Chile: Lessons from a Maturing Pension

System For Other Reforming CountriesFinancial and Private Sector Development Forum:

Pension Session

Axel ChristensenMoneda Asset ManagementFormer Member Presidential Pension Reform Commission

Main Issues• Free Structure and Low Price Elasticity High Fees

• Investments: Successful in 25 years but many challenges ahead

• Payout phase

• Policy Agenda:– Will the Bachelet reform address the issues of high fees and

undiversified portfolios?– Despite its problems, the private pension system in Chile has

performed better than those in other countries? Why? What are the main lessons?

High Fees– Chile: Are fees high in the first place?

– Why the Chilean pension system has not been able to compete in prices?

– Will the current plan to introduce a bidding scheme succeed in reducing fees?

– Are there alternatives to generate more competition?

Chile: Are fees high in the first place?

• No, according to industry actors (AFP Trade Association)

• Yes, according to industry observers (C. Mesa-Lago)

IMHO: Fees are not excessively high but more competition could make them lower

Why the Chilean pension system has not been able to compete in prices?• Low sensitivity to

prices– Mandatory savings– Fees deducted from

gross salary

• Uninformed customers

Reasons to switch AFP Apr 2001 Sep 2004Recommendation 14% 9%

To help a friend 14% 11%

Performance 18% 29%

AFP Image/reputation 9% 10%

Gift 20% 9%

Lower Fee 13% 15%Doesn't know/respond 12% 17%

Source: CERC Survey (hired by AFP Superintendence)

Do you know:How your individual account investments are made?

Don't know 71%How much do AFPs charge to manage your account?

Don't know (Fixed commission) 93%Don't know (Variable commission) 93%

From quarterly report sent by AFP (only 60% says it receives it)% that reads report 75%

% that thinks report is clear and understandable 51%% that uses report to make decisions regarding pensions 16%

Source: Bravo (2004) based on EPS Survey (2002)

Why the Chilean pension system has not been able to compete in prices?• Barriers to entry

– Regulatory risk– Incumbent retaliation

risk– Economies of scale– Design of insurance

# of AFPs vs. AUM in largest 3

AFP customer transferals vs. sales forceRoE: AFPs vs. Banks

Will the current plan to introduce a bidding scheme succeed in reducing fees?• Why a bidding scheme vs. automatic allocation to lowest cost

provider (Mexico)?– Increases awareness given annual event rather than ongoing process.– Positive experience from lifecycle fund inception.

• Why mandatory for new workers?– To provide economic scale to attract new entrants.– Performance less of an issue for new entrants.– Scheme designed to favor new entrants over incumbents, as latter must

extend bid to existing client base.• Main Risks

– Opportunistic new entrants, that sell client base to incumbents.– New worker flow may not be enough to attract new entrants.– Liability if winning bidder has poor performance and/or service.– Signaling given by those who chose not to enter bidding scheme;

incumbents maybe tempted to increase fees.

Are there alternatives to generate more competition?• Most effective to generate more competition is change in pricing

model– From a % of contribution to % of AUM

• Benefits– Evidence to higher degree of sensitivity to (net of fees) performance;

allows to combine performance + cost in one decision variable.– Shifts attractiveness from young, low balance, high income clients

(current) to older, high balance clients, which are more interested in pension.

– Reduces the economy of scale (and thus entry barriers). Positiveexperience to opening up voluntary contribution segment to otherasset managers, based on AUM fee.

– Increases alignment of interests between AFPs and clients– Allows easier benchmarking with other

• Costs– Fee levels would be less visible, as deducted from investment account

rather than monthly paycheck.– Fee paid by members that are not contributing.– Very complex transition from current situation.

Investments: Performance and Portfolios• What has the impact on Chilean economy and financial markets of

the pension fund reform?

• Has AFP investment performance been all that great?

• Why do AFPs invest more than 20 percent of their portfolios in cash?

• Has the pension system simply outgrown the domestic capital market?

• Are there impediments to the development of private domestic instruments?

• Why are AFPs interested in inflation indexed-instruments?

• Why are AFPs not investing more in venture capital and private equity?

• Is Chile’s experience with lifecycle investment rules positive?

• What will happen when the investment regime is liberalized?

AFPs: Impact on Chilean Economy• Close to 10% of GDP growth in 1981-2001 period

explained by social security reform (Corbo-Scmitt-Hebbel):

– Increase in national savings rate– Increase in investment rate– Development of capital markets– Improvement in labor market conditions

Security1981

(USD mill)2002

(USD mill)Capital Markets

Growth

% that pension related funds have of

outstanding (2002) (1)Government bonds 797 17.646 22,1 times 75,0%Mortgage and bank bonds 513 8.431 16,4 times 97,5%Corporate bonds 71 7.459 105,1 times 75,0%Stocks (2) 5.235 47.430 9,1 times 8,2%Bank deposits 4.208 22.167 5,3 times 35,4%Investment funds - 117 NA 89,5%Other 2.703 7.196 2,7 times 37,2%

Capital Markets: Growth and Pension-related Funds’ participation

Source: Corbo and Schmitt-Hebbel, “macroeconomic effects of the Pension Reform in Chile (2002)

Investment Performance: The Bright Spot?

• “Official” gross real return of over 10% p.a.• However, weight-adjusted, after-fee real returns closer to a 4.5%- 6.5%

range.• Until recently, high performance very biased towards early years, mainly

due to capital gains in fixed income as rates fell and local equity market re-rating in the early 90s.

12.9%

28.5%

21.2%

3.6%

13.4%12.3%

5.4%6.9%

15.6%

29.7%

3.0%

16.2%

18.2%

3.5%4.7%

16.3%

4.4%3.0%

5.7%

16.6%

-2.5%-1.1%

6.5%

11.9%

9.1%

6.7%

-5%

0%

5%

10%

15%

20%

25%

30%

35%

1981

1986

1991

1996

2001

2006

Promedio simple1981-2006 -- 10.5%Prom. ponderado1981-2006 -- 9.0%

Promedio simple2002-2006 -- 11.3%

-

10

20

30

40

50

60

70

80

90

100

1981 1986 1991 1996 2001 20060%

10%

20%

30%

40%

50%

60%

70%

80%

90%

AFP AUM (US$bn)as % of GDP (rhs)

Pension Fund Assets Evolution 1981-2006

AFPs: Asset Allocation Evolution 1981-2006

• High % in cash reflects limited supply of instruments and pension fund outgrowing domestic market

– AFPs manage assets represent over 80% of GDP (vs. 12% for emerging markets and 39% for OECD countries)

– Despite that Government bonds represent less than 15% of AUM, AFPs have more close to 75% of outstanding debt.

– Current excess of 30% in foreign assets is creating grounds for a bubble in local financial assets.

– Pension fund assets have grown 25% p.a., combining contribution growth and investment return)

0%

20%

40%

60%

80%

100%

19811986

19911996

20012006

ForeignInvest FundsLocal EquityCorporate BondsBank BondsMortgage BondsGov't BondsBank Deposits

Equity53%

Bonds30%

Cash17%

Sep 2002Multifunds

created

40

80

20

25

60

40

15

40

60

520

80100

0

20

40

60

80

100

Fund A Fund B Fund C Fund D Fund E

Min Equities Max Equities Fixed Income

%

• 5 Funds with different risk-return combinations.• Each Fund has a minimum and maximum limit

for equity investments.

AFPs Lifecycle Funs (“Multifunds”)

Multifunds Design

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

< 20 + 20-25 + 25-30 + 30-35 + 35-40 + 40-45 + 45-50 + 50-55 + 55-60 + 60-65 65 S/I

53%< 35 years

42%36 and 55

years

Fund B Fund C Fund D

5%> 55 years

Multifunds Design: Expected Returns

Type of

FundAverage

annual yieldYield

worst monthYield

best month

Number of

negative months

Number of

positive months

A 10,6% -14,0% 10,7% 40 104

B 9,7% -9,9% 8,2% 37 107

C 8,8% -4,9% 5,5% 25 119

D 8,5% -3,5% 5,3% 18 126

E 7,9% -2,9% 7,0% 11 133Source: AFP Bansander simulating returns for 1991-2001 period

Multifunds Results

Fund A (4.6%, 17.2%)

Fund B (3.6%, 12.2%)

Fund C (2.9%, 9.1%)

Fund D (2.4%, 6.8%)

Fund E (1.7%, 3.7%)

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

1% 2% 3% 4% 5%

Volatility (%)

Ann

ualiz

ed R

etur

n (%

)

◊ Multifund (Volatility, Ann. Real Return)

Timing is everything!

Start of Multifunds could not come at a better time…

…however, MFs still have to withstand less favorable market cycles/

Multifunds Asset Allocation

• Joint limits (especially maximum 30% in foreign assets) poses significant conflict of interest issues among multifunds.

• Return based competition has focused on Funds A and B.

0%

20%

40%

60%

80%

100%

120%

Foreign 53.5% 40.0% 25.5% 12.2% 0.2%

Invest Funds 3.7% 3.3% 3.5% 2.6% 0.0%

Local Equity 17.0% 18.9% 17.7% 12.3% 0.0%

Corporate Bonds 2.6% 5.2% 9.8% 12.5% 24.7%

Bank Bonds 2.0% 2.9% 5.2% 6.2% 14.5%

Mortgage Bonds 1.3% 2.7% 5.4% 8.0% 18.3%

Gov't Bonds 3.7% 8.7% 15.8% 25.2% 28.6%

Bank Deposits 16.3% 18.4% 16.9% 20.9% 13.4%

Fund A Fund B Fund C Fund D Fund E

Equity 74.2% 62.2% 46.7% 27.1% 0.0%Equity Min/Max 40%/80% 25%/60% 15%/40% 5%/20% 0%/0%

Multifunds brought back attention on AFPs, especially on Performance

Payout phase• Why is the payout phase in Chile more competitive than the

accumulation phase?Mainly due to 2 reasons– Insurance companies allowed to use independent brokers, while AFPs

are not allowed to do so, reducing efficient scale that allows a greater number of players.

– Insurance companies are not allowed to charge an explicit fee but must cover their costs from the difference between the rate of return they pay annuitants and the rate they earn on the investment portfolios in which they invest their reserves, which come mainly from annuity premiums. Their profits depend on this spread and the size of the premium on which it is earned

• What can be replicated?– Bidding scheme (SCOMP)

• What to improve?– Actuarial and Asset-liability regulation– LICO credit rating and information to the public

Policy Agenda– Will the Bachelet reform address the issues of

high fees and undiversified portfolios?

– Despite its problems, the private pension system in Chile has performed better than those in other countries? Why? What are the main lessons?

AFPs Main Regulations• Strict regulation originates from booth mandatory nature of

contributions an state guaranteed minimum pension• Each AFP must constitute reserve equivalent to 1% of AUM• Minimum return requirement for each AFP/Fund, based on

industry average performance over 36 months. Fund underperformance has to be covered by AFP.

• Regulator monitors Fund financial statement daily and AFP monthly

• Funds can only be invested in instruments explicitly authorized by Pension Fund Law and cleared by autonomous Risk Classification Committee.

• Regulation considers more than 90 limits per fund.• Costs of excessive regulation have been documented

(Berstein, Chumacero, 2005), establishing impact equal to 5% tax on wealth of contributors.

What will happen when the investment regime is liberalized?• Objective of investment regime liberalization was to

– Reduce costs of excessive regulation – Increase accountability of private managers, that rely

excessively on a extremely detailed regulation• The shift will require

– A mature regulator with more sophisticated risk management capabilities

– A senior leadership at AFPs , increasing resources devoted to their investment teams

– Incentives to make a difference: • Steps to address “herd effect” behavior.• Strategic approach towards more diversified portfolios, including

less liquid asset classes (real estate, private equity, real assets, etc.)

• Gradual approach is key.

Pension Fund Reform 2006During this year, a Presidential Commission proposed several reforms to the social security system, including AFPs, that should be sent to Congress by the end of 2006. The main ones are:

• Basic Universal Pension. The State will provide low-income workers with subsidies to their pension starting with a minimum of approx. 140 USD/month, supplementing their self funded DC accounts.

• Increase in competition in AFP industry. Several measures point to lowering entry barriers, including assigning new entrants to AFP with lowest commission

• Flexibility in investment regulation. Several proposals including gradual elimination of foreign investment limit and creation of AdvisoryCommittee to review changes in AFP investment guidelines (versuscurrent situation were every change has t be approved in Congress)

Conclusions• Fees are very hard to reduce if elasticity is low. Bid

scheme on its own poses major risks. Shift towards fee based on assets leverages on sensitivity to performance.

• Portfolio diversification can be achieved by the sum of several steps– Lifecycle funds to un-bundle diverse risk/return profiles.– Appropriate corporate governance environment– Greater investment flexibility– Greater alignment between contributors and fund managers

• More competition in Payout Phase suggests that distribution and pricing are key.

• Investment liberalization is a MUST but it has to be done in a continuous, albeit gradual fashion.

Chile: Lessons from a Maturing Pension

System For Other Reforming CountriesFinancial and Private Sector Development Forum:

Pension Session

Axel ChristensenMoneda Asset ManagementMember Presidential Pension Reform Commission