**future.** In the best case, the enhanced portfolio will allow VEB to offer returns close to the inflation rate (zero real return).<sup>6</sup> The objective of merely preserving the real value of the accumulated contributions is extremely unusual and modest for a funded pension pillar and significantly disadvantageous for contributors. Countries tend to introduce mixed pension systems with a funded element with the purpose of achieving at least 4 to 6 percent real return in the long run. The difference based on a 40-year contribution horizon between accruing a 0 percent and a 4 percent real return means a 2 to 2.5-fold difference in final pensions and the difference between 0 and 6 percent leads to a 3 to 4-fold difference (depending on assumptions about long term real wage growth).

**A zero real return will be able to provide a replacement rate for individuals of only approximately 6 to 7 percent.**<sup>7</sup> Assuming a 40-year accumulation and 20-year payout period and 3.5 percent annual real wage growth, a zero real return will be totally insufficient to boost the total pensions of individuals. Second pillars should be able to offer much higher returns. A long-term average real return of 4 percent will be needed to reach a 13 to 14 percent replacement rate from the second pillar, while a 6 percent real average performance will be needed to reach a 20 percent replacement rate.

**Besides the problem of returns of the enhanced portfolio, the concentration of the portfolio in state linked securities does not help in reducing pension risk** . For a typical contributor, the risk of receiving a pension from the PAYG system is linked to the country’s demographics and the solvency of the government finances. Individuals who contribute to the second pillar reduce the risk of not receiving a future pension by investing in securities other than government instruments. If investments in the first and second pillars are predominantly government securities, future pensioners will be excessively dependent on the solvency of public finances. Contributors are better off by investing in diversified portfolios, which should include instruments with returns that are not significantly correlated with domestic public finances. By investing in globally diversified portfolios, contributors in the second pillar will be better secured against possible future episodes of restructuring of government debt and parametric changes in the first pillar.

**The investment regulation of the default option should not be different than the one applicable to**

**asset managers and NPFs.** The asset allocation of the default option should be defined in the best interests of the contributors, and the board of directors should be the party designing the portfolio strategy of default option, given the same restrictions applicable to asset managers and NPF. The default portfolio should serve as a benchmark for private asset managers and pension funds. The benchmark should be set with a high level of transparency.

_Pension Portfolios and International Diversification_

**International portfolio diversification is even more relevant for countries with an economic**

**structure similar to Russia’s** . Oomes and Kalcheva (2007), World Bank (2005), and other studies have

> 6 Given the structure of the corporate sector, most of the instruments will be priced close to the sovereign risk.

> 7 Replacement rate is defined as the pension as a percentage of the last wage of the individual.

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