Contractual Savings and Financial Markets Alberto R. Musalem, Thierry Tressel, and Gregorio Impavido

2 Definition and Importance of Contractual Savings n Funded benefit plans:  Retirement savings and Annuities  Life insurance  Funded unemployment benefits, gratuity, end of service indemnity, severance payments n Funded contingencies: down payment for a house, education, weddings, funerals n Importance: supply long term savings

3 Financial assets of contractual savings, (% of GDP)

4 Shares of contractual savings and M2 in financial assets (%, 1996)

5 Economic Impact of Contractual Savings n Potential positive effects on national saving  Requires fiscal adjustment to finance transitional costs of pension reforms that increase funding  More likely with mandatory funded systems due to credit constraints faced by low wage earners  Less likely with voluntary plans n Allocation effects due to higher share of long term funds  Securities market development  Improvement in financial risks management n Growth effects  Due to allocation and potential saving effects

6 Impact of Contractual Savings Institutions on Securities Market (I)  An increase in CS relative to domestic financial assets promotes depth of stock and bond markets (MK/GDP)  The impact on stock market depth and liquidity (VT/GDP) is stronger in countries with more transparent corporate information  The impact on the stock markets is stronger in countries where: 1.The financial system is more market based 2.Contributions to pension funds are mandatory 3.Portfolio transactions in the capital account of the balance of payments are lower

7 Impact of Contractual Savings Institutions on Securities Market (II)  The impact on the bond market is stronger in countries with a bank based financial system  The impact of contractual savings institutions on securities market is not the consequence of a joint determination of both contractual savings institutions and financial markets by other slow-moving characteristics of economies (level of development, education, demographic structures, legal environment)  Accordingly, policies shaping the institutionalization of savings do matter

8 Social and Financial Risk Mitigation Effects  Beneficiaries improve management of longevity, death and other risks  Reduce debtors refinancing risks, including governments, by lengthening the maturity of debts  Reduce pressure on banks to engage in excessive term transformation risks  Reduce enterprise vulnerability to interest rate and demand shocks due to improved financial structure (higher equity/debt ratio)

9 Government long-term to total debt ratio and contractual savings assets, 1996 (% GDP)

10 Banks’ Short Term to Total Loans vs Contractual Savings: Conditional Correlation Regression Line: STL = (4.58) * Log(Csfa,%GDP)+37.5 ( R2=0.18)

11 Banks’ Net Interest Margin (NIM) and Contractual Savings: Conditional Correlation Regression Line: NIM = (-10.78) * Log(Csfa,%GDP)+1.47 (R2=0.35)

12 Banks’ Credit Risk (Loan Loss Provisions to Total Assets) and Contractual Savings: Conditional Correlation Regression Line: LLTA = -2.8 E-3 (-3.23) * Csfa,%GDP ( R2 = 0.043)

13 Firms’ Leverage (TDTE) vs Contractual Savings: Conditional Correlation - Market-based Financial Structure Residual = * (CS Fin. Assets, % Sec. Market) (t-stat = -2.47) Pooled reg., 82 obs.

14 Firms’ Leverage (TDTE) vs Contractual Savings: Conditional Correlation - Bank-based Financial Structure Residual = 4.0 * (CS Fin. Assets, % Sec. Market) (t-stat = 2.37) Pooled regression, 74 obs.

15 Firms’ Debt Maturity vs Contractual Savings: Conditional Correlation - Market-based Financial Structure Residual = * (CS Fin. Assets, % Sec Mkt) (t-stat = -3.84) Pooled regression, 82 obs.

16 Firms’ Debt Maturity vs Contractual Savings: Conditional Correlation - Bank-based Financial Structure Residual = 0.28 * (CS Fin. Assets, % Sec Mkt) (t-stat = 5.28) Pooled Regression, 74 obs.

17 Main Issues with Contractual Savings in Latin America (I)  Except Brazil and Costa Rica, over-reliance on mandatory long term saving schemes  High administrative costs, high transaction costs (for members and fund managers due to interaction between pillars on collections and benefits), high industry concentration and lack of market contestability  High political risk due to dependency of pension fund regulators from governments  Over-regulated investment policies:  High exposure to governments  Restrictions to diversify investments internationally in an environment where the best companies migrate abroad increases pension funds portfolio risks

18 Charge ratio in funded pension schemes

19 Main Issues with Contractual Savings in Latin America (II)  Inadequate opportunities for members to manage market risks  Limited choices regarding portfolio composition (although some countries are expanding choices)  Conversion of accumulated balances into annuities at a given point in time only  Although supervision is gradually shifting towards a risk based approach, it is still focused on compliance

20 Recommendations to promote Contractual Savings in Latin America (I)  Review regulations and tax treatment to encourage voluntary long term savings  Review systems design:  Encourage market contestability by allowing opting out to employer sponsored plans (Australia, Brazil, Hong Kong)  Consider clearing house models (Sweden, Thrift Saving Plan for federal employees in the USA, Bolivia)  Adopt independent benefit payments between pillars (Argentina), and restrict switching across pillars (Colombia, Peru)

21 Recommendations to promote Contractual Savings in Latin America (II)  Consider adopting regulators which are independent from governments and accountable to congresses (central bank model)  Adopt more flexible investment regulations based on the prudent person investment rule in tandem with risk based supervision, and allow gradual opening of investments in foreign securities  Improve members’ ability to manage market risks:  Increase portfolio options  Allow for multiple and partial conversions of members’ accumulated balances into annuities