FRAMEWORK FOR INTRODUCING A SECOND-PILLAR PENSION SYSTEM IN AZERBAIJAN

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JIBE, Volume 20, Number 2, 2020 ISSN: 1544-8037
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FRAMEWORK FOR INTRODUCING A SECOND-PILLAR PENSION SYSTEM IN AZERBAIJAN
Audrius Bitinas, Vilnius University, Lithuania
Alessandro Fiori Maccioni, University of Sassari, Sassari, Italy
dx.doi.org/10.18374/JIBE-20-2.6
ABSTRACT
This paper presents a possible framework for implementing the second-pillar pension system as called for
by the Law “On Labor Pensions” of the Republic of Azerbaijan. The proposed option consists of a defined
contribution plan, in which both employee and employer contribute on a regular basis, with partial support
of government. Simulating the effects for representative workers shows that, even in the most pessimistic
scenario, participants in the second-pillar system who reach pension age can maintain a viable standard
of living at retirement. This result is even more pronounced for workers in the lowest income group,
because of the redistributive effect of the proposed reforms.
Keywords: Pension law; second pillar; income inequality, Azerbaijan.
1. INTRODUCTION
The aim of pension system reforms in Azerbaijan in 2017 has been to increase the efficiency, to ensure
the adequacy and to consolidate the financial sustainability of the pension system by introducing
measures against economic shocks. The Law on Labor Pensions was approved by Azerbaijani
Parliament on March 10, 2017, and was amended by Presidential decree on May 1, 2017. According to
these amendments, the required length of work experience has been increased, with the exception of
police and military personnel. Another change has been the transfer of a larger share of the paid
contributions into the individual pension account of workers for compulsory state social insurance.
On July 1, 2017, further amendments came into force indicating the definition of funded part of individual
pension account, which can be financed voluntarily by the worker in order to get a higher labor pension.
This provision paves the way for the introduction of a second pillar in the pension system. However, no
method of determining the contribution to this funded part has been defined yet. A proposal in this sense
is advanced in this paper.
2. PROPOSED FRAMEWORK
2.1 Benefit
The proposed funded pension scheme involves the active participation of employees, employers, and the
political-administrative system, as described in the following. Participation is also open (with a specific
formula of contribution) to self-employed workers and to farmers.
According to Article 10 of pension law, the amount of an old-age labor pension is calculated as the sum of
an insurance (first-pillar) part and a funded (second-pillar) part. The latter corresponds, in monthly
amount, to the pension capital accrued in the funded part of the individual pension account, divided by the
coefficient set by law (which is currently 144).
Workers unable to fulfil pension requirements, according to Article 7 of pension law, will not receive the
first-pillar pension part but only, at the age of 67, the minimum state social-assistance benefit. In our
proposal, these individuals shall also receive the second-pillar pension part, calculated as above.

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2.2 Formula of contribution
Contribution to the funded part of the individual pension account should be based on the following
formula: 2% +1% +1%.
For persons working as employees, the formula 2% +1% +1% means that contributions to the funded part
are calculated as follows:
 2% deducted from the employee’s own wage, paid as additional social security contribution;
 1% of the employee’s wage, additionally paid by the employer;
 1% of the country average income, paid from the state budget.
For persons working as self-employed, contributions to the funded part are calculated as:
 2% of the worker’s own income, paid as additional social security contribution;
 1% of the worker’s own income, withdrawn from the mandatory contribution due to first-pillar part,
and up to its full coverage;
 1% of the country average income, paid from the state budget.
Farmers will calculate contributions by using the minimum wage, instead of their own income, with the
same formula of self-employed persons. Furthermore, self-employed persons who are in a simplified tax
regime can calculate contributions according to their own turnover.
2.3 Tax incentives
We suggest that the Government provides tax incentives, subject to budget availability, for participation in
the second-pillar system. For coherence with first-pillar regulations, the preferred options would be:
 the complete tax exemption of investment earnings and pension benefits;
 the deductibility from income tax of payments for contributions by workers and employers.
Deductibility of contributions can be full or partial, depending on budget constraints. Notably, the full
deductibility presents a higher advantage for workers in the highest income tax bracket. Therefore, this
measure can be accompanied by compensatory benefits for the other workers, in order to ensure that all
income groups have a proportionally equal incentive. Compensatory benefits can be in the form of
additional government top-up of the funded part of individual pension accounts.
Tax deduction provides a benefit, in proportion to income, equal to the rate of contribution multiplied by
the marginal income tax rate. According to fiscal regulations in 2018, income tax rates are:
 25% of annual income exceeding 30.000 AZN;
 14% of annual income between 1.860–30.000 AZN;
 0% of annual income below 1.860 AZN.
Therefore, given a proposed rate of contribution to 2nd pillar equal to 2% of workers’ income, assuming its
full deductibility from income tax, and introducing compensatory benefits for workers below the highest
tax bracket, we obtain the following incentives:
 0,5% tax deduction for workers earning more than 30.000 AZN annually;
 0,28% tax deduction and 0,22% government top-up of pension account, for workers earning
between 1.860–30.000 AZN annually;
 0.5% government top-up of pension account, for workers earning less than 1.860 AZN annually.
The above formulation ensures neutrality among the different income groups, because it provides them
an equal incentive in proportion of their income.

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2.4 Participation of workers
Participation to the second-pillar system shall be voluntary. However, in return for the strong government
support, participants should make a long-term commitment to save for retirement. Workers shall be
allowed to temporarily suspend their contributions, when desired, without penalty only after 5 years of
contribution, and for a maximum of 12 cumulative months during all pension accumulation period. Early
withdrawal of the pension capital accumulated in the funded part can be allowed in full under exceptional
circumstances prescribed by law, and partially (with a maximum of 20%) after ten years of contribution.
To encourage participation, employees shall be automatically enrolled in the second-pillar pension
system unless they explicitly express the decision of not participating. Indeed, the introduction of auto-
enrolment has proven to be effective in improving participation in voluntary pension schemes by young
workers, those who have traditionally been the least likely to save for retirement (see for example Foster,
2017).
2.5 Administration
Contributions to the funded part of pension accounts shall be paid (by the worker or, for employees, by
the employer) together with mandatory social contributions. Therefore, contribution for each worker to the
first and second pillar system, will be made through a unique payment to the responsible public authority
(currently, the State Social Protection Fund). The authority will ensure the transfer of resources of the
funded part, to the pension fund chosen by the worker. Conversely, at retirement, the pension fund will
transfer to the same authority the pension capital of the worker, accumulated in the funded part.
Voluntary retirement savings might initially be managed by a unique public national entity and, at a later
stage, by new private pension funds, licenced by the Government. The involvement of private entities can
be a valid policy to improve growth in the insurance sector of the country; see for example Gavriletea and
Karimov (2015) and Bulut and Hasanova (2013). The supervision of second-pillar pension funds shall be
entrusted to the Ministry of Labor and Social Protection in matters of administration, policy and
governance, and to the National Bank of Azerbaijan in matters of performance and risks.
3. METHODOLOGY
The effects of the proposed reforms have been studied using standard actuarial techniques that describe
the life-cycle relationship between workers and the pension system. Projected mortality tables have been
estimated through regression techniques by extrapolating past trends among population of Azerbaijan in
the period 1990-2016. For useful reference, see Pitacco (2004), chapter 5 in Iyer (1999) and Benjamin
and Pollard (1993).
The actuarial model has been customized as follows. The first-pillar pension part has been modeled
according to the Law on Labor Pensions of the Republic of Azerbaijan. The second pillar has been
modeled according to the regulatory framework proposed in Section 2. During working years, the model
estimates the life evolution of workers and their contributions to the pension system. During retirement
years, it estimates the benefits paid by the welfare system to the retired workers, until death. W orkers
have been considered individually, to study the effects of regulation on their behaviour and to assess the
economic incentives for participating in the system. We assume that the proposed reforms take place in
2020.
4. RESULTS
We simulated the effects of the proposed reforms for two male workers born on 1995 and 1985, thus
aged 25 and 35 at their initial contribution to the pension system. We assume that their contribution to the
pension system (first and second pillars) is constant during working life until retirement age. Their monthly

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income has been assumed ranging, in the simulations, from 150 AZN to 1.200 AZN (real values in 2020
prices). We compare such income with the initial monthly pension, given by the sum of first and second
pillar parts, assuming different rates of return on investments of the funded pension scheme.
The main results of the simulations are shown in Table 1 and summarized in Figures 1 and 2.
Replacement rates obtained in the simulations suggest that, even in the most pessimistic scenario of
financial returns, participants in the second-pillar system who reach pension age would maintain a viable
standard of living at retirement. Furthermore, workers in the lowest income group can even improve their
standard of living at retirement, because of the state-guaranteed minimum amount of the first-pillar part
(set by Article 6.1 of pension law) and of the redistributive effect of state support to the second-pillar part
of pension.
Table 1. Pension of a male worker, participant in the second-pillar pension system, for different levels of
income and rates of return on pension investments (real values in 2020 AZN). Source: created by the
authors.
A) Worker born in 1995
Monthly
income
(in 2020
manats)
2nd-pillar
total
contribution*
2nd-pillar
total
capital**
Monthly pension
Replacement
rate
1st-
pillar
2nd-
pillar
Total
Rate of return: 2%
150
1.323
8.452
110
59
169
112,5%
300
2.645
11.766
197
82
279
92,9%
600
5.291
19.023
394
132
526
87,6%
1.200
10.581
33.539
788
233
1.020
85,0%
Rate of return: 3%
150
1.323
10.620
110
74
184
122,5%
300
2.645
14.782
197
103
300
99,8%
600
5.291
23.901
394
166
560
93,3%
1.200
10.581
42.138
788
293
1.080
90,0%
Rate of return: 4%
150
1.323
13.477
110
94
204
135,7%
300
2.645
18.759
197
130
327
109,0%
600
5.291
30.331
394
211
604
100,7%
1.200
10.581
53.475
788
371
1.159
96,6%

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B) Worker born in 1985
Monthly
income
(in 2020
manats)
2nd-pillar
total
contribution*
2nd-pillar
total
capital**
Monthly pension
Replacement
rate
1st-
pillar
2nd-
pillar
Total
Rate of return: 2%
150
987
5.721
110
40
150
99,8%
300
1.973
7.964
197
55
252
84,1%
600
3.946
12.877
394
89
483
80,5%
1.200
7.893
22.702
788
158
945
78,8%
Rate of return: 3%
150
987
6.750
110
47
157
104,6%
300
1.973
9.397
197
65
262
87,4%
600
3.946
15.193
394
106
499
83,2%
1.200
7.893
26.785
788
186
974
81,1%
Rate of return: 4%
150
987
8.009
110
56
166
110,4%
300
1.973
11.149
197
77
274
91,4%
600
3.946
18.026
394
125
519
86,5%
1.200
7.893
31.781
788
221
1.008
84,0%
*: Based on expected cash flows, in
actuarial value
**: Nominal value at retirement
age

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Figure 1. Pension of a male worker born in 1995, participant in the 2-pillar pension system, for different
levels of income (real values in 2020 AZN). Source: created by the authors.
A) Rate of return of funded pension plan: 2%
B) Rate of return of funded pension plan: 3%

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C) Rate of return of funded pension plan: 4%
Figure 2. Pension of a male worker born in 1985, participant in the 2-pillar pension system, for different
levels of income (real values in 2020 AZN). Source: created by the authors.
A) Rate of return of funded pension plan: 2%

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B) Rate of return of funded pension plan: 3%
C) Rate of return of funded pension plan: 4%
5. CONCLUSIONS
This paper proposes a framework for introducing a funded voluntary pension system (second pillar) in
addition to the mandatory pay-as-you-go state pension system (first pillar), as called for by the Law on
Labor Pension of the Republic of Azerbaijan. Our analysis suggests that the proposed reforms can
effectively achieve the conflicting goals of guaranteeing adequate retirement savings while still being
affordable for low-income workers and sustainable for the state budget.
The proposed reforms might also attract workers unable to fulfil the first-pillar pension requirements. In
Azerbaijan, this problem involves self-employed workers and farmers who currently have a disincentive to
contribute to the system. Indeed, they fear to never reach 20 years of contribution, and thus never be
entitled to any labor pension. In our proposal, they would receive the second-pillar part of the pension in

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addition to the minimum state social-assistance benefit, thus improving their minimum standard of living in
old age. The reforms can also have an indirect impact on the endowment life insurance market, which
represents the main alternative for workers to participation in the second-pillar pension system and is still
underdeveloped according to Nasirzade (2019) and Gavriletea and Karimov (2015).
In our opinion, a pension system should be ideally: clear, because people trust what they can understand;
efficient, in order to maximize economic and social benefits; open to all workers, without economical or
social barriers to entry; effective in providing workers with a sustainable retirement income;
comprehensive, to address different needs of social protection of people from all income groups; capable
to support the development of capital markets and the modernization of the financial system. Our results
suggest that the proposed reforms can help achieving these desirable outcomes in Azerbaijan.
A limitation of this study is that it addresses a specific issue of the Azeri pension system, therefore it could
be argued that it does not make a broader contribution to proper pension design. However, its policy
implications go beyond the case of Azerbaijan, because the proposed framework can be adapted with
similar results to 'catching-up' countries with high income inequalities. Further research can be devoted to
explore the effects of the framework in the context of developing countries and, specifically, of post -
communist countries (see for example Grishchenko, 2016).
ACKNOWLEDGEMENTS
This work has been performed under the EU Twinning project “Support to the Ministry of Labour and
Social Protection of Population in Reforming Pension System in Azerbaijan” (AZ/15/ENP/SO/38). The
Authors would like to thank the Head of the Actuarial Department of the Ministry of Labour, Mr Azad
Taghi-Zada, and all his staff, and the Azerbaijani Project Leader, Mr Chingiz Aliyev.
REFERENCES:
Benjamin, B., Pollard, J.H. (1993). The analysis of mortality and other actuarial statistics. The Institute of
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AUTHOR PROFILES
Audrius Bitinas earned his Ph.D in Business and Administration at the University of M. Romeris in
Vilnius in 2008. He is an Attorney-at-Law and an international social protection and expert, former Vice-
minister of Social Protection and Labor of the Republic of Lithuania (2011–2013). Actually, Audrius
Bitinas works at the Faculty of Law of the University of Vilnius.
Alessandro Fiori Maccioni earned his Ph.D. in Law and Economics at the University of Sassari in 2011.
He is a certified chartered accountant and a public auditor. Currently, he is Chief Financial Officer at FAP
Banco di Sardegna, a professional consultant at INPS (Italian National Institute for Social Security), and a
research fellow at the University of Sassari.