Public Disclosure Authorized
Public Disclosure Authorized
OFFICE OF THE CHIEF ECONOMIST,
LATIN AMERICA AND CARIBBEAN REGION,
THE WORLD BANK
BACKGROUND PAPER FOR REGIONAL STUDY ON
SOCIAL SECURITY REFORM
The Performance of the Funded Pension Systems in
Latin America
by
Juan Yermo
Organization for Economic Cooperation and Development
Public Disclosure Authorized
Public Disclosure Authorized
30490
1
The Performance of the Funded Pension Systems in Latin
America
by
Juan Yermo
Organization for Economic Cooperation and Development
Abstract: This paper analyses the performance of private pension systems with
respect to two key indicators: replacement rates and the return to pension
contributions. While returns have been high since the inception of the systems,
some deficiencies in the risk management design of the system may put
performance into jeopardy in the near future. Further, the expected cost-cutting
nature of competition has not materialised and most countries have simply
opted to take away the little freedom that individuals had to make choices. Only
Chile has begun to diverge from this trend, liberalizing foreign investment and
introducing some choice over investment during the accumulation stage.
Reforms are still needed during the retirement stage, in order to permit more
flexibility in the timing and form of annuity purchases.
2
Introduction
Pension reform of the kind implemented in some Latin American
countries brings both benefits and new challenges. These reforms constitute a
long learning process that started with the pre-funding of pension benefits and
that will continue for many years to come as many practical aspects of the
systems are refined and readjusted.
This paper aims to assess the validity of various hypotheses about the
potential economic benefits of pension reform of the Latin American kind. The
basic features of these reforms have been the phasing out of publicly managed,
defined benefit plans in favor of defined contribution, personal pension plans
managed by specialized financial companies. Unlike the previous system, which
was run on a pay-as-you-go (PAYG) basis by the state, the new individual
accounts are fully-funded and include some degree of investment
diversification. One exception to this general trend is in Brazil, where a large
public system has been maintained and where occupational pensions are being
promoted on a voluntary basis as a complement to state pensions.
The performance of these private pension systems can be gauged from
several different perspectives. Ultimately, the two key variables are the pension
that the elderly receive when they retire (often measured as a percentage of their
salary – the so-called replacement rate) and the return to pension contributions.
A pension system should provide high enough benefits so that workers can
maintain their standard of living after retirement but should do so for the lowest
possible cost (by minimizing market distortions and any undesirable income
redistribution).
The first part of the paper describes the private pension systems of
Latin America and explains how risks are managed. We observe that
participants in the individual account systems bear the investment risk but have
no say over how their pension contributions are invested. Participants also face
significant investment and longevity risk after retirement. In most countries,
however, individuals are offered more product choice at retirement than during
the accumulation stage.
We then compare the individual account model with the occupational
model that is in place in Brazil. In Brazil, defined benefit plans are still the
norm in the voluntary occupational system, but defined contribution plans are
rapidly gaining ground.
The second part of the paper evaluates the performance of the private
pension system from the perspective of the plans’ participants. We focus on the
3
administrative costs and investment performance of the plans while
contributions are accumulating in the worker’s pension account and on the cost
of annuities during their retirement. We find that the returns to contributions in
the individual capitalization models are significantly reduced by the plans’
administrative costs. Also, replacement rates are unlikely to be high for the
large percentage of workers who do not contribute on a regular basis.
The third part of the paper focuses on the roots of this performance
and analyzes the governance and operation of pension funds and insurance
companies and the effectiveness of the regulatory and supervisory framework.
We analyze three types of risk − agency, investment, and longevity risks.
Agency risks arise from conflicts of interest and the asymmetry in information
among the three main parties involved in the private pension system − workers,
providers, and policymakers (including regulators and supervisors). We first
examine the agency risks that affect the operation of pension funds. We then
evaluate how successful pension funds have been in managing investment risk.
We find that regulatory restrictions on foreign investment have compromised
investment returns, but that restrictions on domestic equities have not been as
costly because of the volatility of these markets. We also look at the role of
insurance companies in managing both investment and longevity risk. The lack
of suitable financial instruments and mortality tables appears to hamper the
efficiency of the insurance business. Regulations are also generally more lax
than those applied to pension funds.
In Part IV, we evaluate the nature and extent of competition in the
provision of private pensions. We assess the efficiency of pension funds in
managing individual accounts, and we look at ways to encourage cost-reducing
competition in pension provision. We also look at the pros and cons of
occupational and personal pension plans and the main policy choices that arise
from this debate.
Our results from this paper call into question the claim that the
introduction of private sector management fosters cost-cutting competition and
innovation and helps to insulate pension systems from political interference. We
also question the soundness of the risk management features of the private
pension systems. The practical absence of individual choice during the
accumulation stage, low ceilings on foreign investment, and restrictions on the
timing and formality of product choices at retirement are putting into jeopardy
the performance of private pension systems. The paper concludes by proposing
some possible venues for reform.
4
I: The Design of Private Pension Systems in Latin America
The two most important risks that an individual faces when saving for
old age are investment and longevity risk. A person who saves for retirement
through financial instruments does not know the exact value of her accumulated
savings when she retires. Similarly, no one knows the number of years of life
that he or she has left after reaching retirement.
In defined contribution plans, the investment and longevity risks are
borne by the individual. In defined benefit plans, on the other hand, these risks
are in principle shifted away from the individual. In public defined benefit
pension systems, these risks are shifted to the state, which in turn allocates them
across generations. In occupational defined benefit plans, plan sponsors, and
hence, ultimately, shareholders, bear these risks. Defined benefit plans,
however, are not risk-free. Both governments and employers can default on
their pension promises. Governments may be forced to reduce pension benefits
to contain fiscal deficits while companies that sponsor pension plans may go
bankrupt.
Some personal pension plans also offer some degree of protection
against investment or/and longevity risk. Annuities for example, are a life
insurance product that can guarantee a fixed benefit until death in exchange for
a lump-sum payment. Life insurance companies are able to offer such contracts
because they can pool the longevity risk across many individuals. Ultimately, it
is also the life insurance company’s shareholders who are responsible for
meeting any promises made by the company.
In addition, any private pension system is laden with a variety of
agency risks or conflicts of interest that arise from the delegation of functions
by an interested party to another party who is better informed or has superior
skills. Agency risks arise in the context of the management of a retirement plan
and in the regulation and supervision of private pension systems.
The Individual Account Systems of Latin America
In nine Latin American countries (Argentina, Bolivia, Chile,
Colombia, Costa Rica, El Salvador, Mexico, Peru, and Uruguay1), publicly
managed defined benefit plans have been curtailed and replaced by personal
pension plans that are managed by specialized financial intermediaries. These
1
Paraguay is undergoing a similar reform.
5
specialized financial institutions are called pension fund administrators or a
similar name2.
The new plans are based on a defined contribution formula. During
the accumulation stage, plan members bear fully investment and longevity risks.
Members can choose a provider (a pension fund administrator) but have no say
in the investment allocation of their savings. Except in Chile, which introduced
a second fund in May 2000, pension fund administrators may offer only one
fund.3 Moreover, the asset allocations of this fund are constrained by
quantitative investment limits, and the performance of each fund cannot stray
too far from the industry average. As a result, the funds offer similar risk-return
trade-offs.
To the extent that plan members differ in risk aversion, such a “onesize-fits-all” defined contribution formula can be rather costly. Individuals who
are highly risk averse may be frightened by the volatility of the returns offered
in the new system. Indeed, in countries where the public’s confidence in the
ability of the government to maintain macroeconomic stability is low, workers
may choose to avoid the new system altogether and invest their retirement
savings abroad.
Chile has been the first country to start tackling this deficiency in the
system by requiring the pension fund administrators to set up a second fund (the
Fondo 2) that is invested exclusively in domestic fixed-income securities. Only
men older than 55 and women older than 50 are permitted to switch their
accumulated balances to the second fund. In April 2002, a law was approved
that extends the number of funds that AFPs manage to five.
2.
Administradoras de Fondos de Pensiones (AFPs) in Bolivia, Chile, El
Salvador, and Peru, Administradoras de Fondos de Pensiones y Cesantías
(AFPCs) in Colombia, Administradoras de Fondos de Jubilaciones y
Pensiones (AFJPs) in Argentina, Administradoras de Fondos de Ahorro
Previsional (AFAPs) in Uruguay, and Administradoras de Fondos para el
Retiro (AFOREs) in Mexico.
3.
This is the case for the mandatory system. Workers are also able to make additional
voluntary contributions to the individual accounts managed by the pension
fund administrators. In some countries such as Chile and El Salvador, these
voluntary contributions must be deposited in the same fund as the mandatory
contributions. In others such as Colombia and Mexico, there is a separate
fund for voluntary contributions, which is subject to a more flexible
regulatory regime. In Colombia, fiduciary societies are also able to manage
these voluntary pension funds.
6
While workers are fully exposed to investment and longevity risk
during the accumulation stage, they are fully insured against the risks of
disability and death. The premiums for these policies are paid by the pension
fund administrators to the insurance companies, except in Mexico, where the
social security institute has retained a monopoly over these services.
As shown in Table 1, workers face more choice during the retirement
stage than during the accumulation stage. . In all Latin American countries
except Bolivia and Uruguay, participants may choose at retirement between
drawing down their accumulated balance as part of a program of scheduled
withdrawals, purchasing an annuity. Some countries also permit a combination
of these two options (deferred annuities). The annuities sold are of the
traditional type (fixed, as opposed to variable). This type of annuity involves the
transfer of (nominal) investment and longevity risks to an insurance company.
In some countries such as Chile, Colombia, and Peru, annuity benefits must be
indexed to a measure of prices, which also transfers inflation risk to the
insurance company. In other countries such as Argentina, there is no indexation
requirement, but benefits may be denominated in US dollars, which offers
protection against devaluation (and hence at least partial protection against
inflation). No Latin American country as yet offers the possibility of buying
variable annuities, in which investment risks are borne by the pensioner and
longevity risks are borne by the insurance companies. Such annuities may be
particularly attractive for high-income workers or for workers in countries
where the public pension system still offers generous pensions.
Table 1: Form of Retirement Benefits
Country
Argentina
Bolivia
Chile
Colombia
El Salvador
Mexico
Peru
Uruguay
Benefit form
Annuity, scheduled withdrawal (up to five
years after retirement)
Only annuity
Annuity, scheduled withdrawal, deferred
annuity
Annuity, scheduled withdrawal, deferred
annuity
Annuity, scheduled withdrawal, deferred
annuity
Annuity, scheduled withdrawal
Annuity, scheduled withdrawal, deferred
annuity
Only annuity
Note: Lump sums are permitted in all countries except Bolivia and Uruguay,
but there are substantial constraints. Relevant data can be consulted in Devesa,
Martínez, and Vidal (2000).
7
The scheduled withdrawal option lays all investment and longevity
risks on the pensioner. This option may be preferable when interest rates are
very low and are unlikely to increase within the time frame permitted for
purchasing a deferred annuity. However, pensioners are not free to choose the
amount that they wish to withdraw as a benefit. Instead, the pension fund
administrator recalculates the scheduled withdrawals every year as a function of
the pension fund’s return and the life expectancy of the worker and his or her
family members.
In Colombia, Chile, and Peru, workers can also buy deferred annuities
and in the meantime draw down part of their accumulated balances as part of a
scheduled withdrawal. Deferred annuities are often attractive when interest rates
are expected to increase. Nonetheless, the problem of mistiming the annuity
purchase is rife, given that workers are not able to buy deferred annuities before
retirement and only deferrals of one to three years are permitted at retirement. In
countries such as Bolivia, Mexico, and Argentina where deferred annuity
purchases are not permitted, the investment risks that workers face are even
greater.
Some countries have restricted the amount of choice that plan
members have among these three main options. In Bolivia and Uruguay,
participants are required to purchase annuities at retirement. In Chile, workers
who want to draw their pension (and retire from the mandatory pension system
though not necessarily from the workforce) before the official retirement age
are required to purchase an annuity, which must exceed 110 percent of the stateguaranteed minimum pension. If the annuity exceeds 70 percent of his or her
average wage, the rest of the accumulated balance can be taken as a lump sum.
A similar rule is in place in Argentina and Peru.
On the other hand, workers in Chile and El Salvador who have
accumulated funds that are insufficient to generate annuities above the
minimum pension are not given the option of purchasing an annuity. Instead,
they must choose the scheduled withdrawals option and draw down a pension
equal to the minimum pension. After their funds run out, the government pays
the minimum pension.
The Brazilian Private Pension System
The Brazilian private pension system, being voluntary, has not been
subject to the constraints that are present in other Latin American countries.
Plan sponsors and plan providers are free to design their plans as they please.
However, some current features of the system can still be costly for some
workers. The defined benefit plans that have been at the core of the Brazilian
8
occupational system are based on back-loaded formulas that encourage long
tenure. Therefore, workers who leave a company after only a few years receive
much lower benefits per year of service than they would have done if they had
stayed for a longer period.
Private pension plans in Brazil form a voluntary complement, or
second pillar, to the social security system.4 This second pillar consists of the
so-called Complementary Pension System (Sistema de Previdência
Complementar), established in 1977 by Law 6435 and the Fundos de
Aposentadoria Programada Individual (FAPIs), which are long-term
investment accounts managed by mutual funds. The complementary system
itself consists of closed pension funds (Entidades Fechadas de Previdência
Privada) and open pension funds (Entidades Abertas de Previdência Privada).
The closed funds are constituted as employer-sponsored non-profit
organizations covering the employees of a particular firm or group of firms.
Closed pension funds support occupational plans that have traditionally been of
a defined benefit nature. Increasingly, however, defined contribution plans are
being promoted.
Occupational pension plans have historically operated under a lax
regulatory and supervisory framework that offered little protection to plan
members against the bankruptcy of the sponsor. Regulations lacked
transparency, the tax treatment of pensions was uncertain, and the supervisory
authority was understaffed and had limited intervention powers. The new
regulatory framework, which derives from Complementary Laws nos. 108 and
109 that were approved in 2000-1, open up a new chapter in the development of
occupational plans. They ensure more effective control of funding and
investment of pension funds, more transparency and effectiveness of
supervision, and greater disclosure of information to plan members.
The open pension funds are constituted as insurance companies that
cover any worker who chooses to enrol. Open pension plans were until recently
structured as defined benefit (DB) schemes and took the form of inflationindexed deferred annuities, though there were some defined contribution
4.
The first pillar consists of programs under the Regime Geral da Previdencia
(RGPS), which covers workers in private firms and public sector employees
who were hired under the Consolidated Labor Code and the Federal, state and
municipal Regimes Juridico Unico (RJUs), which covers tenured government
employees in the executive, legislative, and judicial branches and the
military. A Constitutional Amendment in November 1998 allowed the
establishment of complementary funds for the RJUs.
9
(DC)plans. Hence, the main players in this market are insurance companies,
which carry out the four main services of a pension system: collecting
contributions, administering accounts, managing assets, and paying benefits.
The DB plans offer a guaranteed 6 percent real rate of return and between 50
percent and 75 percent of any actual excess return.5 At retirement, the investor
has the option of receiving the entire accumulated balance in full or in part.
Open pension plans also offer other benefits, such as life, survivor, and
disability insurance.
In 1998, a new form of plan, the Plano Gerador de Beneficio Livre
(PGBL), was created. The PGBL is a DC scheme with flexible contribution and
investment options and without return guarantees. Companies can contract
PGBL plans for their employees, similar to the 401(k) plans in the United
States. Investors may alter the contribution rate and may choose between three
different funds: a “sovereign” fund (government securities), a fixed-income
fund, and a mixed-income fund. The PGBL administrator can invest
contributions in only one of these three funds, which are managed exclusively
by mutual fund companies.6 When the worker retires, the PGBL administrator
takes his or her accumulated assets and buys an inflation-indexed annuity.
II: The Performance of the Private Pension Systems
Policymakers’ main social concern about private pension systems is to
ensure that these systems provide workers with enough retirement income that,
together with other income sources, will lead to sufficiently high replacement
rates (for example, 70 percent). At the same time, policymakers should be
concerned about the efficiency of the system, specifically with the costs
imposed on workers and other economic agents by these private pension
systems.
The Individual Account Systems of Latin America
5.
The actual amount varies between funds. Normally, the maximum that can be
transferred is only achieved after a worker has been in the plan for a few
years (about five on average). The excess return accumulated in a year can be
retrieved or can be left to accumulate in the fund.
6.
Each exclusive fund may receive contributions from more than one PGBL
plan as long as they have similar characteristics. The funds, however, are
only open to investment from PGBLs.
10
Latin American countries differ in the extent to which they reduced benefits
from the PAYG social security system. Correspondingly, these countries differ
in the importance of the individual account systems as a source of retirement
income. A full evaluation of retirement benefits and administrative costs would
therefore necessitate a comparison of benefits from both the public and the
private systems. Replacement Rates. One key measure of the performance of
private pension systems from the perspective of plan members is the level of
retirement income relative to their salary before retirement (the so-called
replacement rate). Because the individual account systems of Latin America are
based on a defined contribution formula, replacement rates depend on the
following factors:
•
The contribution rate
•
Salary growth
•
The worker’s contribution record
•
Returns to pension funds
•
Annuitization rates (or life expectancy if the worker chooses the income
draw-down option).
The sensitivity of replacement rates to these variables can easily be
modeled. In the following exercise, we assumed that salary growth is constant at
0 percent in real terms per year. The base model assumed a 10 percent
contribution rate, a 5 percent real rate of return, 35 years of contributions, and a
5 percent annuitization rate.
Table 2 shows the effect on the replacement rate of a 10 percent
increase in each of these parameters. The contribution record is clearly the most
important parameter. The low ratios of contributors to affiliates observed in
most countries (about one in two in most countries, see Packard (2002) are,
therefore, a threat to the income security of a large segment of the population.
Table 2: Modeling Replacement Rates
10 % increase in:
% Increase in
replacement rate
10.0
11.0
22.7
10.0
Contribution rate
Rate of return
Contribution record
Annuitization rate
11
Source: Authors’ calculations.
The rate of return, net of asset and return-based commissions, is also
an important determinant of the replacement rate. Since in all countries except
Chile, workers have access only to a single fund, regulations and the investment
choices of the pension fund administrators are the only factors that influence the
returns to pension funds.
A worker's choice of pension fund administrator will also affect his or
her replacement rate. However, investment and rate of return regulations have
reduced the extent to which returns vary. The limited availability of liquid,
domestic securities has exacerbated this effect. Srinivas and Yermo (1999)
reported an average correlation between pension fund returns in Chile and Peru
as high as 0.95. In Argentina, the average correlation is lower at 0.87.
Further evidence of the similarity of pension fund returns is provided
in Table 3, which shows average returns (both arithmetic and geometric) since
the inception of the system across AFPs. The maximum amount by which any
AFP’s return deviates from the system’s average return is approximately 3
percent. The similarity in returns means that investors gain very little by
switching between pension funds in these countries, especially in those
countries where returns are subject to floors and ceilings. Nonetheless, over a
40-year period (the typical length of a career), such a small difference in annual
return can lead to a difference in the accumulated balance relative to the
system’s average balance as high as 15 percent.
Table 3: Average Rates of Return by AFP in Chile: 19812000
Cuprum
Habitat
Magister
Planvital
Provida
Santa Maria
Summa Bansander
System
Arithmetic
average
Geometric
average
11.26
10.95
11.22
11.24
10.55
10.69
11.15
10.89
10.94
10.61
10.84
10.89
10.24
10.33
10.77
10.55
Note: Returns are for Fondo 1.
Source: Superintendencies of Pension Fund Administrators
12
Correlations between pension fund returns are even higher for
countries such as Bolivia, El Salvador, Mexico, and Uruguay, where pension
funds invest only in domestic fixed-income securities. The average return of the
industry is, therefore, representative of the actual return that any individual
member obtained on his or her pension fund account and can be used, with little
risk of misrepresentation, for estimating replacement rates.
Table 4 shows the annual returns obtained by the pension fund
industry since the establishment of the private pension systems and over the last
year. The rate of return is calculated net of any asset management fees (only
permitted in Mexico) but is not adjusted for contribution-based charges. These
commissions have no impact on the accumulated fund, since they are paid on
top of the mandatory contribution that goes into the individual account. On the
other hand, contribution-based commissions create a gap between the actual
replacement rate and the potential replacement rate that could have been
achieved had these commissions been also invested in the individual account.
We analyze this gap in the next section and use it as a measure of the costeffectiveness of the private pension system.
As shown in Table 4, the highest real return to date was obtained by
the pension fund industry in El Salvador, a 12.9 percent annual average return
in real terms. The lowest was Peru’s at 5.3 percent. Over the last 12 months,
returns have been much lower. In Peru, the real return was in fact negative in
2000.
13
Table 4: Pension Fund Real Annual Returns
to December 2000
Country
Since
inception
11.1
11.1
10.9
9.9
12.9
9.5
5.3
9.1
Argentina
Bolivia
Chile
Colombia
El Salvador
Mexico
Peru
Uruguay
Last 12
months
3.9
10.9
4.4
N/a
7.9
7.2
-6.7
7.1
Source: AIOS.
Notes: Real returns are annualized cumulative values. Returns for Chile are for
Fondo 1. Colombia does not report returns over last year. For Mexico, returns are
net of asset management fees.
When adjusted for risk, the performance of the Peruvian pension fund
industry is even worse. As shown in Table 5, the pension fund industry
generated returns that averaged 0.46 percent on a monthly basis, but the
standard deviation was one of the highest in Latin America at 1.2. Hence, the
ratio of return to standard deviation (in other words, the return per unit of risk)
was by far the lowest in the region (0.36).
Table 5: Pension Fund Real Monthly Returns
(from Inception to December 2000)
Country
Argentina
Chile
Mexico
Peru
Uruguay
Average
(A)
Standard
Deviation
(SD)
2.00
1.69
0.75
1.20
0.79
1.24
0.84
0.73
0.46
0.85
A/SD
0.62
0.50
0.98
0.38
1.08
Source: Pension fund supervisors.
Note: Colombia does not report monthly returns. Returns for Chile are for
Fondo 1.
While these high returns are likely to generate high pensions (as long
as contribution periods are also long), their volatility will lead to significant
differences in pensions across different retirement cohorts. An example, based
14
on Chilean historical returns, will help to elucidate the impact of return
volatility on the accumulated fund.
Figure 1 shows the AFP-average cumulative annual return for 20
different cohorts. Each cohort represented in the figure, except the 1981 one,
started contributing at the beginning of the year. The 1981 cohort started
contributing in July, the month when the system was launched. As of December
2000, cohorts who started contributing in the 1980s fared significantly better
than those who started contributing in the 1990s. The 1980s cohorts have earned
cumulative returns that range from a minimum of 8.73 percent (1987 cohort) to
a maximum of 10.88 percent (1981 cohort), with an average of 9.44 percent.
The 1990s cohorts, on the other hand, have earned cumulative returns that range
from a minimum of 4.05 percent (1995 cohort) to a maximum of 10.19 percent
(1999 cohort), with an average of 6.99 percent. Such differences in returns will
generate a gap between the average accumulated balance of the 1980s and
1990s cohorts of the order of 35 percent.
Figure 1: In Chile, inter-cohort differences in returns have been large
Ch ile : av e rag e AF P cu mu lativ e re tu rn , 1981-2000
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
0
2
4
6
Source: Superintendencia de AFPs
15
8
10
12
Since 2000, however, Chilean workers close to retirement have been
offered the opportunity to trade out of the so-called Fondo 1 (the original
pension fund) into a fund invested exclusively in fixed-income securities
(Fondo 2). This option has not been taken up by anyone except a handful of
lucky workers (only 64 contributors as of September 2000), who have benefited
since then from bonds' out-performing equities.
For workers who choose to annuitize their accumulated balance, bond
yields and life expectancy are the other two determinants of the replacement
rate that they will achieve. Since only single-premium immediate annuities are
permitted, the timing of the conversion of the accumulated balance into an
annuity can have a dramatic impact on the size of pension benefit obtained.
In Chile, the Superintendency publishes a measure of the annuity’s
yield that is closely linked to the 10-year bond yield. The higher the yield, the
larger the pension benefit will be. While historical data for this measure are not
available, we have constructed a synthetic index of the value of annuities based
on the average yield on fixed-income instruments traded in the Santiago
exchange.
Figure 2 shows the value of the annuity that a premium, fixed in real
terms, would have bought at the end of each year since 1988. The value of the
annuity is expressed in terms of the replacement rate, with the replacement rate
of 1988 set arbitrarily at 50 percent. The interest rate used to calculate the
benefit paid by the annuity is the annuity yield for workers retiring at the
official retirement age, as reported by the Superintendencia de Valores y
Seguros. As shown in Figure 2, there is a lot of variation in the annuity value
over time. The difference between the highest and lowest replacement rate is 22
percentage points, the average replacement rate over the period is 60 percent
and the standard deviation 6 percent. These large differences in replacement
rates across cohorts are caused by the volatility of interest rates over the period.
In particular, the decline in interest rates in the late 1980s lowered the value of
annuities for cohorts retiring in these years. In particular, workers retiring in
1998 and 1999 would have been better off deferring the purchase of the annuity
for two and one years, respectively.
16
Figure 2: Annuities have yielded varying levels of retirement benefits
C h i l e : re p l a c e m e n t r a te fr o m a n n u i ti e s (1 9 8 8 = 5 0 % )
70
Rep lace ment rate (%)
65
60
55
50
45
40
35
2001
2000
1999
1998
1997
1996
1995
1 994
1993
1992
1991
1990
1989
1988
30
Source: Author's calculations, based on data from Banco Central de Chile and the
Superintendencia de Valores y Seguros.
Given the dependence of replacement rates on all of these volatile
variables, forecasting the actual performance of the system in the future is an
exercise in clairvoyance. Pension fund returns and long-term interest rates, in
particular, will evolve according to macroeconomic conditions and investment
legislation, over which neither pension fund administrators or plan members
have any control.
For the moment, Chile is the only country with a significant number
of old-age pensioners from the private pension system. A recent study from an
AFP showed that replacement rates for a sample of 6,000 old-age pensioners
were as high as 81 percent for early pensions and 73 percent for normal
pensions. These replacement rates appear to be significantly higher than those
under the previous system but are largely driven by the high real returns of the
early 1980s.
Commissions in the Accumulation Stage. Replacement rates by
themselves do not provide a full picture of the performance of a private pension
system. If such replacement rates have been achieved at the cost of high charges
17
paid by workers to cover administrative costs7, workers' life-time incomes will
suffer as a result.
There are two main measures of charges that may be used: the
reduction in yield and the charge ratio. The reduction in yield shows the effect
of charges on the rate of return given a set of assumptions about the rate of
return, the time profile of contributions, and the term of the plan. The charge
ratio, on the other hand, is defined as the ratio of the accumulated balance that
the charges by themselves would have generated to the accumulation without
charges (in other words, had charges been added to the other contributions and
also invested).
As discussed by Whitehouse (2001), the use of the charge ratio can
provide a misleading picture of the cost of a private pension system when
commissions are calculated as a percentage of the accumulated fund. On the
other hand, the charge ratio is a more useful measure than the reduction in yield
of the cost-efficiency of the system in countries such as those in Latin America
(except Bolivia and Mexico) where commissions are charged only on
contributions made.
Commissions to cover administrative costs (account and asset
management expenses) are calculated as a percentage of a worker’s salary or
contribution. Fixed commissions are permitted in some countries such as
Argentina, Chile, and Mexico.8 In Bolivia and Mexico, pension fund managers
can set commissions as a percentage of returns on the invested funds. Both
Argentina and Mexico also permit loyalty discounts (for remaining with the
same administrator).
Variable commissions (those calculated as a percentage of
contribution/salary) vary significantly across countries, as shown in Table 6.
For a worker earning an average income, the country with the lowest charge,
measured as a percentage of salary, was Bolivia at 0.5 percent in December
2000. The country with the highest charge was Peru at 2.39 percent.
The ratio of charges to contributions in December 2000 is shown in
the last column of Table 6. For countries where commissions are set only as a
percentage of the worker’s contributions or salary, this measure is equivalent to
7
In addition to these commissions, workers must pay monthly premia for
disability and life insurance.
8
In Peru, fixed charges were permitted until 1996.
18
the charge ratio9.. In the case of Peru, the charges create a gap of 23 percent
between the potential and actual accumulated balance at retirement for the
contributions made in December 2000..
Table 6: Commissions
(December 2000)
Argentina
Bolivia
Chile
Colombia
El Salvador
Mexico
Peru
Uruguay
Average
Administration Contribution /
Fee/total
fee / Salary
Salary
contribution
A
b
C = a/(a+b)
2,09
7,72
21,3
0,50
10,00
4,8
1,61
10,00
13,9
1,63
10,00
14,0
1,83
8,53
17,7
1,98
12,07
14,1
2,39
8,00
23,0
2,04
12,32
14,2
1,76
9.83
15.4
Note: Administration fee includes only account and asset management charges.
Insurance premiums are excluded. Information for Colombia refers only to the
mandatory pension fund system. Information for Bolivia includes only the contribution
charge (the asset management charge varies from 0-0.23 percent, depending on the
amount of assets in the portfolio).
Source: AIOS, Superintendencia Bancaria de Colombia.
Figure 3 shows the commission to contribution ratio at the end of each
year in three countries. Commission levels have fallen over the past few years in
Argentina and Chile, while they have increased in Peru and remained stable in
Uruguay. The different evolution of charges in these countries can be largely
explained by the nature of competition in the industry and regulatory policies
that have aimed at containing costs in Argentina and Chile.10
9
In Mexico the two measures are not equivalent because some providers
charge commissions on assets and returns. In Bolivia, the commission is set on assets
under management. In Chile the AFPs also charge fixed commissions.
10
These issues are discussed further in Part IV.
19
Figure 3: Commissions have not declined systematically over time
C ommission / Contribution, 1990-2000
30
25
20
15
10
5
0
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
A rgentina
Chile
P eru
Uruguay
Source: Superintendencies of respective countries, author’s calculations
The evolution in charges in Argentina and Chile is clearly favorable to
workers who joined the system at a later stage. The accumulated balance to date
of a worker who contributed regularly to the system from its inception is
reduced by a larger percentage (the charge ratio) than that of someone who
joined later. These differences in charges create potentially undesirable income
inequalities between different generations.
Figure 4 shows the cumulative charge ratio11 for Chilean male
workers earning the average wage in successive cohorts, where each cohort is
11
The cumulative charge ratio measures the total impact of charges on retirement
income over a person's career. In order to calculate this ratio for Chile, both
fixed and variable charges need to be taken into account. It is assumed that
the representative worker is charged the industry average commission, where
the weights are the contributions collected by each AFP. It is assumed also
that the participant contributes to the system on a regular basis. In the Chilean
case, the cumulative charge ratio is an accurate measure of administrative
costs for older participants that made contributions from the start of the
20
identified by the year in which they would normally retire, starting with those
that retired in 1982. The salary for the cohort that retired in December 2000 was
set at 285,000 Chilean pesos, the average wage of the contributors to the
pension system (and above the minimum wage stipulated by the Chilean
legislation). Wages are assumed to grow at 2% per year in real terms and the
contribution for disability and life insurance is assumed to be a constant 0.7% of
the worker’s salary, its average level during the last ten years12.
The cumulative charge ratio was highest for the cohorts who retired
soon after the inception of the new system and falls gradually for later cohorts.
During the early years of the system, over three quarters of the total
contributions that were paid into the system were consumed by management
fees. Since the first workers to retire from the new system only started to do so
in the second half of the 1980s, few workers suffered from such exorbitant fees.
Nonetheless, for the first workers to retire from the new system, the new system
has been very expensive. For a worker earning the average wage who retired in
December 2000 and had contributed each year to the system management fees
would have consumed approximately one half of her total contributions.13
system and retired before the year 2000. However, we also calculate the
cumulative charge ratio for workers that will retire after this date. It should be
noted that in their case, the cumulative charge ratio only offers a partial
picture of total administrative costs over the person's career.
12
Precise information on insurance premiums prior to 1990 is not available.
13
The contrast of these results with previous evidence (e.g. James, Smalhout and Vittas,
2001) stems from focusing on commissions at a point in time, instead of their
cumulative effect over a worker’s career (as shown by the cumulative charge
ratio).
21
Figure 4: Half the pension contributions of the average Chilean worker
who retired in 2000 went to management fees!
Chile : cum ula tive cha rge ra tio by ye a r of re tire m e nt,
sa la ry = 200,000 pe sos in De ce m be r 1981
95
85
Pe r ce ntage
75
65
55
45
35
25
2040
2038
2036
2034
2032
2030
2028
2026
2024
2000-22
1998
1996
1994
1992
1990
1988
1986
1984
1982
15
Source: Superintendencia de AFPs, authors’ calculations
For younger workers who only started contributing after 1982 and will
therefore only retire after 2022, the cumulative charge ratio drops to
significantly lower levels (25-35%). The earlier cohorts, therefore, have borne
the brunt of the set up costs of the new pension fund industry: the evolution of
the fee structure has led to a redistribution of income from early (older) to later
(younger) participants. While expected, such large intergenerational transfers
are not unavoidable.14 It is also interesting to note that after a secular decline,
the cumulative charge ratio has began to creep up again for the youngest cohorts
(those who will retire after 2034). This increase is attributable to the increase in
the fixed commission, since the variable commission has actually fallen
somehow over the last few years (see Figure 3).
14
Bolivia and Mexico, for example, allowed asset-based charges. Uruguay's reform,
which required contributions to the new savings pillar only for higher income
individuals, has also ensured that the new industry is subsidized in its early
stages by those most able to create “thickness” in the market and endure high
charges.
22
In countries where fixed commissions are permitted, even intra-cohort
income inequalities can emerge. In Chile, even in the best of cases where
workers choose the combination of flat and contribution-linked commission
most appropriate to their salary level (i.e., that which minimizes the total
commission as a percentage of salary), the poor end up paying a higher
percentage of their salaries in commissions than the rich. The regressivity of the
commission structure is clear from Figure 5, which shows how much higher is
the cumulative charge ratio of the cheapest AFP for a middle income worker
(300,000 pesos in 1990, 2% real growth p.a.) than the cumulative charge ratio
of the cheapest AFP for a high income worker (900,000 pesos in 1990, 2% real
growth p.a.). The gap was greatest at the beginning of the period, at over 3
percentage points. By the end of the decade it had fallen to about 7/10 of a
percentage point, but largely as a result of the sustained increase in the
cumulative charge ratio for higher income workers.
Figure 5: Participation in the Second Pillar Is Costlier for Poorer Workers
Chile : Cum ula tive cha rg e ra tio for diffe re nt sa la rie s, 1990 - 2000
18.0
17.5
17.0
Ch arge ratio (%)
16.5
16.0
15.5
15.0
14.5
14.0
13.5
13.0
199 0
19 91
1992
1993
19 94
1995
Cheape s t A FP - 900 ,000 pes os
1996
19 97
1 998
1999
2000
Cheapes t A FP - 300,000 pes os
Source: Superintendencia de AFPs
Of course, a regressive charge structure would be less worrying if
those AFPs chosen by poorer households offered a better service or performed
better in terms of gross rates of return than other AFPs. There is no evidence
that this is the case. Indeed, there is no correlation between the level of
commissions charged by and the performance of a pension fund. As for the
service offered, giving a worker more frequent or more detailed
23
communications on his or her accumulated balance is unlikely to compensate
him or her for a lower replacement rate or net salary. Moreover, it would appear
that many low income workers may not be choosing the lowest option given
their earnings level, as demonstrated by the low price elasticity of demand
calculated by Mastrángelo (1999) for Chilean AFPs. For Argentina, where
AFJPs could also set fixed charges before November 2001, Rofman (2000) has
calculated that the average commission (including the insurance premium)
would be less than 3 percent instead of 3.4 percent if each contributor chose the
cheapest AFJP for his/her income level.
Commissions in the Retirement Stage. the administrative costs at the
retirement stage appear to be lower than those during the accumulation stage. In
Chile, for example, pension fund administrators did not charge a commission on
scheduled withdrawals until 2000. In that year, all but one of the pension fund
administrators began to charge a commission on the monthly contribution,
which in December 2000 ranged between 1 percent and 1.25 percent.15 Since
disability and survivors’ insurance (from which retired people are excluded)
accounts for approximately 0.6-0.7 percent of the monthly contributions, the
commissions on scheduled withdrawals are somewhat lower than those charged
during the accumulation stage.
The cost of annuities is more difficult to calculate because it includes
a premium for insurance against longevity and investment risk. James and Song
(2001) estimated that the money worth ratio of annuities in Chile (the ratio of
the expected present value of benefit to the net premium) ranges from 95
percent to 100 percent for workers who have low discount rates (equivalent to
the risk-free rate of government bonds) and from 86 percent to 90 percent for
those with higher discount rates (a premium of 1.4 percent percentage points on
top of the risk-free rate). Given that marketing costs account for approximately
6 percent of premiums, insurance companies appear to be providing good value
for money to policyholders.
As shown in Figure 6, sales commissions have increased in recent
years in Chile. The cause of these high commissions (though lower than the
ones applied by pension fund administrators) can be found also in the marketing
process. As for the pension funds, annuities are sold directly to individuals
through sales agents and insurance brokers. Workers receive little information
on the different options they face and the comparison between fees and annuity
rate across insurance companies often lacks transparency. One tactic used by
15
The remaining AFPs charged a fixed commission.
24
insurance companies to attract clients is to offer cash rebates which is often a
decisive factor in the selection of annuity provider.
Figure 6: The cost of buying annuities has steadily increased
A n n u i ty c o m m i ssi o n s / P r e m i u m s (%), 1 9 9 0 -2 0 0 0
7
6
5
4
3
2
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
Source: Superintendencia de Valores y Seguros
The Brazilian System
In Brazil, funded pension plans are a complement to the state-run
PAYG-financed pension system. Most occupational plans (the so-called closed
pension funds) are based on defined benefit formulas, with the worker’s final
salary as the reference wage. Increasingly, however, private companies have
been introducing defined contribution plans as complements to defined-benefit
schemes. Benefits were traditionally much higher for public sector workers than
for other workers in the PAYG pension system. Since the introduction of
Complementary Law No. 108 in May 2001, however, the contributions of
public sector employers (including governments at all levels) as plan sponsors
are capped at the same level as their employees’ contributions.
While benefits for workers who stay with the same employer until
retirement are relatively high and certain, workers with shorter tenures have
traditionally suffered substantial portability losses on leaving the plan.
Complementary Law No. 109, approved by the Brazilian Congress in May
2001, aims to reduce these losses by requiring all complementary pension plans
to meet certain vesting and portability rules. As yet, however, the pension
25
regulator, the Secretaria de Previdência Complementar, has not introduced
these regulations.
III. The Governance and Operation of the Private Pension Systems
The individual account pension systems are administered by two types of
financial institutions: pension fund administrators and insurance companies.
Banks, investment companies and other financial companies only participate in
the pensions industry as owners of pension fund administrators or insurance
companies or as recipients of investments from these companies.
Pension Funds
Open pension funds are the only vehicles for accumulating mandatory
pension contributions in the new mandatory individual account pension systems
of Latin America. Open pension funds are managed by financial institutions that
are exclusively dedicated to this activity.16
In all countries except Colombia and Mexico, participants can make
additional voluntary contributions to their mandatory accounts. In Colombia,
voluntary pension contributions are channeled into separate, so-called
“voluntary” pension funds. These pension funds may be managed by the
pension fund administrators or by so-called ‘fiduciary societies” (investment
management subsidiaries of banks). Colombian employers may also set up
closed pension funds to pay pension benefits to their employees.
Ironically, workers’ risk and time preferences play no part in these
new instruments for retirement saving, which have been otherwise hailed as a
triumph for individual responsibility. Only since April 2000 in Chile have plan
members been able to exercise some choice over their investment portfolio in
accordance to their preferences. The introduction of the second type of pension
fund, invested exclusively in fixed-income securities permits older individuals
to transfer their savings to more conservative portfolios. Mexican pension law
also envisages the establishment of multiple funds, but so far only one type of
fund is functioning in the mandatory system.
Individual investors in all other countries are permitted to have only
one fund account and, therefore, have no power at all over the allocation of their
16
In Colombia, pension fund administrators also manage severance funds,
which, like the pension funds, have individual accounts for each participant.
26
retirement savings. It is pension fund managers who have overall responsibility
for the investment of pension assets.
Pension funds have accumulated a vast amount of assets in all
countries where they have been established. As shown in Table 7, pension funds
are most developed in Chile where they hold assets representing nearly 60
percent of GDP.
Table 7: Assets held by Pension Funds in Latin America
as a Percentage of GDP (December 1998 - December 2000)
Argentina
Bolivia
Chile
Colombia
El Salvador
Mexico
Peru
Uruguay
Average
1998
3.3
3.9
40.3
2.7
0.4
2.7
2.5
1.3
7.1
1999
5.9
7.0
53.3
4.2
1.7
2.3
4.1
2.8
10.2
2000
7.1
10.8
59.8
5.5
3.6
3.0
5.4
3.9
12.4
Source: AIOS, Superintendencia Bancaria de Colombia.
Note: Assets held by the Bolivian capitalization fund are not included.
Growth in assets, however, has been fastest in the more recently
established pension industries (See Appendix A, Table A1), where changes in
assets are mainly determined by new contributions rather than by asset yields.
In Chile’s more mature system, on the other hand, returns are a more important
determinant of growth in the amount of assets that are managed by pension
funds.
Agency Risks. The regulatory and supervisory framework plays a
central role in these systems, controlling conflicts of interest between the plan
members and pension providers. However, some regulations, such as
quantitative regulations that set floors on investment in government securities,
are clearly not in the best interest of plan members. Indeed, one of the major
risks that the pension fund administrators (and hence plan members) face is
government intervention in the industry. This is precisely what happened in
Argentina in December 2001, when the government seized the pension funds’
money deposited in banks (over US$3.5 billion or 16 percent of total pension
27
fund assets) and transferred it to the state-run Banco de la Nación to pay public
service wages and pensions.
Conflicts of interest between pension fund administrators and plan
members need to be strongly regulated in countries such as Argentina, Bolivia,
Colombia, Mexico, and Uruguay. In these countries financial institutions,
especially banks and financial conglomerates, hold large stakes in pension fund
administrators. Foreign companies are strongly represented in these countries.
In Bolivia, for example, both pension fund administrators are majority-owned
by Spanish banks. In Argentina, foreign financial institutions accounted for over
75 percent of the capital of pension fund administrators at the end of 2000.
Chile, Peru, and El Salvador, on the other hand, do not allow domestic
banks and insurance companies to own pension fund administrators directly,
though they can do so through subsidiaries. This prohibition extends to the
distribution channel. Pension fund administrators must also have their own
distribution channels separate from those of other financial intermediaries.
The aim of this separation of pension fund administrators from large
financial conglomerates is to contain potential conflicts of interest. However, it
is not clear how successful it has been in this objective, especially when
compared with the other Latin American countries where this restriction is not
imposed.
Another important regulation that aims to limit conflicts of interest is
the rule that limits investment in companies that are related by ownership to the
pension fund administrator. The limit on investment on “related parties” is set
at low levels in most countries (below 5 percent). The difficult task, however, is
not setting the limit but ensuring that it is adhered to. The complex ownership of
some financial conglomerates in the region (for example, in Mexico) can make
it difficult to monitor and enforce.
Investment Risk. Pension fund bodies should in principle be long-term
investors that should be able to take on big risks in the hope of big pay-offs. In
Latin America, the liabilities of the pension fund industry as a whole are
illiquid, since members cannot retrieve their mandatory savings before
retirement. However, pension fund management companies must perform well
in the short term because workers may switch pension fund managers, and, in
most countries, the government requires the fund managers to provide a return
that is not too far out of line with the industry average.
28
Pension funds’ investment strategies are also affected by quantitative
regulations that limit the extent of investment in specific kinds of assets. These
restrictions are more severe for equities and foreign securities than for fixedincome securities. Investment in foreign securities is still not permitted in
Bolivia, Colombia, El Salvador, Mexico, and Uruguay. Bolivia, Mexico, and
Uruguay also impose floors on investment in government securities. In Bolivia,
the floor is set as an absolute amount of bonds that must be purchased every
year by the pension funds. In Mexico, pension funds must invest at least 51
percent of their assets in inflation-linked or inflation-protected securities, a
requirement that is only satisfied by certain government securities.17 Finally in
Uruguay, pension funds must invest a minimum of 65 percent of their assets in
government bonds, though this ceiling is set to decrease gradually over the next
few years.
As a result, pension fund portfolios in these countries are concentrated
in domestic fixed-income instruments, especially government bonds. As shown
in Table 8, the allocation of portfolios to government securities was the highest
in El Salvador, Mexico, Uruguay, and Bolivia, ranging from 61.4 percent in
Uruguay to 92.6 percent in Mexico.
Table 8: Pension Fund Portfolios (%) December 2000
Govern- Corporate Financial Equities
ment
bonds institution
Securities
securities
/ deposits
Argentina
56.0
2.8
15.6
12.3
Bolivia
69.5
3.7
23.2
0.0
Chile
35.7
4.0
35.1
11.6
Colombia
48.8
18.6
27.1
2.3
El Salvador 71.3
0.0
25.3
3.4
Mexico
92.6
5.4
2.0
0.0
Peru
9.0
18.6
34.0
29.0
Uruguay
61.4
1.9
34.9
0.0
Invest- Foreign
ment securities
funds
8.2
0.0
2.4
0.0
0.0
0.0
0.7
0.0
4.5
0.0
10.9
0.0
0.0
0.0
6.7
0.0
Other
Total
0.6
3.7
0.2
3.2
0.0
0.0
2.1
1.8
100
100
100
100
100
100
100
100
Note: Information for Colombia refers only to the mandatory pension fund system.
Source: AIOS, Superintendencia Bancaria de Colombia.
17
In Mexico, there is also a regulatory requirement to invest at least 65 percent
of the mandatory funds' assets in securities that either mature in less than 183
days or have floating interest rates whose rate is revised in less than 183
days. This regulation does not apply to the voluntary pension funds.
29
In the other countries, where quantitative regulations are less onerous,
diversification into equities, mutual funds, and foreign securities has reached
significant levels. This is most noteworthy in Peru, where 29 percent of assets
were invested in domestic equities in December 2000 and in Chile, where 11.6
percent were invested in domestic equities and nearly 11 percent in foreign
securities in December 2000.
Chile and Peru are also the only two countries where government
securities account for less than one-half of pension funds’ assets. In Peru,
investment in government securities is as low as 9 percent. This remarkable
situation can be explained by the Peruvian government’s fiscal stringency
program, which has resulted in a government bond market that lacks depth and
liquidity. As a result, pension funds have shifted their focus towards private
sector securities (equities and corporate bonds) as well as towards fixed-income
instruments issued by financial institutions (for example, subordinated and
leasing bonds).
An important characteristic of fixed-income portfolios in Argentina,
Bolivia, Peru, and Uruguay is the denomination of some of this paper in US
dollars. In Peru, for example, Brady bonds accounted for nearly 60 percent of
the government and central bank assets held by pension funds in December
2000. In Argentina, AFJPs held about one-half their government bond portfolio
in dollar-linked securities. In addition, pension funds in these countries can
invest abroad, which increases the total percentage of their portfolio
denominated in foreign currencies.
In Bolivia and Uruguay, on the other hand, all foreign currency
denominated securities are issued by domestic institutions since investment in
securities issued by foreign institutions is not permitted. These assets include
local government bonds, instruments issued by financial institutions (for
example, time deposits, mortgages, leases, and subordinated bonds), and
domestic corporate bonds.
As shown in Figure 7, the proportion of pension fund assets
denominated in foreign currency (mainly US dollars) was as high as 98.7
percent in Bolivia and 73.6 percent in Uruguay in December 2000. While in
general, investing dollar-denominated assets offers some protection against
inflation over the long term, but in the short term, workers are exposed to
currency risk. This exposure is most worrisome at retirement when a sudden
revaluation of the domestic currency could substantially reduce the worker’s
accumulated fund and hence pension benefits.
30
Figure 7: The exposure to US $-denominated assets varies significantly
across Latin America
Foreign currency denominated assets (% of total assets)
100
P e rce nta ge of tota l a sse ts
90
80
70
60
50
40
30
20
10
0
A rgentina
B olivia
Chile
El
S alvador
1999
M ex ic o
P eru
Uruguay
2000
Source: AIOS (2001).
The situation in Chile, Mexico, and El Salvador is rather different. In
Chile, indexation to a unit of the cost of living (the Unidad of Fomento, UF) has
been the institutionally chosen alternative to dollarization. Understandably,
therefore, investment in dollar-linked fixed-income securities has been low,
since indexation offers full protection against inflation. Practically all of the
pension funds’ fixed-income portfolios are invested in UF-indexed securities.
There is also a trend towards inflation-protected securities in Mexico,
driven by the regulatory requirements described above. Moreover, foreign
investment is not permitted, and pension funds can only invest in dollar-linked
securities issued by the federal government up to 10 percent of total assets.
Bank deposits in foreign currency are also limited, up to an amount of
US$25,000. As a result of all these regulations, investment in dollar-linked
assets has been minimal (0.1 percent as of December 2000).
El Salvador, meanwhile, did not permit investment in domestic
government bonds denominated in foreign currency as of December 2000 or
investment in foreign securities. This situation has been altered by the
31
introduction of the dollarization plan in January 2001. All assets are now
denominated in US dollars.
Portfolio limits are clearly the determining factor of the asset
allocation of pension funds in Bolivia, Mexico, and Uruguay. They also largely
explain the foreign investment strategy of pension funds in all Latin American
countries, since, as is shown in Table 9, pension fund investment in foreign
securities is close to the stipulated ceiling in those countries where it is
permitted. However, portfolio limits cannot account for the low investment in
domestic equities in Argentina, Chile, and Colombia. As shown in Table 9, the
level of investment is far below the permitted limit.
Table 9: Asset Allocation and Portfolio Limits, December 2000
Domestic equities
Actual
Limit Difference
investment
Argentina
12.3
35.0
22.7
Bolivia
0.0
0.0
0.0
Chile
11.6
37.0
25.4
Colombia
2.3
30.0
27.7
El Salvador
3.4
5.0
1.6
Mexico
0.0
0.0
0.0
Peru
29.0
35.0
6.0
Uruguay
0.0
0.0
0.0
Foreign securities
Actual
Limit Difference
investment
4.5
10.0
5.5
0.0
0.0
0.0
10.9
13.0
2.1
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
6.7
10.0
3.3
0.0
0.0
0.0
Source: AIOS, Superintendencia Bancaria de Colombia.
Moreover, in recent years, pension funds if anything have been
reshuffling their portfolios, moving to even more conservative positions in
domestic assets, while they moved gradually towards greater international
diversification of their equities portfolios.
The evolution of pension fund portfolios in Chile is shown in Figure
8. During the first five years of the system, Chilean pension funds invested
exclusively in fixed-income securities (including mortgage bonds), since these
were the only instruments permitted by legislation. Investment in domestic
equities was first permitted in 1985 (up to 30 percent). By 1990, 11 percent of
pension fund portfolios were made up of domestic equities, a proportion that
increased rapidly to 30 percent by 1995. Since then, however, this level has
fallen dramatically to a figure close to the 1990 level. At 11.6 percent,
investment in equities in December 2000 is far below the limit of 37 percent.
While part of the fall in the allocation to equities was the result of the under-
32
performance of equities relative to bonds, pension funds have also been net
sellers of domestic equities.
While pension funds have been shying away from the opportunity to
invest a greater portion of their assets in domestic equity, they have continued to
diversify their equity portfolios. As described in Lefort and Walker (1999), the
number of issuers in pension funds’ equity portfolios grew from two in 1985,
when equity investments were first permitted, to 108 in 1998. Since then, the
number of issuers has fallen (to 90 by December 2000).
Despite this growth in the number of issuers, diversification by
industries is still rather low. At the end of 1998, 50.4 percent of the stocks held
by pension funds in Chile were in the electricity sector and 21.5 percent in the
telecommunications sector. The degree of concentration in equities portfolios
has since fallen. By December 2000, 31.7 percent of equities belonged to the
electricity sector and 24.7 percent to the telecommunications sector. This
concentration reflects to a large extent the composition and liquidity of the stock
market rather than a specific choice by pension funds.
Investment in corporate bonds also reached a maximum level in 1990
(11 percent) and has since fallen to 4 percent, far below the ceiling of 45
percent. Meanwhile, over the last five years, time deposits, mortgage bonds, and
related instruments issued by financial intermediaries have become more
prominent in pension fund portfolios for the first time since the inception of the
system.
Pension funds, on the other hand, have made the most of the chance to
invest in foreign securities. Since they were allowed to invest abroad in 1994,
Chilean pension funds have increasingly been investing in foreign securities.
Their diversification into overseas markets increased to nearly 11 percent by
December 2000, the largest share for any Latin American country. Over 80
percent of these assets were invested in foreign equity mutual funds.
33
Figure 8: Chilean pension fund portfolios have become more diversified
over time
Chile: Portfolio allocation 1981-2000
100%
P e rce nta ge of portfolio
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1981
1985
Government securities
Shares
Source:
1990
1995
Financial institutions
Investment funds
2000
Corporate bonds
Foreign securities
Superintendencia de Administradoras de Fondos de Pensiones (SAFP).
In Argentina, the increase in investment in domestic equities was also
arrested at the end of the 1990s (see Figure 9). The portion of pension fund
assets invested in equities fell from 20.5 to 12.3 percent between 1999-2000, far
below the ceiling of 35 percent. Part of this fall was due to the substitution of
Telefonica Spain for Telefonica Argentina in the middle of 2000. About 2.5
percent of pension fund assets were thereby transferred from the domestic
equity portfolio to the foreign securities portfolio. The decline in the stock
market in 2000 also partly explains this fall, while some additional investment
in domestic equities may have been channeled through mutual funds, which
increased from 6.3 to 8.3 percent during the same period. Nonetheless, a
significant part of the fall was due to net sales of equities by pension funds.
As in Chile, the number of equity issuers in pension fund portfolios
increased rapidly, more than doubling from 18 to 36 between 1994 and 1998.
Investment in corporate bonds has also fallen significantly from levels
in the first few years of the system. Corporate bonds reached their highest level
in 1996 at 7.1 percent of pension fund assets. Since then, it has fallen to 2.8
percent (December 2000), far below the ceiling of 40 percent.
34
Foreign investment, meanwhile, jumped from 0.4 to 4.5 percent of
pension fund portfolios between 1999-2000. Practically the whole of this
increase was accounted for by purchases of shares of foreign companies (and
the Telefonica equity exchange), while there was no investment in debt issued
by foreign governments. Investment in foreign equity is now close to the 7
percent ceiling.
Figure 9: Argentine pension funds have maintained a high exposure to
government debt
Argentina: P ortfolio allocation 1994-2000
100%
P e rce nta ge of portfolio
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1994
1995
Governm ent s ec urities
S hares
Source:
(SAFJP).
1996
1997
1998
Financial ins titutions
Inves tm ent funds
1999
2000
Corporate bonds
Foreign s ecurities
Superintendencia de Administradoras de Fondos de Jubilaciones y Pensiones
Colombian pension funds have been even more reluctant than their
Chilean or Argentine neighbors to invest in equities. As shown in Figure 10,
investment in equities in Colombia was at 2.5 percent of total assets at the end
of 2000, compared with a ceiling of 30 percent. Corporate bonds have also lost
their appeal and now account only for 15 percent of total assets compared with a
level of 47 percent in December 1996. As in Argentina, the under-performance
of the stock market during this period can largely account for the seemingly
conservative investment strategy of Colombian pension funds.
35
Figure 10: Colombian pension funds are increasingly investing in
government bonds
Co lo mb ia: Po rtfo lio allo catio n 1995-2000
100%
90%
Pe rcentage of portfolio
80%
70%
60%
50%
40%
30%
20%
10%
0%
19 95
1996
Gov ernment s ec urities
199 7
1 998
Financ ial ins titutions
1 999
Corporate bonds
2 000
Shares
Other
Source: Superintendencia Bancaria de Colombia
In El Salvador, pension funds are also permitted to invest in domestic
equities but not in foreign securities. Nonetheless, pension funds have so far
been able to allocate only a small portion of their assets to domestic equities. In
this case, however, the obstacle seems to be the lack of issues. Only after the
recent spate of privatization has the stock market actually begun to offer some
liquid securities.
The investment strategy of pension funds in these countries contrasts
with that of Peruvian pension funds. Peru is the only country in this more
“liberal” group where pension funds’ investments seem to be constrained by
current portfolio limits. As shown in Figure 11, investment in both equities and
foreign securities is close to the permitted level, while investment in
instruments issued by financial institutions has already surpassed the legal
ceiling.
36
Figure 11: Peruvian pension funds’ investments in private sector financial
assets are close to their permissible ceiling
Pe ru: Inve stm e nt a nd lim its, De ce m be r 2000
45
40
35
30
25
20
Inv es tment
Foreign
s ec urities
Equities
bonds
Corporate
Financ ial
15
10
5
0
ins titutions
% of to tal as s e ts
50
Dif f erenc e
Source: Superintendencia de Administradoras de Fondos de Pensiones
Furthermore, unlike pension funds in Argentina and Chile, Peruvian
funds have only slightly reduced their allocation to domestic equities and
corporate bonds (see Figure 12). Most of the decrease in fact is due to the
under-performance of the stock market. The diversification of equity portfolios
has also increased significantly since the system was launched in 1993; the
number of issuers has risen from zero in 1993 to 18 in 1998.
Meanwhile, an impressive shift towards foreign securities took place
between 1999 and 2000, when for the first time pension funds were allowed to
invest abroad. Investment in foreign securities already stood at 6.7 percent in
December 2000. The securities bought were exclusively American Depositary
Shares18 of Teléfonica Spain.
18
American Depositary Shares are a form of equity issue via a financial
institution that is denominated and pays dividends in US dollars.
37
Figure 12: Peruvian pension funds’ exposure to government securities is
the lowest in Latin America
P eru: Portfolio allocation 1993-2000
100%
P e rce nta ge of portfolio
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
1993
1994
1995
Governm ent securities
S hares
1996
1997
Financial ins titutions
Investm ent funds
1998
1999
2000
Corporate bonds
Foreign s ecurities
Source: Superintendencia de Administradoras de Fondos de Pensiones
This evidence on asset allocation raises some challenging questions. If
equities are supposed to perform better in the long term than bonds and if
pension funds are supposed to be long-term investors, should pension funds in
Argentina, Chile, and Colombia not invest a larger portion of their assets in
domestic equities? It certainly cannot be said that pension fund managers have
failed to understand the value of diversification. Pension funds in these
countries have increasingly spread their equity portfolios across an increasing
number of companies, hence ensuring greater diversification of their equity
portfolios.
This limited interest in domestic equities contrasts with the prominent
presence of government securities and instruments issued by financial
intermediaries in pension fund portfolios in Argentina, Chile, and Colombia.
This seemingly conservative investment strategy can be explained by various
factors. First, the limited experience of pension fund managers in equity
investment and the relative underdevelopment and volatility of local equity
markets may explain why pension fund managers have been hesitant investors
in domestic equities. As discussed in Part III, the stock market is relatively
concentrated(a small number of companies, mainly privatized utilities, account
38
for most of the capitalization of the stock market), and hence most shares are
not very liquid.
Moreover, in the second half of the 1990s, stock markets in Latin
America were shaken by a succession of external shocks, starting with the
Tequila crisis in 1995 followed by the Asia, Russia, and Brazilian crises. Stock
markets in Argentina and Colombia have been further hit by economic
recession. This highly volatile period has certainly not been conducive to equity
investments by pension funds.
Second, the availability of government securities and other fixedincome instruments denominated in US dollars in Argentina and indexed to a
measure of the cost of living in Chile has offered pension funds an opportunity
to diversify away from inflation risk in an efficient manner. This has also made
these instruments more attractive than equities, which are priced in nominal
terms.
Argentina has a liquid market in government debt, some of which is
indexed to the dollar. The dollar offers Argentine investors (including pension
fund managers) a hedge against the risk of devaluation. Moreover, in Argentina,
an accounting artifice was created to reduce the volatility of government bond
portfolios (and hence of pension fund returns), while at the same giving the
government access to captive long-term funding. In the so-called “investment
account” of pension funds, where up to 30 percent of pension assets can be
invested, government bonds must be maintained up to maturity. Pension funds
kept their investment in this account close to the 30 percent limit between 1999
to 2000.
In Chile, on the other hand, the indexation of fixed-income markets to
the Unidad de Fomento has reduced the attractiveness of dollar-linked
government bonds. Investing in domestic debt denominated in foreign currency
exposes pension funds to exchange rate risk without necessarily offering a good
hedge against inflation risk.19 Long-term UF-denominated government bonds
are in fact the closest that long-term Chilean investors (such as pension fund
members) have to a riskless investment opportunity. Moreover, as shown by
Walker (1998), the real returns offered by such securities during the 1990s were
greater than the optimal combination of foreign fixed-income securities or
foreign currency denominated bonds.
19
As shown in Part III, a private indexed bond market also exists in Peru. The
indexation unit is known as the VAC. The government, on the other hand,
has not issued any VAC-indexed bonds, preferring instead dollar-linked
issues.
39
The attractiveness of domestic fixed-income instruments compared
with domestic equity in Chile and Argentina is corroborated by the historical
rates of returns yielded by both instruments in local currency.
In Chile, during the 1990s, the average annual return in pesos of the
10-year government bond was only slightly below the IFCG stock market return
(the IFC index for local investors) but was much less volatile (see Figure 13).
Hence, taking into account the fact that the 10-year bond offered a risk-free rate
of return (inflation indexed) over this period, an investor looking to invest in
equities during the 1990s would have received no compensation at all for the
additional risk that he would have to bear. In other words, Chilean government
bonds were a much more attractive investment option than domestic equities.
Figure 13: Chilean government bonds have been a more attractive
investment than the stock market over the last ten years
C h ile : B o n d a n d Eq u ity re tu rn s, 1991- 2000
(D e c 1991 = 100)
350
300
250
200
150
100
50
0
1991
1992
1993
1994
19 95 1996
1997
1998
1999
20 00
IFCG
PRC10
Source: Banco Central de Chile, International Finance Corporation
In the case of Argentina, domestic equities also performed worse than
government bonds during the 1990s. Figure 14 shows two return indices for
Argentine government bonds from the EMBI+ database. One index tracks total
returns from dollar-denominated bonds, while the other tracks total returns on
40
peso-denominated notes (of much shorter maturity). Data on these markets
benchmarks are available from 1993, the year before the pension system was
launched.
The contrast with the IFC’s stock market index is quite significant.
The two government bond indices have outperformed the equity index in terms
of risk-adjusted returns, with the return from the two government bond indices
being higher on average and its standard deviation lower. Given the high
correlation between the two indices (0.8), it can be concluded that Argentine
investors would have gained very little by diversifying from bonds into equities
during this period. The conservative behavior of the Argentine AFJPs is thus
perfectly rational considering the performance of the equities market during the
1990s.
Figure 14: In Argentina, government bonds outperformed the stock
markets until December 2000
Ar ge ntina: Go ve r nm e n t Bon d an d Do m e s tic Eq uitie s in de x (199399), De c 1993 = 100
200.00
180.00
160.00
140.00
120.00
100.00
80.00
60.00
EMBI+ US$
EMBI+ loc al
Dec -00
Jun-00
Dec -99
Jun-99
Dec -98
Jun-98
Dec -97
Jun-97
Dec -96
Jun-96
Dec -95
Jun-95
Dec -94
Jun-94
Dec -93
40.00
IFCG
Source: JP Morgan, International Finance Corporation
In Peru, government bonds are denominated in US dollars. The
EMBI+ index for these bonds has also outperformed the domestic equities
market since the inception of the system. However, as shown in Figure 15, for
the first years of the system, the equities index earned a higher return than the
bond index.
41
Figure 15: Peruvian government bonds beat the local stock market since
the inception of the new pension system
Pe r u: Go ve r nm e n t Bon d and Do m e s tic Eq uitie s in de x (1993-2000),
De c 1993 = 100
650
550
450
350
250
150
EMBI+ US$ in loc al c urrenc y
Loc al?
Dec -00
Jun-00
Dec -99
Jun-99
Dec -98
Jun-98
Dec -97
Jun-97
Dec -96
Jun-96
Dec -95
Jun-95
Dec -94
Jun-94
Dec -93
50
IFCG
Source: JP Morgan, International Finance Corporation
The evidence is equally compelling for those countries where
domestic equity investments are not even permitted yet. Figure 16 shows the
return from domestic equities and government bonds in Mexico. The IFC stock
market index has trailed far behind the EMBI government bond index and has
also been more volatile.
42
Figure 16: Returns on Mexican stocks have trailed far behind yields on
government debt.
M e xico : Go ve r n m e n t Bo n d an d Do m e s tic Eq u itie s in d e x (19932000), De c 1993 = 100
650
550
450
350
250
150
EMBI+ US$
Loc al?
Dec -00
Jun-00
Dec -99
Jun-99
Dec -98
Jun-98
Dec -97
Jun-97
Dec -96
Jun-96
Dec -95
Jun-95
Dec -94
Jun-94
Dec -93
50
IFCG
Source: JP Morgan, International Finance Corporation
Such evidence raises some critical issues. A decade is certainly not a
sufficiently long period to draw conclusions about long-term trends. Pensioners,
however, are concerned less about equilibrium or long-term values than about
the actual yield from their contributions. A decade is, at minimum, a quarter of
their contribution record, and under-performing equities over such a period can
cut down pension benefits significantly. The cautious approach towards
domestic equity investment would, therefore, seem to be justified by the
experience of these countries.
In principle, however, the value of investing in equities relative to
fixed-income securities should increase in the near future. As these countries
aim to achieve stable macroeconomic conditions, real yields on money market
instruments and government bonds should fall. High interest rates will become
less necessary to defend weak currencies, and the risk premium on government
securities will diminish.
This is precisely what has happened in Chile, where pension funds are
finding that fixed-income instruments no longer provide the high real returns
that they did in the early years of the system. As shown in Figure 17, real
43
interest rates have fallen from their double-digit levels of the early 1980s and
have been averaging between 6 and 7 percent per year during the 1990s.
Moreover, the situation that prevailed in the early 1980s was exceptional (a
rapid decline in interest rates at the outset of the macroeconomic stabilization,
which led to a surge in bond prices) and is unlikely to be repeated in the future.
Figure 17: The high interest rates in Chile during the early 1980s explain
the extraordinary pension fund returns
Chile : Re a l inte re st ra te s, 1982-2000
14
Ann u al ave r age r e tur n (%)
12
10
8
6
4
2
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
0
A nnualis ed real av erage return on f ix ed inc ome ins truments
Depos it rate 90-365 day s (UF adjus ted)
Source: Banco Central de Chile
A similar situation is beginning to emerge in other Latin American
countries. Mexico’s long-term debt, for example, has begun to converge
towards US securities of the same maturity. At the end of 2000, it was trading at
300-350 basis points over US debt.
Despite these trends, government bonds maintained their superiority
over domestic equities during the 1990s. The critical question is how long this
situation can be maintained. Macroeconomic conditions will be a key
determinant of the return of bonds relative to equities. As inflation is reduced in
Chile, real interest rates will probably fall even further, helping the stock market
to recover. A similar scenario could become evident in other Latin American
44
countries. On the other hand, if sustained economic growth continues to elude
these countries and if interest rate and exchange rate volatility continue at
similar levels as at present, then dollarization will spread further. Government
bonds linked to the US dollar will then continue to offer the best protection
against domestic inflation, thus limiting the attractiveness of domestic equities.
The weak performance of stock markets has further implications for
the discussion about the purported benefits of pension reform. If pension funds
are likely to shy away from investing in domestic equities, then it seems likely
that stock markets will continue to be underdeveloped. Yet even the small
allocation to domestic equities in Chile seems to have had a significant impact
on the country’s stock market and its resilience to external shocks (Yermo,
2002). Hence, it is reasonable to expect that the performance of domestic
equities will improve over the next decade relative to government bonds
provided that favorable macroeconomic conditions are reestablished.
While benefits from investing in domestic equities during the last
decade were low at best, diversifying into foreign equity yielded substantial
gains. Using data since 1976, Srinivas and Yermo (2000) found that equity
investors in Argentina, Chile, Mexico, and Peru would have achieved much
higher risk-adjusted returns by investing a large portion of their assets in foreign
benchmarks such as the S&P index (for the United States) and the MSCI EAFE
index (for non-US equity investments) instead of in domestic equities. In some
cases (for example Peru since 1990 and Argentina from 1976 to 1990),
domestic investors would have done best if they had invested their whole equity
portfolio in foreign equities. In all other cases, investors would have benefited
by investing at least half of their equity portfolios in foreign equities.
The value of diversifying into foreign equities is likely to increase as
interest rates fall and macroeconomic conditions stabilize. Thus, the pressure to
liberalize the foreign investment regime will intensify as pension funds find it
increasingly difficult to maintain the high real rates of return that they achieved
in the past.
On the other hand, international diversification of bond portfolios is
and will remain less valuable than that of equities portfolios. The availability of
indexed fixed-income instruments in Chile and of dollar-linked instruments in
Argentina coupled with the high integration of international bond markets has
significantly reduced the value of investing in foreign bonds. In fact, the main
attraction of diversifying into foreign bonds would be to diversify credit risk,
which in some countries may be significant. Indeed, the high spreads of US
dollar-denominated sovereign bonds in most Latin American countries relative
45
to securities issued by the US federal government, and hence the high returns
they yielded in pension funds’ portfolios, are a reflection of such a risk.
An alternative way to manage pension assets in these countries
(Argentina, Chile, Colombia, and Peru) is to invest in collective investment
schemes (mutual funds). These instruments are also the only channels for
investing in real estate, infrastructure, and venture capital. Such investments
have been permitted in Argentina and Peru since the inception of the systems. In
Chile, on the other hand, investments in real estate funds were permitted in
1990 and in venture capital funds only in 1996.
Pension fund assets can be invested in these schemes but only up to a
certain percentage of total assets. Currently, mutual funds are a significant
investment only in Argentina and, to a much lesser extent, in Chile. In the other
countries, pension fund investment in mutual funds is either negligible or not
permitted by existing regulations.
One of the main reasons for the limited interest in mutual fund
investment is the high commissions charged. Pension fund assets have grown
to a level where economies of scale give them an advantage over mutual funds
in capital market transactions. In addition, mutual funds are not under as much
regulatory and social pressure to maintain low fees as the pension fund
administrators.
Investment Performance. Ignoring fees and commissions, which were
dealt with above, there are two measures of pension fund performance that are
relevant from the perspective of plan members:
•
Peer benchmark: the performance of a pension relative to other pension
funds.
•
Market benchmark: the performance of a pension fund relative to a relevant
market benchmark.
In principle, there should be a one-to-one mapping between the
rankings of pension funds in the two performance evaluations. In other words,
pension funds that do well relative to the industry should also be the ones that
perform well relative to market benchmarks. Hence, workers can choose among
pension funds on the basis of either ranking.
46
However, the performance of each pension fund and thus of the
pension fund industry in absolute terms will vary depending on the
benchmarking carried out by the pension fund administrators. When pension
fund administrators aim to beat the performance of the industry, the dynamics
of benchmarking can lead to sub-optimal asset allocations, where pension funds
aim to copy each other’s portfolios, without necessarily thinking through the
value of the investment strategy pursued.
The evidence that was given in Part II showed clearly that peer
benchmarking is common in the Latin American systems. The focus of this
section will, therefore, be on the performance of pension funds relative to a
market benchmark.
The high rates of return of pension funds reflect the high allocation of
their assets in government securities and instruments issued by financial
institutions. Real interest rates were at abnormally high levels in all Latin
American countries throughout the 1990s as monetary conditions were
tightened to reign in inflation and stabilize the currency. Countries like Chile,
that have achieved a high level of macroeconomic stability have benefited even
more from the fall in interest rates, raising price of the bonds held in pension
fund portfolios..
Since investment performance is driven largely by strategic asset
allocation, a question arises about to what extent pension funds could have
obtained higher risk-adjusted returns had they been subject to a less onerous
investment regime and had they taken advantage of such regime. Any
evaluation, of course, must consider the short time that has elapsed since the
establishment of the system. Except for Chile, therefore, it is still a hazardous
business to evaluate the performance of these systems.
For Chile, Srinivas and Yermo (1998) found that the average annual
return obtained by pension funds from 1982 to 1998 − 10.4 percent − was
actually lower than the return that could have been obtained on a market
benchmark consisting of a bond market index and a stock market index with the
same volatility (standard deviation) as that of the average pension fund return.
During the 1990s, on the other hand, the performance of pension
funds would have been better had their investment in domestic equities been
kept low, since, as was shown earlier, the Chilean stock market performed
rather badly relative to domestic bonds.
A similar picture can be drawn for all of the other Latin American
countries. Pension funds in these countries were established in the 1990s, which
47
was a bad time for Latin American equities. Indeed, the poor performance of
Peruvian pension funds relative to its peers can be explained largely by its high
allocation of investment to domestic equities.
On the other hand, relative to foreign benchmarks, the performance of
pension funds appears to have been poor. Srinivas and Yermo (2000) found that
pension funds in Argentina, Chile, and Peru would have achieved higher riskadjusted returns during the 1990s had they invested a greater portion of their
assets in foreign equity (both US and non-US). However, the value of
diversifying pension fund portfolios into foreign equities was greatest for the
equity portfolio. The value of diversifying from domestic bonds into foreign
equities was, on the other hand, more muted. As shown in the previous section,
only US equities provided an opportunity for higher risk adjusted returns.
The future performance of pension funds relative to market
benchmarks is likely to deteriorate further unless they diversify into foreign
equities in earnest. As was mentioned above, emerging market equities can
provide high returns in the long term but at a cost of significant volatility over
the short term. Hence, pension funds are unlikely to perform much better in the
short term by investing in domestic equities.
The weak performance of domestic equities coupled with the natural
decline in real interest rates resulting from greater macroeconomic stability has
led to a seemingly paradoxical situation in Chile. While quantitative restrictions
have been eased and pension funds have been aiming for increasingly
diversified domestic portfolios, risk-adjusted returns have been dropping
dramatically. This is shown in Figure 18, which plots the 12-month moving
average of the monthly real return of the pension fund industry per unit of risk
(measured as the standard deviation). The risk-adjusted return fell
systematically from a level of over 1 in the early 1980s to less than 0.5 by the
end of 2000.
48
Figure 18: Domestic portfolio diversification has not been sufficient to
maintain the extraordinary level of risk-adjusted returns of the early 1980s
C hile: R eal monthly return per unit of risk (12month MA): 1982-2000
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
Dec-00
Dec-99
Dec-98
Dec-97
Dec-96
Dec-95
Dec-94
Dec-93
Dec-92
Dec-91
Dec-90
Dec-89
Dec-88
Dec-87
Dec-86
Dec-85
Dec-84
Dec-83
Dec-82
0.0
Source: Superintendencia de Administradoras de Fondos de Pensiones
Pension funds in Chile have gradually learned the value of
diversifying into foreign equities. In Argentina and Peru, the lesson has been
learned much quicker. As returns from domestic government bonds fall in
countries such as Bolivia, El Salvador, Mexico, and Uruguay, it is likely that the
pressure to liberalize foreign investment will intensify. At stake are the pension
benefits of millions of workers.
Pension Funds in Brazil. In Brazil, pension funds have traditionally
operated in a lax regulatory and supervisory framework. Until the introduction
of the Complementary Law No. 109 in May 2001, basic regulatory principles
such as annual audits, conflicts of interest regulations, vesting and portability
rules, disclosure requirements, and funding rules either did not exist or were
weakly enforced. With the introduction of the new law, this situation is rapidly
changing. The latest development has been the introduction of a regulation by
the regulatory and supervisory body, the Secretaria de Previdência
49
Complementar, that establishes procedures for the annual auditing of all closed
pension funds. This process will include both a financial and an operational
audit.
While there are few differences in asset allocation or rate of return
between pension funds in any one country, there are very marked contrasts
among countries. As shown in Table 6, Brazil is the odd country out with 27
percent of its portfolio of closed funds invested in non-financial assets (“other
investments”). This portion of the closed fund portfolio consists mainly of real
estate (10.7 percent), lending to affiliates (6.3 percent), and lending to the
sponsoring company (8.4 percent). The investment regime of closed funds also
differs significantly from that of open funds and the FAPIs, which hold assets
worth 5 percent and 0.1 percent respectively of the value of the assets held by
closed funds. Open funds had over 89 percent of their assets invested in fixedincome securities, including 37 percent in government securities. The rest
consisted of stocks (9.5 percent) and real estate (1.4 percent). FAPI portfolios
were equally conservative, with over 97 percent invested in fixed-income
securities. Another peculiarity of the Brazilian regime is the high degree of
investment in mutual funds, almost 30 percent of closed funds’ total portfolio of
closed funds and 45 percent of open funds’ total portfolio. This compares
strikingly with countries that have a mandatory pension system. After Brazil,
Argentina had the largest investment in mutual funds, representing 7 percent of
total assets.
In Brazil, the investment regime followed by pension funds has not
changed much in the past few years, largely because pension funds have been
allowed to invest in a wide range of domestic assets for over one decade. Table
10 shows the investment portfolio of closed funds between December 1993 and
December 1998. In the table, mutual fund investment is disaggregated by asset
class and is included under the respective type of asset. The relatively high level
of investment in stocks is noteworthy, having reached a record 39 percent of
total assets in 1997.
Open pension funds, on the other hand, invested in a much more
conservative portfolio. As of November 1998, 8.5 percent of technical reserves
were invested in stocks, 1.4 percent in real estate, and 36 percent in government
securities. Their investment in government securities contrasts with closed
funds, which have rarely invested more than 5 percent of their assets in such
instruments. Of the other investment vehicles, the FAPIs invested mainly in
fixed-income securities (over 95 percent of the portfolio), while data on the
PGBLs are not yet available.
50
Table 10: Brazilian Closed-fund Investment in Mutual Funds, 1998
FIF
FAQ
FMI
FII
FEE
FIE
Total
assets
Public fund Percentage Private fund Percentage
Total
Percentag
of
of
assets
e
Assets
public assets
Assets
private
(US$mill) Of total
(US$mill)
(US$mill)
assets
8 433
14.3
6 093
23.3
14 525
17.0
2 517
4.3
3 290
12.6
5 806
6.8
6 271
10.6
1 889
7.2
8 160
9.6
372
0.6
162
0.6
534
0.6
16
0.0
6
0.0
21
0.0
86
0.1
0.0
86
0.1
59 028
29.8
26 163
43.7
85 191
34.1
Notes: FIF and FAQ are fixed-income investment funds, FMI are mainly equity mutual funds, FII
are real estate funds, FEE are foreign investment funds, and FIE are venture-capital funds.
Source: Secretaria de Previdência Complementar.
Another unique characteristic of the Brazilian system is the high level
of intermediation of mutual funds in asset management and the high percentage
of pension assets invested directly in mutual fund accounts. As of October
1998, 34 percent of assets were invested in some mutual fund (see Table 12).
Private company funds invest significantly more than public funds in mutual
funds (43 percent compared with 30 percent), despite the fact that the former
make more use of professional asset management firms.20 The role of mutual
funds in the Brazilian pension system contrasts with the experience in other
Latin American countries, which have imposed low limits on investment in
mutual funds (between zero and 15 percent of the funds’ portfolio).
Insurance Companies
In all Latin American systems except in Mexico, insurance companies
have a mandate to insure plan members against biometric risks, including
disability, death, and longevity. In Mexico, on the other hand, the social security
institute has retained the provision of disability and survivors' insurance.
Insurers' products must also insure workers against investment risk.
20.
One would expect internally managed funds to rely more on mutual funds.
The largest public funds, however, are able to hire professionals to manage
their funds internally.
51
Agency Risks. Since the function of insurance companies is limited to
providing insurance against disability and longevity risks, conflicts of interest
over investment generally do not arise. On the other hand, there are concerns
over the pricing of insurance products and in particular the possible collusion
between pension fund administrators and insurance companies. In principle,
pension fund administrators have a responsibility to search for the best
insurance policies for their members. This is unlikely in countries such as
Argentina where the pension fund administrator and the insurance company
belong to the same financial group. Solvency regulation, on the other hand, is
functioning relatively well in Latin America, offering a high degree of
protection to policyholders. Insurance companies are subject to solvency
requirements that are comparable to those of the European Union’s Third Life
Directive. On the other hand, policyholders do not benefit from protection
funds, as they do in some OECD countries. In case of the bankruptcy of an
insurance company, therefore, policyholders can be left with significantly
reduced benefits.
Insurance companies themselves are affected by various agency risks
arising from the way in which disability and survivor's insurance is managed.
The certification of disability is regulated in Chile by the Superintendency of
AFPs and is executed by Medical Commissions that report tothe pension
supervisor.
In Chile, insurance companies have been facing increasing casualty
rates for disability insurance, which appear to be linked to the increasing rate of
unemployment in the country. In the absence of unemployment insurance (it
was only introduced in 2001), Chilean workers have been claiming disability
benefits.
Investment and Longevity Risk. Insurance companies operate in a
more lenient investment regime than pension funds. In particular, they can
invest more in equities and foreign securities than pension funds. However,
unlike pension funds, which have no legal liabilities (except those imposed by
the relative performance rules), insurance companies must ensure that their
assets are sufficient to cover their liabilities generated by the policies sold.
To the extent that insurance company liabilities are fixed value terms,
bonds are a better risk management tool than equities. Thus, the investment
portfolios of insurers in Latin America focus on government and corporate
bonds and various bank instruments such as mortgage bonds.
52
In Chile, where annuities sold to pension fund members account for
the majority of insurance premiums, maturity matching is the key risk
management strategy. The availability of inflation-indexed bonds has permitted
Chilean insurers to offer the inflation-indexed annuities required by the
legislation. In Chile also, there is a liquid market of medium- and long-term
bonds, which help to keep maturity mismatch low. Mismatching appears only in
maturities of more than 17 years old. The average duration of annuities,
however, is less than that, which has ensured relatively efficient asset liability
management.
The situation is more complicated in other countries. While dollarlinked securities are available, they do not provide a perfect match for inflationindexed annuities, the type of annuity required by the legislation in countries
such as Colombia and Peru.
Furthermore, the average duration of bond portfolios denominated in
domestic currency is very low, less than 10 years. Hence, insurance companies
are exposed to substantial mismatching between assets and liabilities and may,
therefore, be expected to charge high premiums.
In Argentina, the other country with one of the oldest mandatory
pension systems, annuities do not need to be indexed to some measure of the
cost of living. However, many consumers choose to negotiate contracts in US
dollars. Insurance companies hedge the resulting liability by investing in dollar
denominated debt. Long maturities, however, can only be matched (as they are
in Peru and Colombia) by investing in foreign government bonds, such as US
bonds.
The increasing life expectancy of the Latin American population
presents another major risk management challenge for the insurance industry. In
principle, life insurance companies can hedge the risk of unexpected increases
in life expectancy through sales of life insurance policies. In countries, such as
Argentina, that require the separation of annuity companies from life insurance
companies, the longevity risk faced by the former may become unmanageable.
Insurance Companies in Brazil. Insurance companies play an
increasingly important role in Brazil as providers in the open fund system.
Unlike insurance companies in other Latin American countries, those in Brazil
are able to play a role in all stages of the pension plan.
53
IV: Competition in Pension Provision
Perhaps the greatest challenge to policymakers in designing a private
pension system is the extent and nature of competition that will be permitted
and encouraged. Most of the services that constitute pension provision, such as
record keeping and fund management, are subject to significant economies of
scale and hence may lead to high market concentration and to a very few
players assuming dominant positions in the market. This is precisely what
seems to be happening in all of the individual account systems of Latin
America.
The extent of concentration and competition in the pension industry
also depends critically on the nature of market demand. To the extent that
consumers have low price elasticities of demand but are highly sensitive in their
choices to marketing and advertising campaigns (in other words, high
advertising elasticities of demand), the result is likely to be a high cost
oligopoly, where advertising acts as the driving force for product differentiation,
which in turn pushes up operational expenses and commissions.
The ability of Latin American open pension funds to differentiate
what is essentially a homogeneous product through marketing and advertising
calls into question the rationality of consumers. As shown above and thanks to
strict regulations, pension funds vary only marginally in asset allocation and
performance, and the services that they offer in terms of record keeping and
reporting are also very similar. Under such conditions, the main differences
between pension funds are commissions and the perceptions of consumers as
developed through marketing and advertising.
Competition in the Individual Capitalization Model
Pension fund administration is an industry with important economies
of scale. There is no evidence on the size of these economies because of a lack
of data on the subject. However, some observers for Argentina and Mastrángelo
(1999) for Chile have identified a significant inverse relationship between the
size of a pension fund (in assets or affiliates) and its costs.
Scale economies have led to market concentration. As shown in Table
12, Argentina has the largest number of administrators (13), while Bolivia has
the lowest (two). Bolivia is also the only market to which entry was restricted
by law. Only two pension fund administrators were allowed to operate in
Bolivia. They were chosen by the government in a bidding process, and the
market was divided geographically between the two companies. In 1999, the
two Spanish banks that owned these pension fund administrators merged. The
54
government has since been in talks with the bank in order to eliminate what is a
de facto monopoly in the industry.
In both Chile and Argentina, there has been substantial recent
consolidation in the pension funds industry. In 1994, there were 26 funds in
Argentina, but this number fell to 18 at the beginning of 1998 and to 13 after
four recent mergers. In Chile, the number of AFPs has gone up and down and is
now lower at seven than when the system was started in 1981 when there were
12 (see Table 11).
Table 11: Number of AFPs in Chile
(1981- 2000)
1981
1988
1992
1993
1994
1995
1996
1998
2001
12
14
16
22
21
15
13
9
7
Source:Superintendencia de AFPs
Mexico has also experienced substantial consolidation, despite the fact
that its private pension fund industry is very young. The number of fund
managers has fallen from 17 in 1997 to 13 in 2000, and more mergers are
expected soon. In other Latin American countries, where reforms were adopted
more recently, there were fewer funds initially (for example, nine in Colombia,
five in Peru, six in Uruguay, and two in Bolivia). Hence, it is not surprising that
there has been little consolidation in these countries.
Industry concentration is relatively high in all Latin American
countries. A measure of concentration – the percentage of the market measured
in terms of the assets held by the largest two administrators – is provided in
Table 12. The lowest level of concentration is Argentina’s (35.8) while the
highest is Bolivia’s (100 percent).
55
Table 12: Pension Fund Management Industry
(December 2000)
Argentina
Bolivia
Chile
Colombia
El Salvador
Mexico
Peru
Uruguay
Average
Number of
Market
administrators concentration
(two largest)
13
35.8
2
100.0
8
54.1
6
52,0
3
98.8
13
38.7
4
60.1
6
66.1
7
52.0
Note: Assets held by the Bolivian capitalization fund are not included. Information for Colombia
refers only to the mandatory pension fund system.
Source: AIOS, Superintendencia Bancaria de Colombia.
One potential outcome of the oligopolistic structure of the pension
fund industry in these countries is high prices. As discussed by Valdés-Prieto
(1998), the relatively high commissions that were identified in the previous
section can be traced back to strategic competition between the pension fund
administrators, which results in high costs. Pension fund administrators have
relied heavily on their sales forces to attract new affiliates, which has pushed up
the cost of their services. In Chile, for example, marketing/sales costs accounted
for over one-half of operational expenses in the late 1990s (SAFP, 1998).
The resulting high cost, high price equilibrium also depends critically
on a low price elasticity of demand. Mastrángelo (1999) in fact showed that
participants are much more reactive to marketing and advertising by the pension
fund administrators than to prices (the marketing elasticity of demand is 18.5
times greater than the price elasticity). Furthermore, workers do not appear to
react to differences in returns, though this could be due to the fact that returns
vary very little among AFPs. Pension fund administrators, therefore, have a
strong incentive to spend large amounts on their marketing and sales forces in
order to attract new affiliates.
Policymakers have attempted to deal with the problem of high costs in
a variety of ways. These can be classified into two main groups: first, those who
aim to regulate the market as it currently operates and, second, those who aim to
change the structure of the market. We analyze these two channels in turn.
56
Regulatory Options for Lowering Administrative Costs
One solution that has been tried in Mexico and Peru is to limit
switches between funds (one switch is allowed per year in Mexico, and one
every six months is allowed in Peru). In Bolivia, switching between the two
pension fund administrators is prohibited, at least until the entrance of new
players in the market in 2002. These regulations have led to these countries
having the lowest switching rates of all Latin American countries (see Figure
19).
A similar strategy has been tried in Chile, where in October 1987 the
Superintendency of Pension Funds announced a reform that tightened the rules
for participants who wished to transfer to another pension fund. More recently,
the Superintendency has been coercing the pension fund administrators into
cutting back on their marketing and advertising efforts. The result has been a
drop in marketing expenses and, hence, in overall costs. Each pension fund has
essentially frozen its market share, leading to a drastic drop in switching rates.
Switching rates in Chile halved between 1999 and 2000.
Restricting transfers between pension funds, however, can be
counterproductive to the extent that this dampens competitive pressures and
reduces incentives for pension fund administrators to come up with cost-cutting
innovations. In Chile, the main winners from the restrictions on transfers and
the lower marketing expenses have been the AFPs, whose profitability has
surged in recent years. In 2000, their operational expenses dropped much more
than their commissions, which has led to profit margins for the industry that are
by far the highest in Latin America; the ratio of operational profits to
commission revenue increased from 37.8 percent in 1999 to 70.7 percent in
2000, according to The Latin American Pension Fund Supervisors Association
(AIOS).
A potentially more effective solution is to increase the transparency of
the commissions, as proposed by Whitehouse (2000). One problem observed in
Chile by Acuña and Iglesias (2001) is that fixed commissions are deducted
directly from the accumulated balance, while variable commissions are retained
by employers, who then transfer them to the AFP chosen by the worker. Even
though reports about the commissions appear in the quarterly statements sent to
the participants, they are not particularly visible. Moreover, workers would
have to find out the prices of other AFPs for themselves.
This situation changed in November 1998 when the Superintendency,
with the aim of increasing transparency and facilitating comparisons between
AFPs, made it mandatory for pension fund managers to include information on
57
their commissions in the quarterly statements along with a comparison with the
commissions charged by their competitors. . This regulation was followed by
another in May 2000, which required clear disclosure of the different types of
commissions (fixed, variable, and transfer costs).
A partial but potentially highly effective solution is the one proposed
by Roffman (2000) for Argentina. He proposed that the criterion for allocating
undecided workers (since 1987, these workers have been allocated in equal
proportions to all AFJPs) should be changed so that undecided workers are
assigned to the cheapest administrator according to their expected income level.
Given that up to 30 percent of workers do not state a preference regarding
AFJPs when they join the system, this reform would immediately raise the price
elasticity of demand and have a powerful downward effect on the average cost
of the system.
Some observers have also claimed that permitting greater investment
choice and eliminating the restrictions on performance would bring about
greater product differentiation and, hence, less price competition.
Another way to increase the price elasticity of demand, and hence the
extent of price competition in the industry, involves reforming the commission
structure. Various reforms have been proposed. One possible reform that could
help to reduce administrative costs would be to permit groups (for example,
employees of the same employer) to negotiate fees with an AFP. This option
was discarded in Chile at the beginning of the system because of its potentially
regressive effect. In fact, in all Latin American countries, pension fund
administrators must charge the same commission to all affiliates.
The problem of inequality can be dealt with by permitting not just
employers but also professional and trade associations to negotiate fees for their
members. For those independent workers who are left out of these collective
negotiations, the state can set up a special institution that will negotiate directly
with pension fund administrators.
Another possible reform is to permit pension fund administrators to
offer discounts on commissions for affiliates who remain with the fund for a
certain period. Such "loyalty" discounts are currently permitted in Argentina
and Mexico.
Liberalizing the commission structure is also a highly controversial
reform option. As yet, only Mexico has followed this route. The main problem
with this option is that it is very complicated to make comparisons among
pension funds with different commission structures as it requires projections of
58
future commissions, salaries, rates of return, and contribution densities. Few
workers will have the capacity or the time to carry out such modeling exercises.
Price Controls. The main objective of the aggressive marketing and
advertising campaigns observed in Chile and other Latin American countries
was to achieve a sufficiently high market share to make the operation of the
fund profitable in as short a time as possible. As was shown above, this market
development strategy had a downside for the participants, as the industry
equilibrium had high operational expenses and, hence, high commissions.
One way to avoid this possibly wasteful competition would be to limit
the commissions that pension fund administrators could charge. Setting limits
on commission levels is a strategy that has been tried by some OECD countries
(such as Poland, the United Kingdom, and Sweden), but it can have adverse
effects on the quality of services and rates of return. Moreover, determining the
"right" price can be an arduous if not impossible task, since the cost structure of
the industry may be constantly changing.
One way to reveal the cost of the industry is through a competitive
bidding process. This was the route followed by Bolivia, where only two
licenses for pension fund administrations were auctioned in 1997 through an
international public tender. The Bolivian government, however, went further in
banning competition between the two fund administrators, who operated in two
different regions of the country. Participants were eventually allowed to transfer
between the two administrators in January 2000, but the authorities suspended
transfers when the two Spanish banks that owned the administrators merged.
The ban has been extended until May 2002 when new players will be permitted
to enter the industry.
Structural Options for Lowering Administration Costs
There are two main routes to reform competition in the pension industry to
reduce fees. One route consists in liberalizing the market, as Chile did in early
2002, in order to extend the degree of product choice that workers have and
increase competition by bringing in different financial institutions into direct
competition in the pensions market. The second route consists in restricting
further competition in the industry by for example, centralizing some services
and promoting occupational pension plans.
Promoting Choice and Competition. Individual choice among
products and providers can help to reduce administrative costs in two ways.
First, it can bring into the market players with superior technologies or other
competitive advantages as a result of their activities in related industries.
59
Second, it can lead to consumers being able to make choices that better meet
their needs and, therefore, to providers making strategic decisions that take
these needs into account.
There are three main stages of this "market liberalization" policy that
can be evaluated:
(i) Giving workers’ a wider choice of funds in which they can invest by
increasing the number of funds that pension fund administrators can manage,
with each fund having different risk-return characteristics.
(ii) Allowing other financial intermediaries to manage pension funds directly.
(iii) Allowing workers to choose the financial products (such as mutual funds,
bank deposits, and insurance policies) in which to invest their retirement
savings.
As was discussed in Part I, the first option is one that was recently
approved in Chile. Chilean AFPs can now administer up to five funds of
different risk-return characteristics. Introducing individual choice over
investment, however, is not without its problems. There are many signs that
workers are not sufficiently well informed and are making bad decisions despite
having access to the right information:
-
The AFP’s Fondo 2, though highly suitable for workers near retirement
and despite having performed better than the Fondo 1 in 2000-1, has
not been chosen by many workers.
-
Some low-income workers are choosing AFPs whose commissions are
higher than those of other AFPs, despite the fact that there is no
correlation between commissions and returns.
-
Before restrictions were introduced in 1987, some workers were
switching funds more than twice a year, though there is little to be
gained by changing to another AFP since returns are very similar across
AFPs.
As well as requiring additional disclosure, giving workers a choice
over the investment of their retirement savings requires financial education.
Even in OECD countries with sophisticated financial systems and an educated
workforce such as the United Kingdom, there is much evidence that people are
ignorant of even basic financial planning, such as the difference between bonds
and equities (Whitehouse, 2002). Such problems are likely to be much more
60
acute in Latin America. Without independent advice and financial literacy
campaigns, it may not be desirable to give workers, especially for the most
vulnerable, the choice over where to invest their retirement savings.
The second option for reducing administrative costs in the individual
capitalization systems of Latin America is to open up the pension fund market
to other financial institutions. Shah (1998) strongly advocated this option.
However, the gains from opening the market are likely to be achieved through
economies of scale in distribution channels rather than from increased
competition per se.
The main advantage of opening the pension market in fact would be
that pre-existing financial institutions that sell financial instruments (such as
banks, mutual funds, and insurance companies) could use their existing
distribution channels to market pension funds without the need to incur further
marketing or advertising expenses. Administration costs, and hence
commissions, would be significantly reduced.
In the bank-dominated financial markets of Latin America, bank
branches are clearly a cost-effective means of distributing pension fund
accounts. As yet, Mexico is the only country where this is permitted. Chile is
also in the process of allowing banks and AFPs to share branches.
It is less clear, on the other hand, whether the third option − opening
up the private pension system to other financial products such as mutual funds
and insurance policies − would increase its cost-efficiency.
The evidence from Chile shows that the financial industry that most
closely resembles that of pension funds − mutual funds − actually has much
higher administrative costs and commissions. Maturana and Walker (1998)
found levels of commissions for equity mutual funds in Chile as high as 6
percent, which over sufficiently long investment horizons (more than about 10
years) far exceed current pension fund commissions.
Nonetheless, in December 2001, Chile approved just such a “bigbang” reform, the so-called Law of Voluntary Saving, which opened the
voluntary pensions market to all financial intermediaries and financial products.
Permitting workers to switch their voluntary savings between financial
providers that offer different services and have different commission structures
is likely to lead to more confusion and bad decisionmaking than before. For the
majority of the population, however, voluntary savings are still a luxury. Were
61
the government also intending to extend this structure to the mandatory system,
much rethinking would be required.
Promoting Centralization and Institutionalization in the Provision of
Pension Services. Cost savings can also be made by eliminating market
competition from the provision of certain pension services, such as contribution
collection, record keeping, and reporting services. Argentina, Mexico, and
Uruguay have centralized the collection of contributions by the social security
institute.
In Sweden, the centralization process went even further than in these
countries, including not just the collection of contributions but also record
keeping and reporting services. This market structure has eliminated the
possibility of using sales forces to reach consumers, since providers do not have
access to the names of accountholders. However, providers can and do still use
advertising as a way to attract new members.
The absence of marketing and advertising expenses helps to lower the
administrative costs of occupational pension plans relative to personal pension
plans. Hence, one possible way to reform the mandatory individual
capitalization systems of Latin America would be to permit employers to set up
pension funds for their employees (Arrau and Valdés-Prieto, 2001).
Such a strategy has been tried successfully in some OECD countries,
including some where defined contribution plans are predominant (for example,
Australia and Switzerland). However, comparing administration costs among
countries is complicated by differences in the coverage of the pension system
and of economic and financial market development.
One possible criticism of the idea of introducing occupational pension
plans in Latin America is that they would only cover a small portion of the
workforce, since many workers are self-employed. One possible solution would
be for the government to set up a special fund for the self-employed.
The Brazilian Approach to Private Pensions
In contrast with its Latin American neighbors, Brazil has a large
number of pension funds − 352 closed funds (sponsored by a total of 2,092
companies) and 47 open funds as of October 1998. However, only the open
funds compete against each other.
While public companies were the first to organize closed pension
plans, the process of privatization and continuous expansion in the private
62
sector has led to a predominance of funds sponsored by private firms. In
October 1998, there were 257 closed pension funds sponsored by private
companies compared with 95 sponsored by public companies. However, public
companies still hold the vast majority of assets (70 percent) and account for half
of all affiliates.
The open fund industry is even more highly concentrated, with one
fund, Bradesco, accounting for over half of all pension reserves. The three
largest companies account for over 70 percent of industry reserves, while the
five largest companies account for 84 percent of reserves.
V: Conclusion
The empirical evidence from Latin American countries only partly
supports the hypothesis set out at the beginning of this paper. The individual
account systems have given workers responsibility for a choice (of pension fund
administrator) whose only consequence is to increase the administrative costs of
the system. Commissions can eat up as much as one-quarter of the accumulated
balance and can negatively affect the most vulnerable groups of society who are
less likely than others to choose a suitable commission level and are likely
instead to fall into the hands of unscrupulous sales agents.
Replacement rates, while potentially high, rely on regular contribution
records. Moreover, volatility in pension fund returns and interest rates means
substantial differences across different cohorts who may insist on the
government compensating those who are worst off. Some degree of individual
choice is necessary during the accumulation stage to permit workers with
different degrees of risk aversion to optimize their investment choices. Relaxing
the restrictions on annuities purchases is also needed in order to permit some
smoothing of the interest rate risk over time.
Pension fund administrators have been relatively efficient as financial
risk managers, but the system has not been effectively insulated from political
interference. In at least four countries (Bolivia, El Salvador, Mexico, and
Uruguay), pension funds are used by the governments as captive sources of
finance. In Argentina, the government has gone so far as to appropriate the
pension assets kept in the banking system and defaulted on the government
bonds after exerting pressure on the pension funds to increase their exposure to
these assets.
Pension fund performance has also been worse than it could have been
under less restrictive investment regimes. In particular, investment risk would
have been better managed had pension funds been allowed to invest in foreign
63
securities. The gains from diversifying domestic equity portfolios into foreign
equities (both US and non-US) would have been enormous in all countries.
In Argentina, Chile, Colombia, and Peru, on the other hand, there is
little evidence to suggest that investment regulations have hampered the
performance of domestic asset portfolios. In Chile, higher investments in
equities since the establishment of the system would have yielded higher riskadjusted returns. During the 1990s, on the other hand, domestic government
bonds outperformed domestic equities. Therefore, the limit on equities did not
constrain asset allocation during this period since pension funds kept investment
in domestic equities far below this level. In Argentina, domestic equities also
performed worse than domestic government bonds in the 1990s. In fact, only
US equities would have offered consistent diversification gains for domestic
bonds in all four countries.
The performance of insurance companies has been shown to be
positive in the case of Chile, thanks largely to the presence of long-term,
inflation-indexed bonds. In other countries where such instruments are not
available, it is unlikely that insurance companies are able to offer annuities with
as high a value as those in Chile. The mismatching between assets and liabilities
in countries such as Colombia and Peru, where indexation of annuity benefits is
mandatory, forces insurance companies to price these products at a very high
level, thus reducing the attraction of this option. The management of longevity
risk is also likely to become an increasingly difficult challenge for insurance
companies, especially in countries such as Argentina, where annuity companies
are separated from the life insurance industry.
Finally, more creative solutions are needed for reducing
administrative costs than simply constraining choice further. In fact, the systems
are in bad need of more investment choice by workers. Costs can be contained
most effectively through caps of prices and structural reforms of the industry.
One industry model that effectively tackles the problem of fees is the centralised
model, where some pension services such as account management are carried
out by a single agency or company. Occupational plans, where employers play a
central role in negotiating plan management contracts with financial institutions,
could also help to bring down fee levels significantly.
64
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67
Appendix A
Table A1: Pension Funds, Assets under Management
US$ million, 1995-2000
Argentina
Bolivia
Brazil
Chile
Colombia
El Salvador
Mexico
Peru
Uruguay
1995
2 492
0
60 080
25 358
270
0
0
0
1996
5 323
0
70 423
27 495
884
0
0
949
50
1997
8 816
0
79 600
30 876
1 481
0
755
1 509
191
Source: Pension fund regulators
69
1998
11 526
332
78 308
31 336
2 411
47
10 594
1 700
374
1999
16 787
592
2000
20 381
841
34 501
3 324
213
11 430
2 406
591
35 886
4 201
482
17 355
2 978
811
Table A2: Asset Allocation of Pension Funds in Chile (%), 1981-2000
Government
securities
Financial
institutions
Corporate
bonds
Shares
Investment
funds
Foreign
securities
Other
Government
securities
Financial
institutions
Corporate
bonds
Shares
Investment
funds
Foreign
securities
Other
1981
28.1
1982
26.0
1983
44.5
1984
42.2
1985
42.6
1986
46.3
1987
1988
41.5
35.4
1989
41.6
1990
44.1
71.3
73.4
53.3
56.0
56.3
49.0
49.8
50.1
39.2
33.6
0.6
0.6
2.2
1.8
1.1
0.8
2.6
6.4
9.1
11.1
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
3.9
0.0
6.2
0.0
8.1
0.0
10.1
0.0
11.3
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
1991
38.3
1992
41.8
1993
39.2
1994
39.8
1995
39.5
1996
39.2
1997
1998
39.6
41.0
1999
34.6
2000
35.7
26.7
24.9
20.7
20.1
22.4
24.8
29.4
31.8
33.2
35.1
11.1
9.6
7.3
6.4
5.2
5.0
3.3
3.8
3.8
4.0
23.8
0.0
23.5
0.2
31.9
0.3
32.4
0.3
30.1
2.5
27.0
3.4
23.4
3.1
14.9
2.9
12.4
2.6
11.6
2.4
0.0
0.0
0.6
0.9
0.2
0.5
1.1
5.6
13.4
10.9
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.2
Source: Superintendencia de AFPs
Table A3: Asset Allocation of Pension Funds in Argentina (%), 1994-2000
1994
Government
57.3
securities
Financial
32.6
institutions
Corporate bonds
3.0
Shares
1.6
Investment funds 5.4
Foreign securities 0.1
Other
0.0
1995
57.5
1996
54.4
1997
44.8
1998
52.2
1999
52.3
2000
56.0
27.1
17.0
26.1
19.7
15.5
15.6
7.0
6.0
1.8
0.7
0.0
7.1
18.7
2.6
0.2
0.0
2.6
21.5
4.6
0.4
0.0
2.3
18.6
6.9
0.3
0.0
2.1
20.5
6.3
0.4
2.9
2.8
12.3
8.2
4.5
0.6
Source: Superintendencia de AFJPs
70
Table A4: Asset Allocation of Pension Funds in Colombia (%), 1995-2000
Government
securities
Financial
institutions
Corporate bonds
Shares
Investment funds
Foreign securities
Other
1995
29
1996
23.8
1997
20.8
1998
30.0
1999
41.7
2000
49.2
31
56.3
43.7
48.2
31.6
26.7
29
1
0
0
0
18.4
0.3
0.0
0.0
1.2
27.4
7.4
0.0
0.0
0.7
17.5
3.2
0.0
0.0
1.1
21.7
3.0
0.0
0.0
1.9
18.6
2.3
0.0
0.0
3.2
Source: Superintendencia Bancaria de Colombia
Table A5: Asset Allocation of Pension Funds in Peru (%), 1993-2000
Government securities
Financial institutions
Corporate bonds
Shares
Investment funds
Foreign securities
Other
Source:
1993
31.9
68.1
0.0
0.0
0.0
0.0
0.0
1994
26.0
56.1
3.4
14.5
0.0
0.0
0.0
1995
22.5
49.0
10.4
18.1
0.0
0.0
0.0
1996
0.4
44.0
23.9
31.7
0.0
0.0
0.0
1997
0.3
42.2
22.7
34.8
0.0
0.0
0.0
1998
4.9
41.5
19.7
32.9
1.0
0.0
0.0
1999
7.1
39.3
15.4
37.1
0.6
0.0
0.5
Superintendencia de AFPs
Table A6: Asset Allocation of Pension Funds in Mexico (%), 1998-2000
Government securities
Financial institutions
Corporate bonds
Shares
Investment funds
Foreign securities
Other
1998
95
2
3
0
0
0
0
Source: AIOS
71
1999
97.4
0.1
2.5
0.0
0.0
0.0
0.0
2000
92.6
2.0
5.4
0.0
0.0
0.0
0.0
2000
9.0
34.0
18.6
29.0
0.7
6.7
2.1
Table A7: Asset Allocation of Pension Funds in El Salvador (%), 1998-2000
Government securities
Financial institutions
Corporate bonds
Shares
Investment funds
Foreign securities
Other
1998
74
25
1
0
0
0
0
1999
64.3
31.7
0.0
3.7
0.0
0.0
0.0
2000
71.3
25.3
0.0
3.4
0.0
0.0
0.0
Source: AIOS
Table A8: Asset Allocation of Pension Funds in Uruguay (%), 1998-2000
Government securities
Financial institutions
Corporate bonds
Shares
Investment funds
Foreign securities
Other
1998
75
22
0
0
0
0
3
1999
60.1
36.0
1.9
0.0
0.0
0.0
2.0
2000
61.4
34.9
1.9
0.0
0.0
0.0
1.8
Source: AIOS
Table A9: Asset Allocation of Pension Funds in Bolivia (%), 1998-2000
Government securities
Financial institutions
Corporate bonds
Shares
Investment funds
Foreign securities
Other
1998
68
32
0
0
0
0
0
Source: AIOS
72
1999
67.2
32.4
0.4
0.0
0.0
0.0
0.0
2000
69.5
23.2
3.7
0.0
0.0
0.0
3.7
Table A10: Asset Allocation of Closed Pension Funds in Brazil (%), 19932000
Instrument/Asset class
1993
1994
1995
1996
1997
1998
Govt. Securities
Other fixed-income secs.
Shares
Real estate
Lending to participants
Lending to sponsor
Other
Total
4
26.8
34.8
16
4.2
7.8
6.4
100
3.8
25.8
39.1
14.4
6.5
7.8
2.6
100
4.4
31.7
29.5
14.9
7.7
9.4
2.5
100
5.7
31.2
33.5
12.9
7.3
6.9
2.4
100
3.7
30.8
39.2
10.4
6.4
7.4
2.2
100
6.5
36.1
29.4
10.7
6.3
8.4
2.6
100
Note: Shares include equity investment in sponsoring company.
Source: Secretaria de Previdência Complementar, ABRAPP
73
1999
2000