Keeping the Promise of Social Security in Latin America

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1 Keeping the Promise of Social Security in Latin America Guillermo Perry Council of the Americas Conference October 27, 2004 Based on a book by Indermit Gill, Truman Packard and Juan Yermo, with Todd Pugatch Office of the Chief Economist, LAC Region, The World Bank 1

2 Keep in Mind: Differences across reforms, including structure of pillars Choice of system Choice of system Mandatory Contributions FF PAYG FF PAYG PAYG FF FF PAYG Bolivia Colombia Argentina Costa Rica Chile Peru Uruguay Dominican Republic El Salvador Mexico 2

3 Summary of results Fiscal: positive results, but Reduction of implicit pension debt, but Transition costs and transformation of implicit debt into explicit debt can compromise fiscal stability in some countries Financial: positive results, but Pension funds deepened capital markets when they didn t invest excessively in public debt. Regulatory challenges remain, such as high commissions, homogeneous portfolios Social: positive results, but with limits Greater equity among covered population, but Little progress in coverage, threatening equity gains. Lack of sufficient attention to poverty prevention pillar. Structural: positive results, but Demographic change makes individualization of pensions appropriate, but Unclear extent to which mandate to save is appropriate: balance between pillars two and three 3

4 Three Propositions Reforms motivated more by macro (fiscal and financial) concerns than coverage With some important long-term structural benefits: individualization of accounts. Reforms motivated by loss of faith in government and not by consideration of government s role Used to reduce government role in pensions: private administration of funds, but Government still has central role: funds exposure to country risk, need for regulation, minimum pensions, uncovered old age population. Reforms sought to increase coverage, but did not consider range of needs and options available to entire population. Improved incentives to participate, but coverage still low. 4

5 Achievements and challenges in fiscal and macroeconomic dimensions 5

6 Simulations show that reforms reduced implicit pension debt 400% IPD in 2001 IPD in 2020 IPD in 2030 IPD in % Government's Implicit Pension Debt as Percentage of GDP 300% 250% 200% 150% 100% 50% 0% Reform No reform Reform No reform Reform No reform Reform No reform Reform No reform Reform No reform Reform No reform Reform No reform Chile Peru Colombia Argentina Uruguay Mexico Bolivia El Slavador 6

7 But estimating transition costs is difficult, complicating fiscal management: case of Bolivia Cash Flow Gap: Bolivia pension-related deficit as percentage of GDP actual projected in

8 Transition costs worsened fiscal situation in Argentina Consolidated Public Sector Primary Balance Social Security Balance Consolidated Public Sector Overall Balance -8 Source: Ministerio de Economía de la República Argentina and International Monetary Fund. 8

9 Achievements and challenges in the financial sector 9

10 1. Financial impact of reform Private, non-financial issuers of securities have benefited only in countries in which fiscal positions have been strong (Government is not crowding out other investment options and regulation has been adequate options) and regulation has been adequate Even in successful countries, reform s contribution to market liquidity has been limited Reforms led to some modernization of financial infrastructure and financial regulation/supervision 10

11 Median of two-thirds of fund assets invested in domestic sovereign debt Private Pension Fund Portfolios Consist Mainly of Government Paper Percent of Total Portfolio Costa Rica El Salvador Mexico Argentina Bolivia Uruguay Colombia Chile Peru Government Securities Financial institutions Corporate Bonds and Equities 11

12 Market capitalization has increased in Chile 250 Market capitalisation relative to GDP (%) Bank assets Stock market Private bonds Public bonds 12

13 But stock market liquidity has not taken off % of GDP Source: Cifuentes et al.(2001) Stocks Bonds Banks 13

14 Improving the second and third pillars: main challenges High mandatory contributions: : possible conflicts with liquidity needs of low- income households and no room for development of third pillar. Risk management: : need to consider risk aversion of individuals. Management of costs and competition: economies of scale and asymmetric information. 14

15 Problems with high mandatory contributions for the poor Greater economic and health risk need for liquidity Shorter life expectancy less savings required Greater housing and educational deficiencies priority for other forms of saving Mandatory contributions should be lower in Latin America than OECD 15

16 Latin America has high mandatory contribution rates Cotizacion / Salario medio (%) Argentina Bolivia Chile El Salvador Mexico Peru Uruguay Capitalizacion Comisiones y primas seguros 16

17 Remaining tasks to manage investment risk Liberalize investment in foreign instruments without compromising macro stability Sovereign bonds with better credit rating Opening to instruments with guaranteed minimum income Portfolio choice, but simplified, with adjustments based on age 17

18 Remaining tasks to manage longevity risk Mandatory annuities to cover minimum pension beginning at a certain age? Rigidity of early retirement requires purchase of annuities Simplification of annuity options, including variable benefits Strengthen supervision of insurance companies 18

19 Management of costs and competition Administrative costs have decreased but remain high in some countries Highly concentrated industries, with little competition and, in some cases, possible conflicts of interest with insurance companies and other financial entities Absence of employer as referee or mediator, in contrast with OECD countries 19

20 Large differences in commissions (December 2003) 25 Com. var. / (Capitalizacion + com. var.) (%) Argentina Bolivia Chile El Salvador Mexico Peru Uruguay 20

21 Also differences in reduction of commissions ( ) 45 Com var / (Capitalizacion + com var) (%) Argentina Chile Peru 21

22 Regulatory deficiencies: cost savings not passed to consumers (AFPs in Peru) Rendimiento del capital (%) Cargos/Contribuciones netas Gastos operativos/cargos netos Rendimiento del capital Comisiones/Contribuciones netas y Gastos Operativos/Comisiones netas (%) Fuente: Lasaga y Pollner (2003) 22

23 Conclusions A large second pillar does not correspond to level of development in Latin America. Origin: large mandated benefits in previous PAYGO systems that were only modestly reduced through reforms Risk and Cost Management in mandatory pillar can still be improved Voluntary pillar should be more open to competing firms and products 23

24 Achievements and challenges in social dimension 24

25 Participation rates remain low, worsening equity: in best cases, coverage barely surpasses 60% of EAP 70.0% 60.0% Proporción de PEA afiliada al sistema de pensiones o en el sector formal 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Chile 2000 Perú 1999 Colombia 1999 Argentina 2002 México 2001 Bolivia 2000 El Salvador 1998 Costa Rica 2000 Nicaragua 1999 Hombres 63.6% 12.8% 19.8% 35.2% 45.1% 11.8% 24.2% 23.2% 8.9% Mujeres 60.9% 9.1% 26.9% 37.2% 46.6% 8.3% 27.6% 22.5% 15.3% Total 62.7% 11.2% 22.3% 36.0% 45.7% 10.3% 25.5% 22.9% 11.0% 25

26 How to close this gap and cover the population against the risk of old age poverty? Second pillar is not the appropriate instrument for poverty reduction Need to pay more attention to structuring a poverty reduction pillar that is Fiscally sustainable Equitable in outcomes Blind to labor history 26

27 Design must respond to realities and preferences of each country; variables to consider are Benefit level Minimum wage, poverty line or another threshold? Eligibility age Eligibility age adjustments with advances in longevity Indexing benefits To inflation or wage growth? Benefits and the tax system Financing benefits: through VAT? Benefits taxable to ensure proper targeting? Other considerations Implications for other public benefits 27

28 Looking Forward: How to increase coverage? In particular, how to cover the risk of poverty in old age pillar one, pillar zero or general antipoverty programs? How to make pillar two more efficient? How to diversify away public risk in pillar two? What is the proper balance between pillars two and three? How to achieve full fiscal sustainability? 28

Privatizing Social Security in Latin America

Privatizing Social Security in Latin America Indermit Gill December 9, 2004 Based on Keeping the Promise of Social Security in Latin America By Indermit S. Gill, Truman Packard and Juan Yermo, with Todd