Linking pension reform and financial market development: the LA experience Augusto Iglesias P. PrimAmerica Consultores Bled, Slovenia. June 9, 2007.

Pension reform in LA Source: FIAP, PrimAmérica Consultores

Pension funds in capital markets

Pension funds portfolio composition in LA (2006) n.d: not available n.a: not authorized

Pension funds portfolio diversification rules (Limits by asset class. % Pension Funds)

Some well known facts The accumulation of pension funds can facilitate the development of capital markets Efficient capital markets are a condition for better results of pension fund management Then, there could be a positive dynamic interaction (D.Vittas) between pension funds and capital markets development To capture the potential benefits from this interaction: Pension fund investment regulation must be carefully designed Eventually, capital markets regulations will need to be improved

Potential impacts of pension reform on capital market development Total savings may increase Increased long term supply of funds Development of an institutional capital in financial markets: better corporate governance practices; improvement in capital market regulations; better auditing practices Increased trading volumes and economies of scale: incentives to the creation of new instruments; lower transaction costs; greater specialization of capital market agents Better allocation of capital Cost of capital for firms may decrease The magnitude of the impacts depend on: the size of the funded pension system; how developed was the capital market before pension reform; the design of pension funds investment rules; other concurrent conditions of the economy

Capital market development and pension funds returns (and risk) In a developed capital market: Lower information and trading costs More efficient clearence settlements and custodial arrangements Better corporate governance practices Enough supply of different asset classes by many issuers If supply of different classes of financial assets from several issuers is abundant: Greater diversification opportunities for pension funds Price distortions coming from pension fund demand concentrated in few assets are avoided

Lessons from LA experiences What have been the main challenges in designing and implementing pension fund investments regulations?: Portfolio diversification rules: stocks; foreign investments; mandatory investments in certain asset classes (particularly government bonds) Insulation of pension funds investments decisions (and portfolio diversification rules) from political interference Development of good corporate governance standards for pension funds Design of pension funds assets valuation rules Opening of portfolio choices to pension fund members Timing of changes towards less restrictive investment limits regulation

Lessons from LA experiences From the perspective of pension funds, what have been the main weaknesses in (local) capital markets?: Lack of efficient trading and settlement arrangements Lack of coordination in the pace of capital markets reforms with that of pension fund reform Insufficient supply of different asset classes Interest rates controls Price controls over intermediation rates Inefficient tax rules High concentration (including state own monopolies) in the financial industry Legal restrictions for the development of indexed assets market (and inflation) Restrictions to international flows of capital Weak banking sectors Low corporate governance standards Lack of reliable and timely information

Final comments Because of imperfect pension fund investment rules and lack of coordination between pension reform and capital markets reform, the impact of pension funds on capital markets development in most LA countries has been limited (the most significative exceptions are Chile and Perú) Capital market development is a necessary condition for pension reform success, but pension reform can go ahead even if the capital market is not well developed However, capital market should be prepared to respond to demands coming from pension funds: Remove all regulatory obstacles that may hamper capital market development (these obstacles may be found in financial market regulations, tax regulations and pension funds regulations themselves) Coordination of pension reform and capital markets reform is crucial

Many thanks Augusto Iglesias P. June 9, 2007