2) Increase the rate along with maintaining the replacement ratio within certain preferable limits, or

3) Use other State budget revenues in order to cover the financial deficit of the system.

12. None of the above-mentioned, however, is a solution of the issue in terms of long-term financial sustainability. Despite the fact starting January 1, 2008 the RA Government increased the pensions by 60% at the expense of state budget general revenues, the demographic trends show that any “lump sum” increase of pensions will make the gap of ensuring financial sustainability of the system large and will not tackle the issue of providing adequate pensions to the population. Expert assessments - which are based on actuarial calculations - show that a continuous upward adjustment of pension sizes and securing minimal pension which is equivalent to the minimal consumer basket will lead to an irreversible deficit (given only the gap between social contributions collected and expenditures) of the existing system whose level will consistently grow thus reaching 1.4% of GDP in the 2020s. Under these conditions of budget deficit even the government may not succeed in preventing the decline of the pension replacement ratio. The gap between pensions and salaries cannot be filled if the existing system continues.

Breakup of the Link between Pensions and Incomes

13. A fundamental principle of pension insurance is the establishment of direct link between the contributions made by the individual and the size of paid benefits. But the existing pension system does not guarantee a replacement which is adequate to the individual’s income. The lack of the link between benefits and incomes is a disincentive in terms of contributions to the system. Presently only 37 percent of employed labor pay mandatory social contributions.

14. The existing system is particularly unattractive for high income groups of employed population. Pensions of persons receiving compensation which is above the average salary do not exceed 10 percent of their salary whereas the pension system ensures a replacement ratio over 75 percent for those who are paid a minimal salary. Employers also avoid paying mandatory social contributions by concealing the real number of their employees and underreporting the actually paid salaries. As a result, around 70 percent of social contributions are paid from minimal and below the average salaries.

15. The rapid growth of incomes of the population leads to even a greater gap between the sizes of pensions and salaries. At the same time, payment of social contributions from low salaries lessens the amount of collected contributions thereby restricting the financial possibilities for adequately increasing pensions against income growth. In this situation the issue of ensuring adequate pensions in relation to employment incomes encounters the impossibility of solving the issue of financial sustainability of the pension system. Experts estimate that the current pension system created under all equal conditions is unable to mitigate to disproportion between salaries and pensions without impairing the financial equilibrium of the system.

16. The current pension system should be radically reformed in the following directions:

1) To significantly increase of pension amounts, with the aim to firstly bring the level of poverty to a minimum, and then to eliminate poverty and poverty risk among pensioners.

2) To ensure the financial sustainability of the pension system linking the occupational incomes of the individual to the amount of pensions by introducing the mandatory funded pension system.

17. Within the context of the above-mentioned, the Government plans pension system reforms and formation of a new unified multi-pillar system based on the current state pension system.

Lessons Learned from International Experience of Pension Reforms

18. In problem of financial sustainability of “pay-as-you-go” pension systems is faced by many countries of the world as a consequence of rapid ageing of population. International experience shows that countries which have appeared in the above described situation respond to challenges by making three main transitions (transformations):

1) transition from the “pay-as-you-go” pension system which is financed by the principle of solidarity of generations to the “self-sustainable” funded system;

2) transition from the defined benefit (DB) model - where pensions are calculated based on formulas and political decisions – to the defined contribution (DC) model which is based on actual incomes(Mainly two models are used in pension systems of the world: defined benefit or defined contributions. In the former case initially the formula of the pension is defined by legislation. Then their source of financing is identified. In the second case the rate of contribution payable for accumulation is defined and the size of pensions is determined based on the amount of real accumulations and return on their investment.)

3) transition from a pension system directly managed by the State to the private pension system regulated and controlled by the State.

True to the principles mentioned above and based on the peculiarities of RA, the Armenian model of pension reforms has been designed.

19. The proposed transitions vary across countries. However, they are all covered by the general concept of “introduction of multi-pillar pension system” adopted rather by all countries which have embarked on systemic reforms. The Armenian model of multi-pillar pension system is developed based on the lessons learned from international experience and a comprehensive analysis of the social and economic situation in the country.

Description of Multi-Pillar Pension System

20. The multi-pillar pension system which will be implemented as a result of the pension reform will consist of four pillars with each pillar designed to serve its specific purpose, and each different depending on the number of years worked by beneficiaries and their age.

21. «0» pillar of the pension system secures an income from the state budget equivalent to the minimal consumption basket for the old-age, disability and survival of those persons who do not qualify for an occupational pension (do not have enough occupational (insurance) service).

22. 1st pillar compensates lost income from the state budget to persons who worked in the formal economy for the period specified by law and who paid corresponding taxes (social contributions) upon retirement, in the events of disability and survival.

23. 2nd pillar of the pension system compensates lost income from contributions made and their investment income to persons who make mandatory funded contributions upon retirement.

24. 3rd pillar secures additional income from voluntary funded pension contributions to persons of retirement age.

Pension System: Pillar 0

25. Social pension will be paid from Pillar 0 of the pension system for the purpose of ensuring minimal income in cases of old age, disability and survival to individuals who have not earned other pension rights, i.e.

1) they are considered social pension beneficiaries in accordance with the RA Law on State Pensions HO519-N of November 19, 2002 (hereinafter, current legislation).

The conditions qualifying for social pension will be maintained with increasing the minimal working service qualifying for occupational pension from 5 years to 10 years (List N 1).

26. Beneficiaries of Pillar 2 may also receive social pension, if the person does not have the required minimal work service. The assigning of the social pension does not depend on other, non-pension incomes.

27. The social pension is calculated based on the basic pension. The calculation methodology, differentiating types of pensions, as per the current legislation, will be retained.

2.1.2

Table 1. Terms for granting old age pension by length of service and years of retirement

28. The amount of the old-age social pension will amount to the 100% of the minimal consumption basked in 2018 and starting 2021, it will total 80% of the basic pension which will be in the amount of the minimal consumption basket. The size of the basic pension should be determined on the basis of actuarial calculations and the value of the minimal consumer basket.

The social pension should be granted by the State authorized body and be financed from the State budget.

29. The procedure for assignment and payment of disability and survivor’s social benefits will be maintained. In the framework of revising the model of disability status issuance the social pension calculation will also be revised.

Pension System: Pillar 1

30. Employment pension should be paid from Pillar 1 of the pension system. Employment pension represents a replacement of employment incomes of individuals.

31. Entitlement to the occupational pension corresponds to the entitlement of the current, insurance pensions i.e. the types of the insurance pensions, qualification conditions, calculation methodology will be maintained, with the exception of the above-mentioned changes.

32. The minimal working (insurance) service qualifying for old-age occupational pension will be 10 years instead of the 5 years of the current legislation.

33. In order to organize this transition smoothly the following schedule of minimal service year increase will be applied:

34. The occupational pension consists of the basic pension and additional amount calculated on the basis of the number of insurance (occupational) service taking also into consideration the individual coefficient of the pensioner.

The pension is calculated in accordance with the procedure approved by the current legislation.

35. For defining the amount of the basic pension and the value of one year’s insurance (occupational) service, the RA Government will apply the following rules and targets:

1) starting 2012, the average occupational pension shall match the minimal survival budget.

2) In 2018 the average occupational pension shall match 150% of the minimal survival budget, and the basic budget – to the minimal living budget.

3) Starting 2012, for the purposes of calculation, one year’s insurance (occupational) value, and starting 2018 the basic pension will be adjusted by the consumption price index (CPI).

36. Those individuals who wish to transition to the mandatory funded system, will also receive an occupational pension in correspondence to their service (insurance) duration before joining the mandatory funded system (before paying funded contributions), calculated in accordance with the procedure of Clause 34.

37. The government will simultaneously take measures to reform the disability and survivor’s pension system with the aim:

1) To pay this type of pensions through insurance companies,

2) To review the model of disability status issuance by transitioning to the model applied in the EU, i.e. definition of the degree of working ability. In this context the calculation methodology of disability pension will also be revised linking its amount to the degree of loss of ability to work.

38. The government will take measures to reform the long-service and privileged pension system with the aim:

1) to ensure payment of this type of pensions from the funds of the employer, including within the insurance scheme:

2) besides the mandatory professional service qualifying for the partial pension of long-service pension, to establish a requirement of minimum 25 years of total occupational (insurance) service.

39. Before making the relevant changes, assignment and payment of disability, survivor’s pensions of persons participating in the mandatory funded system and qualifying for these pensions will be carried out in accordance with the rules of the 1st pillar.

40. The occupational pension is assigned by the relevant authority and is funded from the state budget.

Pension System: Pillar 2

41. The mandatory funded pension will be paid from Pillar 2. Its purpose is to compensate the lost incomes of individuals of the retirement age in consistency with their paid contributions.

42. From January 1, 2010 the participation in Pillar 2 will be mandatory for those wage earners, sole entrepreneurs and notaries regardless of citizenship who are born on or after January 1, 1970 and/or who are below 40 at the moment of their first entry to the labor market.

43. Access to the mandatory funded component is open to: the individuals not included in the age group mentioned in Clause 42, as well as military servants and owners of agricultural land included in this age group. The individual can also voluntarily join the mandatory funded system, however will not have the opportunity to revisit this decision.

44. For those persons who became a participant of the mandatory funded system starting January 1st, 2010, the funded contribution rate will be defined in the amount of 10% of the wages and equivalent payments, half of which or 5% of wages and equivalent incomes, but not more than 25000 AMD will be paid by the state (i.e. if the wages are lower 500.000 AMD, then the state will pay in 5% of that amount, however in the event of wages higher than 500.000 AMD, the participation of the state will amount to only 25.000 AMD for each worker. Thus, the funded contribution by persons receiving wages higher than 500.000 AMD will in fact, exceed 5%).

45. For those persons who became participants of the mandatory funded system voluntarily, the funded contribution rate is defined as 5% of the wages, without the state’s participation (the state shall not make a funded contribution).

46. Regardless of his age, the participant of the mandatory funded component should pay income tax, and upon retirement the participant will be paid a basic pension against the paid income tax.

47. Individuals who have contributed to the mandatory funded Pillar 2 should receive:

1) a basic pension and funded pension if they have not reached 40 as of January 1, 2010, and at the moment of retirement have acquired the required service period.

2) a basic pension and credit for length of service (employment pension) and funded pension if they are above 40 as of January 1, 2010 and at the moment of retirement have acquired the required service period.

3) social pension and funded pension, if at the moment of retirement they did not have sufficient occupational service.

48. Individuals under 40 who have a certain record of employment service upon their entry to Pillar 2, will also receive a pension linked to his length of service (employment pension).

49. The rules for use of mandatory funded pensions are established under the respective legislation. The person may use the funded accrued on his individual account:

1) At his retirement age allowing for pension, as prescribed by RA law,

2) In the event of changing his RA citizenship.

50. Upon reaching the retirement age, the individual may use his pension assets in the following forms:

1) Programmed withdrawals, i.e., receipt of monthly pensions according to a specific scheme. In this case, the monthly pension is calculated by dividing the total accumulated amount into life expectancy at retirement (amount divided by number of months),

2) Annuities when the accumulated amounts are transferred fully to an insurance company, which undertakes to pay a certain amount of monthly pension to the person till the end of his life,

3) Lump-sum payment when in the legally prescribed specific cases the person obtains the right to receive his accrued funds through a single payment.

51. The individual may use his funded pension before reaching the retirement age only if he or she has such a disease – the list of diseases is established by the authorized body of the Government – which can lead to the death of the individual unless the health expenses necessary for treating such a disease are incurred or regardless of the incurrence or non-incurrence of these expenses the disease is terminal.

52. In case of not having or changing Armenian citizenship, amounts accumulated by the person could be used in the following forms:

4) They are transferred to the individual pension account opened in the country of new citizenship (for non-citizens – in the country of new residence), if a mandatory or voluntary funded system is operating in the given country and the appropriate legal grounds are in place for effecting a transfer of pension assets,

5) They remain in Armenia, if mandatory or voluntary funded systems do not operate in the given country and/or the appropriate legal grounds are not in place for effecting a transfer of pension assets. In this case the person should receive his accumulated funds in accordance with the Armenian legislation.

53. 2.3.14 The use of the funded (mandatory) pension should be limited to the following:

6) If the monthly annuity of accumulated funds of the person at retirement is less than 25% of the basic pension, then the person has the right to receive the accumulated amounts in the form of programmed withdrawals or lump-sum payment,

7) If the annuity of accumulated funds of the person at retirement expressed in the monthly amount is more than 25% of the basic pension, but less than the five-fold amount of that pension, then the person should use his funds by purchasing annuities,

8) If the annuity of accumulated amounts of the person at retirement expressed in the monthly amount is above the five-fold amount of the basic pension, then the person should pay part of his amount in order to purchase an annuity which covers five-fold amount of the basic pension. He may use the remainder of the amount through programmed withdrawals or lump-sum payment. Personal replacement ratio or minimal market price of the annuity may be also serve as criteria.

54. In order to calculate annuities and programmed withdrawals, the Central Depository of Armenia (hereinafter CDA) and insurance companies should use universal mortality matrixes for either sexes. The matrixes should be provided by the National Statistical Service of Armenia (NSS).

55. 50. Programmed withdrawals are calculated by dividing the sum of the accumulated funds by the number of months of life expectancy. Programmed withdrawals are calculated based on the rules approved by the Government of Armenia.

56. The main portion of the funded pension will be paid in the form of annuities, and the inheritability of annuities is a binding requirement. According to this requirement, the following types of annuities will be applied:

1) Single Life with Guarantee is the purchase of annuity for one person only, where payments stop after the death of the person. If the person dies during the guarantee period, then in accordance with the contract his heirs receive certain part (25, 50, 75%) of the amount that he has not received.

2) Survivor with Guarantee is the purchase of annuity by spouses, where after the death of…