How to strengthen the pension systems in Latin America

Transcription

1 How to strengthen the pension systems in Latin America Experiences, lessons and proposals Volume I An international study from SURA Asset Management

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3 An international study from SURA Asset Management How to strengthen the pension systems in Latin America Experiences, lessons and proposals Volume I Co-ordinator Rodrigo Acuña Heads of research Rodrigo Acuña, Chile, Uruguay, El Salvador Miguel Palomino, Peru Leonardo Villar, Colombia Alejandro Villagómez, Mexico Diego Valero, OECD

4 How to strengthen the pension systems in Latin America Experiences, lessons and proposals Volume I SURA Asset Management Printed in Chile, March 2015 All unauthorised reproduction of this publication, whether total or partial, is prohibited, with the exception of data or comments that quote the title of the study. Each article is the exclusive responsibility of its author and does not necessarily reflect the opinion of SURA Asset Management.

5 Contents Prologue Researchers Executive summary and proposals Introduction Experiences, lessons and trends in pension systems Non-contributory pillars Planning and design of programmes Amount, coverage and funding of non-contributory pensions Focusing of benefits Incentives and disincentives to contribution in the contributory system Experience of non-contributory pillars in OECD countries Challenges Individually-funded mandatory systems Coverage Fairness Solidarity Efficiency Pillar Three: voluntary pension savings Integration and complementation between pillars and the adequacy of pensions Integration and complementation between pillars in the pension system Problems caused by the duality of contributory systems Experiences with pay-as-you-go schemes in the region

6 Level of pensions and replacement rates in the system Pension risk Integration and complementation between different social security programmes Description of the pension systems Chile Pillar Zero or non-contributory pensions Pillar Two : individual funding Pillar Three : voluntary pension savings Peru Pillar Zero or non-contributory pensions Competitive mixed scheme in the contributory pillar Pillar Two : individual funding Pillar Three : voluntary pension savings Colombia Pillar Zero or non-contributory pensions Competitive mixed scheme in the contributory pillar Pillar Two : individual funding Pillar Three : voluntary pension savings Uruguay Pillar Zero or non-contributory pensions Complementary mixed scheme in the contributory pillar Pillar Two : individual funding Pillar Three : voluntary pension savings Mexico Pillar Zero or non-contributory pensions Pillar Two : individual funding Pillar Three : voluntary pension savings El Salvador Pillar Zero or non-contributory pensions Pillar Two : individual funding Pillar Three : voluntary pension savings References How to strengthen the pension systems in Latin America

7 Prologue The long-term prospects for Latin America continue to be promising, even though its growth has slowed down in the past three years. The impetus of the private sector, reforms that favour the development of markets and large infrastructure projects, will revitalise the formal labour force and increase people s income, especially in Mexico, Peru and Colombia, deepening a trend that we have already been seeing. Informal labour in the region has fallen from almost 53% to 47% in the past five years, according to the International Labour Organisation and the middle class in Latin America grew 47% between 2003 and 2009, according to World Bank studies, arriving at a total of 152 million people. Although this increase has slowed down in the last two years, the organisation estimates that by about 2030 the middle class in this area will represent almost half its total population. The most important point is that this growth will be headed by a greater proportion of economically active people because over 40% of the Latin American population pyramid is concentrated in the segment between 20 and 45 years of age. Life expectancy continues to rise, just as in the developed world, and currently stands at around 78 years of age in the region. This is one of the factors that is putting the effectiveness of the pension systems to the test in these countries, because the systems are relatively new compared with those of Europe and the United States. The Chilean pension system, which began in 1981, is the oldest in Latin America and has served as a reference for other countries. At the beginning of 1990, Colombia and Peru adopted a similar system, followed by Mexico in Today, all of these have shown themselves to be financially sustainable, but they are facing a common prob- Prologue 5

8 lem: the replacement rate is not meeting the expectations and needs of the population, or will find it difficult to do so. In this context, it is necessary to introduce adjustments and innovations that will enable greater levels of pension savings to be generated, and will increase the coverage of the solidarity type of benefits that the individually-funded system has made possible by reducing the long-term fiscal deficits of the old pay-as-you-go schemes. One of the main corporate commitments of SURA Asset Management is to contribute our knowledge and experience, built up over 30 years of managing financial assets, in order to support positive changes that deal in a technical manner with the various proposals that have been put forward to improve coverage and density and to encourage voluntary saving, in the interests of the countries and population of Latin America. We wish to collaborate with the authorities and experts from both the public sector and the industry, in discussing and generating key reforms to enable the pension system in our countries to perform better. In 2013 we did this by means of the study entitled Contribution of the private pension system to the economic development of Latin America. On this occasion we have asked distinguished economists from different countries to make studies of the individually-funded pension programmes, and also to include other contributory and non-contributory pillars. We trust that by analysing experiences and good practices in all these fields and markets, including the cases of the United States, Sweden and the United Kingdom, and studies for countries belonging to the OECD, we shall have valuable information available to enable us to advance in improving our systems at the speed that the context demands. Executive President SURA Asset Management 6 How to strengthen the pension systems in Latin America

9 Researchers Coordinator Rodrigo Acuña Rodrigo Acuña has a first degree in Business Administration from the Pontificia Universidad Católica de Chile, with specialisation in Economics, and postgraduate studies in Applied Macroeconomics from the same university. He is a partner at PrimAmérica Consultores, a firm specialising in social security, pensions, savings, life insurance and finance; lecturer at the Management Development Centre of the Pontificia Universidad Católica de Chile in the Diploma Course on Investments for the Long Term and Retirement, and advisor to the International Federation of Pension Fund Administrators, FIAP. He has been an executive of pension and financial institutions and international consultant for governments, multinational bodies and private-sector investors on matters of social security and savings programs. Researchers 7

10 Peru Miguel Palomino Miguel Palomino is an economist from the Universidad del Pacífico with a Ph.D. in Finance from the Wharton Business School at the University of Pennsylvania. He is Managing Director of the Peruvian Institute of Economics, director of the Lima Stock Exchange, Partner and Director of Palomino y Asociados and Director of the Master s Course in Finance at the Postgraduate School of the Universidad del Pacífico, where he has lectured in Finance and Financial Economics. He has been a member of the Advisory Committee of the Ministry of Economics and Finance and President of the Financial Services Committee of the American Chamber of Commerce. In the private sector, he is Chairman of the Board of Aventura Plaza S.A. and Director and Member of the Auditing Committee of Southern Copper Corporation. OECD Diego Valero Diego Valero has a Doctorate in Economics, an Actuarial qualification from the Universidad de Barcelona and a Diploma in Corporate Top Management from the IESE Business School belonging to the Universidad de Navarra. He is also Honorary President of the 2008 graduates of the MBA and Executive MBA at ICADE. Diego Valero lectures at the Universidad de Barcelona, where he has taught courses on Actuarial Statistics and the Economics of Social Security and directed the Master s Course in Social Pensions. He is also Academic Director of the Global Pensions Programme of the London School of Economics. Co-founder and President of Novaster, a pension consultancy firm in Spain and Latin America, he was also President of Ocopen (Organisation of Spanish Pension Consultants) for ten years. 8 How to strengthen the pension systems in Latin America

11 Colombia Leonardo Villar Leonardo Villar is an Economist Cum Laude and Magister, Universidad de los Andes, Colombia and has an M.Sc. in Economics from the London School of Economics. He has been Executive Director of Fedesarrollo since April 2012, prior to which he was Chief Economist and Vice-President of Development and Public Policy Strategies of CAF Latin American Development Bank. In the Colombian public sector he was Member of the Board of Directors of the Banco de la República de Colombia for twelve years; Technical Deputy- Minister at the Ministry of Finance and Advisor to the Executive Council for Foreign Trade. He has been linked with the Colombian financial system as a member of the board of public and private institutions, as Vice-president of the Banco de Comercio Exterior and Technical Vice-president of the Colombian Banking Association. Mexico Alejandro Villagómez Alejandro Villagómez has a Licentiate in Economics from the Universidad Nacional Autónoma de Mexico, UNAM, and a Ph.D. and M.A. in Economics, from Washington University in St. Louis. He is Research Professor of the Economics Division of the CIDE, Centre of Economic Research and Teaching and is a member of the Latin American and Caribbean Economics Association, of the Technical Advisory Council of the Centre of Economic Studies of the Private Sector and the Academic Advisory Council of the FIAP. He was advisor to the National Commission of Savings for Retirement (CONSAR), consultant to the Mexican Association of Retirement Fund Administrators (AMAFORE) and Academic Secretary of the CIDE. He was involved in the reform of the pension system corresponding to the Mexican Social Security Institute, IMSS, and has also been external advisor of the IDB and the CEPAL. Researchers 9

12 10 How to strengthen the pension systems in Latin America

13 Executive summary and proposals The aim of this publication is to analyse the experiences, lessons and trends recorded in the pension systems of six Latin American countries that made reforms in the eighties and nineties, bringing in individually-funded programmes with defined contributions: Chile, Colombia, El Salvador, Mexico, Peru and Uruguay. The case of Sweden was also studied, and those of the non-contributory and voluntary pension saving pillars of various developed countries, in order to compare them with the situation in the Latin American region and evaluate experiences that may help towards identifying proposals to improve the way the pension systems operate. The conclusions given here are preliminary ones because the systems are still in transition, meaning that their current results do not fully reflect the long-term position. Why the individually-funded systems were created The pension reforms that created the systems based on individual funding to replace defined-benefit pay-as-you-go schemes, either partially or totally, or operate as a complement to them, were motivated essentially by the need to improve workers pensions in the long term, reduce the financial deficits of those schemes, reduce the commitment of state funds to the pension system and promote economic development. The operation of the pay-as-you-go schemes in the Latin American region suffered a series of problems that led to the implementation of structural reforms to the pension systems. These were necessary in order to achieve the efficiency, fairness, viability and sustainability of the programmes in the long term. The main problems that existed were the awarding of benefits that bore no relation to the contributions paid during the active stage of life, but only to the final wages; the regressive aspect involved in the granting of the pensions, these usually being higher than the capitalised Executive summary and proposals 11

14 contributions are able to cover and concentrated on members with high incomes, who generally exceed the contribution periods required and have a higher income at the end of the working life; the lack of fairness caused by granting special treatment to certain groups of workers; the rigidities imposed on the operation of the labour market, due to there being no portability for pension rights, and the segregation of the administration of the pension programmes; and the lack of financial sustainability, which obliges the State to provide permanent support to cover the actuarial deficits, diverting resources that could be used more efficiently from the social point of view by improving benefits for the lower-income sectors. Many of these schemes end up financing part of the pensions of the higher-income population with the contributions of the lower-income workers, because a significant proportion of the latter group fails to contribute enough to receive a pension. An example of the financial imbalances that were found in the pay-as-you-go schemes is the case of Colombia, where it is estimated that the actuarial debt, at current net value, was 297% of the GDP before the creation of the individually-funded system, falling to 162% with the pension reform. Currently fiscal commitments to the pay-as-you-go schemes in Colombia continue to be significant, even though they are lower than before. The payment of pensions chargeable to the Central Government amounts annually to 3.8% of GDP, though only 1.1% is channelled to Colpensiones, the body administering the general pay-as-you-go scheme, while the remaining percentage goes to paying special-scheme pensions. The problems besetting pay-as-you-go schemes with defined benefits are not confined only to Latin American countries. In Europe, one of the main concerns in pension systems is the financial sustainability of their pay-as-you-go, defined-benefit programmes. With a view to facing up to the deficits that exist, numerous countries have brought in reforms to those programmes. These consist mainly in raising retiring age; introducing automatic adjustment mechanisms or sustainability factors, which seek to bring the parameters of the pension systems into line with demographic, economic and financial trends; adjusting the formula for defining pensions; freezing benefits, especially in the case of higher-income pensioners; and discouraging early retirement. In the past eighteen years, a total of seventy-two countries with public pay-as-you-go systems have increased their contribution rate, forty-five have put up their retiring age; and fifty-six have adjusted the formula of benefits or reduced them. 1 These reforms have led to a situation in which the majority of the European Union s Member States are tending to reduce the proportion of public pay-as-you-go pensions in the total pensions, and give a more important role to complementary private plans with defined contributions. 2 On the other hand, the OECD has detected that the speed of carrying out pension system reforms has increased in the countries belonging to the organization, in an attempt to stabilise unsustainable government debt 1 FIAP (2014) 2 European Commission (2010) 12 How to strengthen the pension systems in Latin America

15 and public expenditure on pensions. Furthermore, private pension plans are playing an important role in supporting pension sufficiency, because it is foreseen that new generations will be more dependent on these plans. 3 The replacement of pay-as-you-go schemes and the creation of individually-funded systems in Latin America have stimulated greater economic growth, basically in four crucial ways: the level and structure of employment and its formality; saving and investment; the development and efficiency of the capital market; and the evolution of total factor productivity (capital and labour). A research study by SURA Asset Management (2013) for four Latin American countries estimated that the creation of the individually-funded systems produced a higher annual growth-rate of GDP of 0.3% in Mexico and Peru, 0.4% in Chile and 0.6% in Colombia in the period analysed. Experiences of the pension systems following the reforms in Latin America The evolution of the pension systems in Latin America shows important advances in terms of meeting the objectives of the reforms that created the individually-funded systems and producing adequate management on the part of the pension fund administrators, but there are still major challenges to be faced. The main ones are: how to extend the coverage of the contributory system to a higher percentage of the population; to increase contribution density; and provide adequate pension amounts for the system s members. In the long term, there are likely to be gaps between the replacement-rate estimates of what can be provided by the pension programmes and the benefits expected by members, meaning that measures must be adopted promptly to reduce these. The existence of structural barriers makes increasing coverage and contribution density more difficult The introduction of individually-funded systems improved the real coverage figures of the pension systems by eliminating or reducing the hidden under-coverage that exists in the pay-as-you-go schemes, due to the existence of workers generally the most vulnerable and lowest paid who never manage to meet the minimum requirements in terms of contribution years or years of service that are needed to qualify for a pension, and who lose the contributions they have paid, either partially or totally. This does not happen in the individually-funded systems, in which workers have ownership rights over the funds accumulated, including the corresponding yields. In addition to the above, it was hoped that by implementing the reforms, the direct relationship between contributions and benefits, the existence of ownership rights and the elimination of the unfairness of the pay-as-you-go schemes implied in the 3 OECD (2014) Executive summary and proposals 13

16 creation of the individually-funded systems, would improve the coverage of the population in the active stage. However, with the exception of Chile and Uruguay, there is no evidence of a trend towards increased coverage over time in the remaining countries studied. The main obstacles to achieving this objective are the existence of structural barriers that complicate the extension of the system and the systematic, frequent payment of contributions into the individual accounts by both workers and employers; deficiencies in design and integration between the different pillars of the pension system and between the various social security programmes, and the low average income levels of the workers. The characteristics of the labour market in Latin American countries, especially the rates of informality, which reach levels of 70% in some countries, and the turnover between types of occupation, unemployment and non-activity, represent a substantial part of those structural barriers. Implementing reforms that reduce costs of formal work contracts and increasing incentives to belong to the formal labour market are necessary measures, but are not sufficient to solve these problems. International experience shows that significant, sustainable increases in coverage and contribution density are possible in the long term and occur as countries develop and increase their per capita income levels (see graph). However, it is possible to adopt measures in the shorter and medium term that enable these problems to be reduced, such as those already mentioned, especially in certain Latin American countries in the study that have coverage levels below other countries with similar levels of development and per capita income. RELATIONSHIP BETWEEN LABOUR FORCE COVERAGE AND PER CAPITA INCOME 100% 90% y = e x R 2 = Active members (% Labor Force) 80% 70% 60% 50% 40% 30% 20% 10% 0% Log (Income per capita (Thousands)) Source: Paralles-Miralles, Romero and Whitehouse, World Bank (2012). 14 How to strengthen the pension systems in Latin America

17 For example, the coexistence of pay-as-you-go and individually-funded contributory schemes in Colombia and Peru has limited the effects of the reforms on coverage expansion, because the maintenance of those schemes makes it necessary for public resources to be set aside to sustain the pay-as-you-go and defined-benefit programmes which run at a deficit, instead of their being dedicated to increasing the coverage of workers with lower incomes who need state help if they are to be included in the system. Furthermore, these schemes contain elements of unfairness that are generally damaging for lower-income workers and affect the image of the system and its possibilities of increasing coverage, while their coexistence with individually-funded systems creates room for opportunist behaviour by better-informed members who find ways between programmes. Towards a multiple-pillar scheme in the pension system When the individually-funded systems with defined contributions were set up, it was thought that these would solve the matter of providing adequate pensions for the vast majority of enrolled workers. The accumulated evidence shows significant structural improvements compared with the performance of the pay-as-you-go schemes that were in force previously. However, a considerable proportion of members fail to contribute with the regularity required to achieve the expected replacement rates. In addition, changes have occurred since the systems were set up which have had a negative impact on the replacement rates that the systems are in a position to finance and have increased the risk facing lower-paid workers of falling into poverty in old age. These changes include increases in life-expectancies and reductions in yields on investments and in the interest rates for converting accumulated balances into pensions, while on the other hand, there have been no necessary adjustments to the systems most relevant parameters (contribution rates and legal retiring ages). In view of the difficulties involved in increasing the coverage and level of pensions in the contributory systems, since the 2000s a rapid process was put in train to create and extend non-contributory programmes, in order to decrease levels of poverty in old age. This process has led to a reinforcement of the pension systems role of redistribution and solidarity and the creation of a multiple-pillar system, in which the State offers subsidies targeting people with lower incomes to replace or complement the pensions from the contributory system. This multiple-pillar scheme had been recommended by the World Bank in The development and strengthening of non-contributory pillars was favoured by the improved financial position of the Latin American countries and the positive impact produced by the creation of the individually-funded systems on the financial deficits of the pay-as-you-go schemes and public budget, enabling funds to be released that were previously tied up in covering those deficits. This positive impact is seen most 4 In the book Averting the Old Age Crisis (1994). Executive summary and proposals 15

18 clearly in the case of Chile, where more time has elapsed since the reform was enacted. Its experience underlines the importance of creating and developing individuallyfunded programmes, not only to provide adequate pensions for a significant sector of workers, but also to contribute towards allowing the State to concentrate its efforts and resources on the help needed by the most vulnerable lower-paid workers. According to the presidential message of the draft law that concluded with the Chilean pension reform in 2008, setting up the System of Solidarity Pensions, one of the main sources contributing to its funding was the reduction in the deficit of the old pay-asyou-go scheme and the interest accrued by the recognition bonds. Cerda (2006) predicted that without the 1981 reform which brought the individually-funded system into being, the deficit of the pay-as-you-go scheme would have been around 4% of GDP by 2014 and, following a transitory improvement, would have been approaching 8% of GDP by 2050, and that despite parametric adjustments and an average contribution rate amounting to 20% of wages. On the other hand, Arenas et al (2009) estimated that with the 1981 reform, the operating deficit of the old system reached its maximum level at around 4.5% - 4.7% of GDP in , subsequently falling to 1.9% in 2014 and 0.1% in Another paper by Arenas et al (2008) estimates the total fiscal effect of the System of Solidarity Pensions and other benefits granted in the 2008 pension reform, forecasting an impact of 0.6%, 1.2% and 1.4% of GDP in 2009, 2014 and 2025, respectively. The operation and development of the multiple-pillar pension system that exists in the Latin American countries is still insufficient. It is necessary to continue making progress on the fine-tuning of its various components, so that each one will meet its objectives and that all together they may complement one another to provide members with adequate pensions. The non-contributory programmes have suffered certain problems that must be evaluated and corrected, such as the lack of planning and integration with the contributory pillars of the pension system, the fragmentation between programmes and the non-existence of an institutional framework that defines the levels of their benefits and the permanent sources of their funding. Furthermore, it is necessary to study the effects that non-contributory benefits may have on participation and contribution in the contributory programmes. Preliminary evidence shows that the improvement in non-contributory benefits has produced negative effects on the offering of work and on incentives to contribute. There is the risk that a vicious circle may be produced if welfare-type non-contributory programmes are reinforced, encouraging a lower offering of work and a reduction in contributions to the contributory systems. This in turn will make the coverage and pension-level figures of these systems worse, producing further pressures to expand the benefits of the non-contributory schemes. In order to avoid this, it is necessary for there to be appropriate planning of the pension system and the social security system as a whole. Non-contributory benefits are 16 How to strengthen the pension systems in Latin America

19 necessary for tackling poverty in old age, but they must be designed in such a way that they are not simply welfare but also include incentives ex-ante that encourage participation in the contributory system during the active stage, in order to improve benefit levels in old age. The granting of state subsidies in the passive stage must be concentrated on those who really had no ability to save during their active life and fall into poverty. Furthermore, their funding must be backed by having sources of money in place that will give them long-term sustainability. It is also necessary to review the design of the various benefits that make up the social protection system, and how they are granted, to reduce as far as possible any incentives they may contain to under-declare income or not declare it, and include rewards for participating in and contributing to the contributory systems, in such a way as to encourage formal employment by offering a better social security package than can be achieved by people belonging to the informal economy. On the other hand, voluntary pension savings plans (Pillar Three) have not been developed to any great extent in Latin America, unlike the situation in more developed countries, where they have had a very important role in providing workers with pensions, with considerable input from employers. The voluntary pension savings plans existing in most of the Latin American systems have tax incentives associated with them and have obtained good results in terms of yield. However, in several of these countries the plans do not have appropriate features to encourage workers to save, such as the possibility of making withdrawals with a penalty (liquidity) or investing the accumulated balances in options other than those available for mandatory savings. Furthermore, with the exception of Chile, there are no fiscal incentives to encourage saving on the part of formal workers with average-low incomes who pay no taxes. There is also little knowledge among members about the advantages of saving voluntarily for pensions and employers appear to have no special incentives to promote saving of this type among their employees. Neither have automatic enrolment mechanisms and default options been applied, although these have been effective in other countries to increase workers participation in voluntary plans, especially in the United States and New Zealand. In the mandatory contributory pillar, the operation of the individually-funded systems and the results of the work of the pension fund administrators have been positive. The annual average historic yield of the pension funds exceeds 6% in real terms in all the countries studied; administration fees have shown a downward trend; and existing evidence shows that the quality of the administration of the individual accounts has been satisfactory. Nevertheless, the Latin American experience reveals a series of important refinements that need to be carried out in order to improve the operation and future results of these systems. Executive summary and proposals 17

20 There must be a consistent relationship between reference replacement rates and the design of the individually-funded system An intrinsic characteristic of the individually-funded systems is that there are no defined benefits in old age. These depend instead on the yield recorded on the investment of the pension funds and on retiring ages. Nevertheless, it is necessary to set pension targets that are seen to be reasonable for the average member and for the real situation of the country, and define the design and values of the parameters of the contributory programmes in such a way that they are consistent with reaching these targets, bearing in mind the contribution to pensions that the various pillars of the pension system are expected to provide. In addition, in order to obtain adequate replacement rates for members that are sustainable in the long term, it is necessary to carry out such adjustments as may be necessary over time on the basis of the changes and trends that occur in the labour and financial markets and in life expectancies. These adjustments must be accompanied by other policies to facilitate their implementation, such as incentives to make older adults more employable in the event of rises in the legal retiring age. In Latin America there is no institutional scheme included in the pension systems for regular, technical revision of their design and main parameters, to ensure that they are consistent. 5 In point of fact, following the reforms that created the individually-funded systems, most countries have not changed the contribution rates and legal retiring ages that were established when the reform took place, regardless of the changes that have occurred in the labour and financial markets and the increases in life expectancy, which have shortened the period of contribution payment, extended the period for receiving pensions and reduced the yield of the investments, so reducing the benefits to be expected of the pension system. Experience has also shown how important it is for members to form reasonable expectations of the pensions that they can finance on the basis of their contributions and retiring ages, and for those expectations not to differ substantially from the reference targets set out in the design of the individually-funded programmes and the multiple-pillar pension system. In this sense, the information, education and advice provided for members by the authorities and the pension fund administrators is a central part of the long-term success of the individually-funded system. A systematic contact with members should concentrate on explaining the central aspects of the system to them clearly and simply, so that they can form reasonable expectations of pension amounts and understand their rights and obligations; the variables that most affect those pension amounts; and the decisions that they can take to improve their benefits and, if necessary, close any gaps that exist compared with the goals 5 Only Peru has a provision obliging the Superintendence of Banks, Insurance and AFPs to appoint a body of recognised prestige to evaluate the viability of the mandatory contribution rate, to provide an adequate replacement rate, in average terms, for members, bearing in mind life expectancies, yield on long-term investments, and the contribution density of the workers. The evaluation has to be carried out regularly, seven years being the maximum period allowed. 18 How to strengthen the pension systems in Latin America

21 that have been defined. The focus of pension information, education and advice must concentrate less on short-term yields and the volatilities of investments, and more on ways of achieving the expected flows of pension and reducing pension risks. The challenge of maintaining the good real yields obtained in the investment of the pension funds Since the beginning of the individually-funded systems, the historic yields of the pension fund investments have been high, fluctuating between 6.5% and 8.9% annually in real terms, depending on the country. REAL AVERAGE ANNUAL YIELD SINCE THE BEGINNING OF THE INDIVIDUALLY-FUNDED SYSTEM, UP TO DECEMBER % 9% 8% 8.5% 8.9% 7.8% 8.0% 8.2% 7% 6% 6.5% 5% 4% 3% 2% 1% 0% Chile Colombia El Salvador Mexico Peru Uruguay Source: Prepared by the author on the basis of information from the International Federation of Pension Fund Administrators (FIAP). The trend recorded in the world s financial markets make it unlikely that these high yields will be maintained into the future, and represent a common challenge for all the countries studied: the need to open up new investment alternatives that coincide with the special characteristics required for placing pension funds resources and make it possible to boost the yield results of the investments. The regulation of the investment of pension resources is an aspect of the individually-funded systems operations that must be improved, and the effects on pension amounts are expected to be significant. In several countries, pension fund administrators face serious limitations to the diversification of their investments, which must be corrected in order to increase the expected long-term yield of the pension resources and so improve pension results. In El Salvador, for example, there are minimum limits on compulsory investment in public sector instruments that are issued at below-market rates, and it is not pos- Executive summary and proposals 19

22 sible to acquire foreign securities that are traded on international markets. Investment abroad is not authorised in Uruguay either, except in the case of government and international bodies with high credit rating, and the maximum investment limits are much higher for State instruments than for private-sector securities. In Mexico, the maximum limit for investment abroad is only 20% of the pension funds and, on certain occasions, the regulation has been made conditional on meeting macroeconomic objectives. Another challenge for the individually-funded systems in terms of investments is to improve the operation of pension multi-funds and limit the levels of risk to which members are exposed in their pension results. When the multi-funds began to operate (as from 2002 in Chile), they made it possible for members to adjust their investment structure to their personal situations and preferences, and also for those approaching retirement or already retired to limit the risk to which they were exposed by transferring to more conservative pension funds. It is necessary to evaluate additional advances in this area because, with current rules, the exposure of these latter members to funds with a high component of equities may be excessively high is some countries. In addition, given that a significant number of members end up in the fund options fixed by default, it is important to ensure that the rules for fund allocation and transfer by age, which are applied in the case of members who do not choose, are defined appropriately to optimise pensions in the long term. It is also important for members who do choose a fund to be able to sign mandates with the administrators so that their funds are changed according to age-band. Strengthening competition between administrators to potentiate positive effects The effects of competition between Pension Fund Administrators (AFPs) on the results of the individually-funded systems have been limited by the fact that the demand for pension services is passive and relatively unresponsive to the qualities of pensions, especially administration fees. In response to this situation, the authorities in the different countries have adopted various measures to boost competition, concentrating mainly on the aim of reducing the fees charged by the administrators. In the Chilean system, tendering for the administration of individual accounts began in 2009 for new workers enrolling in the system, and greater flexibility and encouragement was given to outsourcing services to third-party companies, to take advantage of economies of scale. The tender for accounts is awarded every twentyfour months to the AFP, or investor authorised by the Superintendence of Pensions, that offers the lowest administration fee. This measure has led to a considerable reduction in fees, the entry of a new administrator and the de-concentration of market shares in the industry, meaning that the objectives hoped for have so far been achieved. 20 How to strengthen the pension systems in Latin America

23 HOW THE PENSION COST OF THE AFP SYSTEM HAS EVOLVED, INCLUDING THE PREMIUM OF THE DISABILITY AND SURVIVORSHIP INSURANCE: CHILE (1) (% OF TAXABLE INCOME AS OF DECEMBER EACH YEAR) 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% Average AFP AFP awarded tender (1) Corresponds to the sum of the fixed and percentage fees charged by the AFPs in the period. Source: El Sistema Chilena de Pensiones. Superintendence of Pensions (February 2010), Acuña (2014a). After the first three tendering processes, the weighted average of the fee, net of the cost of the disability and survivorship insurance, fell from 1.49% to 1.32% of wage, and will continue to fall as new members enrol in the administrator that was awarded the contract. In addition, any member of the system has the option of joining in with the new workers who have to enrol in the winning AFP, and paying a fee of 0.47% of wage, equivalent in the long term to 0.2% on the balance. This fee, plus the cost of the disability and survivorship insurance (1.15% of the wage) add up to a pension cost of 1.62% calculated for the AFP that wins the tendering process, as may be seen on the graph, together with the changes in the average pension cost of the AFP system from 1982 onwards. On the other hand, making outsourcing possibilities more flexible has meant that many operational and administrative tasks, such as collecting and charging contributions, paying pensions and IT services are now carried out by third-party companies, thereby encouraging a reduction of operating costs and allowing new administrators to enter the market, fixing fees that are significantly lower than those charged by the rest that were already operating in the industry. Tendering for the administration of individual accounts was also introduced in Peru in 2012 for new members entering the private pension system, and this has meant pressure to lower fees. However, the results are more difficult to measure, because there were changes in the fee structure at the same time as the tendering process which will mean the replacement of the fee-on-flow by a fee-on-balance over a period of ten years. Regulations in Colombia and El Salvador fixed maximum limits on the sum of Executive summary and proposals 21

24 the fee charged by the administrators plus the disability and survivorship insurance. The Mexican system requires the fees charged by the administrators to be presented and approved annually by the supervisory authority, and assigns the workers who do not choose an administrator to those institutions with the highest yield on investments, net of fees. Uruguay assigns workers who do not choose an administrator to those that charge the lowest fees. The results of these reforms and others aimed at boosting competition and reducing fees must be analysed carefully and compared with other models or changes in industrial organisation that have been proposed with similar objectives. One suggestion in particular has been to separate off the functions of individual account administration, where it is felt that it would be possible to take advantage of economies of scale if it were done by a centralised body, from the functions of pension fund investment, with accounts that are blind from the point of view of the managers of the pension resources, who do not play an active role in relating with the members or providing them with services and advice, because they are unaware of their identity. This type of industrial organisation exists in the mandatory and complementary individuallyfunded system in Sweden, which was designed with the idea of achieving low administration costs. The low costs existing in that system, currently 0.49% of the balance under management, have been attributed to the blind accounts and the lower commercial costs that these may generate. However, the Swedish experience shows that the main reasons for these cost-levels are the use of public institutional schemes that already existed for carrying out operational and administrative functions and the negotiation of contracts with the fund managers, which include discounts for volume. The Swedish experience raises important questions, particularly the applicability of this type of design to other countries whose individually-funded systems are already operating and whose public bodies have less development and institutional solidity than Sweden, and the costs that may be involved in reforms that mean radical changes in the rules of the game and produce uncertainty among administrators and potential investors who might wish to enter the industry. What is more, based on this experience, the effects on fees in successful scenarios are quite limited or even nonexistent, compared with the levels of fees that have been achieved in the industrial organisation models of the individually-funded systems in Latin American countries. On the other hand, the existence of blind accounts does not allow the fund-managers to have contact with members and provide them with guidance and advice in the choice of appropriate investment portfolios and in other matters that are important for optimising pensions. This possibility does exist in the industrial organisation models of the individually-funded systems in Latin American countries, though the work that has to be done in these areas by both pension fund administrators and authorities needs to be improved, in order to provide appropriate education and advice for members who, on average, have little financial preparation. 22 How to strengthen the pension systems in Latin America

25 Improvements in the retirement process and pension options It is important to improve the existing process and pension options to reduce pension risks and increase the amount of the benefits received by members. This issue will become increasingly relevant as the number of pensioners in the individually-funded programmes grows. Research carried out on the Latin American pension systems shows considerable progress in these matters, but also significant weaknesses that are important to correct. For example, the programmed withdrawal option has great advantages, such as the fact that the decision can be annulled and the ownership rights on the accumulated funds remain in place, together with the possibility of leaving an inheritance, but it suffers from serious drawbacks from the point of view of pension objectives, because it fails to ensure a stable income during the retirement stage. Solutions to this problem may be found by applying measures to encourage the development of the temporary income with deferred life annuity market, a pension option that already exists in several Latin American countries and has been recommended by the OECD, or taking out a longevity insurance policy to cover the remainder of life after a certain age. On the other hand, the existence of a minimum number of years of contribution to qualify for a pension, with the reimbursement of the accumulated balance in a lump sum in cases where this requirement is not met, is not consistent with pension objectives either, though it occurs in some countries. With the exception of cases of members who have very low accumulated balances and are not eligible to receive the benefits of the non-contributory pillars, a better alternative is to provide a minimal pension flow until the funds are exhausted, accepting the fact that the period for receiving the benefit will be shorter. In the case of life annuities, measures must be evaluated and taken to reinforce the companies solvency and reduce the risks that they run, facilitating the appropriate match between their pension payment obligations and the assets that cover them, and promoting the development of appropriate markets and instruments for the investment of their reserves, such as longevity bonds. The regulation and operation of the individually-funded system must guarantee competition between the different pension providers. To achieve this, it is necessary to ensure the existence of transparent, clear, simple and comparable information in the market about the amounts of pension that members can obtain from the pension fund administrators, and the life annuities offered by the life insurance companies. In addition, the pension process must allow the providers to have relevant information about those requiring pensions and to participate on an equal footing in presenting pension offers. The implementation of an electronic system of consultations and pension offers in Chile in 2004 was a great step forward in this area. It made for increased competition, greater transparency in the market and a reduction in intermediation costs, all of which resulted in better pensions for the members. It is also important to create the conditions for there to be real competition in the lifeinsurance markets, and specifically in pension insurance policies, and avoid situations Executive summary and proposals 23