National Commission for the Retirement Savings System The Mexican Pension System for Private Sector Workers Adapting India’s Financial Sector to a Globalizing World November 2002

2 Content Overview of the Pension System for Private Sector workers Desirable Characteristics of an Individual Capitalization Account System Conclusions

3 In 1997, Mexico reformed the Private Sector Workers’ Pension System Previous regime was a defined benefits PAYG system. The PAYG system was severely underfunded. The new scheme is an Individual Capitalization Account (ICA). Contributions are made by the worker, the employer and the Federal Government.

4 By September 2002, the System has affiliated 28.5 million workers As of September 2002, 8.5 million accounts of workers who had not chosen a Fund Manager (Afore) were distributed Active contributors: 43.6% Average monthly income: 500 USD Figures as of December of each year September 2002 Millions of Affiliates

5 The system has been able to offer high real returns Real Annual Compound Return (Last 12 months) Oct-01 Nov-01 Dec-01 Jan-02 Feb-02 Mar-02 Apr-02 May-02 Jun-02 Jul-02 Aug-02 Sep-02 Percentage As of today, annual average compound real return is 9.3%

6 Five years after the inception of the System, total assets sum up 59 US billion dollars, or 10% of GDP Figures as of December of each year Retirement Housing SAR 92 Retirement Savings as % of GDP Retirement Funds invested by Pension Funds 5.0% September 2002 Percentage of GDP 6.1 % 7.1 % 8.9 % 10.1 % Housing 3.0% SAR 92 (Old Regime) 2.1% 12.0 Siefores are expected to receive US$4.0 billion dollars of mandatory contributions in 2002

7 Assets under management will reach 50% of GDP Pension Funds’ Assets Under Management Estimations *Assumptions: 3.5% GDP real annual growth rate, 4.25% real annual return rate and CONAPO’s population growth rates Source: CONSAR Percentage of GDP

8 Content Overview of the Pension System for Private Sector workers Desirable Characteristics of an Individual Capitalization Account System Conclusions

9 The ultimate goal of a pension system is to provide adequate replacement rates to the greatest number of workers Effective checks and balances Sufficient contributions High risk-adjusted returns Low costs Competitive fees Broad coverage or a National Pension System To achieve that goal the system should have the following desirable characteristics:

10 Content Overview of the Pension System for Private Sector workers Desirable Characteristics of an Individual Capitalization Account System –Effective checks and balances –Sufficient contributions –High risk-adjusted returns –Low costs –Competitive fees –Broad coverage or a National Pension System Conclusions

11 Effective checks and balances are a must since any pension system is sensitive to social, political and economic issues... Regulatory Agency –Board composition: Workers and employers representatives in addition to government officials from the social and the financial sector participate in the governing bodies. Investment and fees regulations are subject to the favorable opinion of the above mentioned representatives. –Core activities: A daily automated surveillance of the system’s operational process and compliance with the investment regime is performed. In-site inspections at fund managers’ premises take place on regular basis. In Mexico, checks and balances take place at the Regulatory Agency and at the Fund Manager level:

12 Effective checks and balances are a must since any pension system is sensitive to social, political and economic issues (Cont) Fund Manager – Independent board member: avoids conflicts of interest in key decisions. – Compliance officer: verifies Consar’s and own regulation compliance. It develops self regulation schemes and designs corrective programs. – Risk committee: establishes a risk profile of the fund and authorizes limits, models and guidelines. – Investments committee: determines the investment strategy and designates the authorized portfolio manager. In Mexico, checks and balances take place at the Regulatory Agency and at the Fund Manager level:

13 Content Overview of the Pension System for Private Sector workers Desirable Characteristics of an Individual Capitalization Account System –Effective checks and balances –Sufficient contributions –High risk-adjusted returns –Low costs –Competitive fees –Broad coverage or a National Pension System Conclusions

14 Sufficient contributions are the cornerstone of adequate replacement rates... Target replacement rates should be primarily a function of contributions Reliance on high expected returns is not advisable In Mexico, the Government participates in the new system in two ways: –Contributing periodically to each worker’s account. A fixed amount has redistributive effects. –Guaranteeing a minimum pension.

15 Sufficient contributions are the cornerstone of adequate replacement rates (Cont) A special voluntary savings account with favorable tax treatment is highly desirable: –In October, Mexican Congress reformed the Law governing our system. One of the new features was the creation of a Retirement Complementary Contributions account. –Last December, Congress approved some changes to the tax code that will allow workers to deduct voluntary contributions to a pension plan. –These two reforms are key building blocks to create a US-type 401-K scheme.

16 Pensions in developed countries depend heavily on voluntary savings Replacement Rates in Developed Countries Voluntary System Mandatory System Replacement Rate (%) JapanUnited StatesUKCanada Source: OCDE, The Macroeconomics of Ageing, Pensions and Savings (Khol y O’Brien 1998)

17 Content Overview of the Pension System for Private Sector workers Desirable Characteristics of an Individual Capitalization Account System –Effective checks and balances –Sufficient contributions –High risk-adjusted returns –Low costs –Competitive fees –Broad coverage or a National Pension System Conclusions

18 Mandatory contributions Sole financial asset for most participants Socially and politically sensitive scheme Governmental minimum pension guarantee Need to avoid excessive risk An investment regime is necessary given the characteristics of the system

19 The investment regime should allow the greatest diversification in order to maximize returns at each risk level However, according to our vision, a comprehensive risk limit is granted given the system’s characteristics Return Risk  maximum level

20 The risk limit can be expanded as asset managers build up the necessary skills Return Risk 11 Independent Risk Committee that establishes internal limits, methodologies and policies Risk Management Unit that carries on a daily basis the Risk Committee’s guidelines ISO-9000 for the investment strategy process Compliance with international “best practices” for operational risks 00 Mexico’s skills-build-up path

21 Given fund managers’ increasingly comprehensive set of skills, Consar’s Board recently approved two important changes to the investment regime Operations with derivatives of underlying securities permitted in the investment regime will be allowed. Fund Managers will have to comply first with strict regulations of risk management prudential rules and operative requirements. A VaR limit that will substitute actual duration-type parameter will come into effect by December 2002.

22 Content Overview of the Pension System for Private Sector workers Desirable Characteristics of an Individual Capitalization Account System –Effective checks and balances –Sufficient contributions –High risk-adjusted returns –Low costs –Competitive fees –Broad coverage or a National Pension System Conclusions

23 A cost effective ICA industry should capture available economies of scale Contributions’ collection Workers database (Name, Social Security Number, Fund Manager) Contributions and returns’ recordkeeping To accomplish it, some core processes can be centralized: In Mexico, Fund Managers take care of the third process

24 A key feature of the Mexican Pension system is the design of its mandatory contributions collection process Social Security Institute National Data Base Employer Collector Bank Central Bank Fund Manager 1 a. Sends a bill of due contributions Clearance Bank 2. Pays contributions 3 a. Sends information on received payments 3 b. Sends contributions 4. Sends information on received payments 5. Sends contributions 6. Delivers contributions 1 b. Audits companies’ correct and prompt payments The Social Security Institution and the National Data Base play a key role in this process

25 Content Overview of the Pension System for Private Sector workers Desirable Characteristics of an Individual Capitalization Account System –Effective checks and balances –Sufficient contributions –High risk-adjusted returns –Low costs –Competitive fees –Broad coverage or a National Pension System Conclusions

26 Competitive fees are the result of the interaction of three key elements Simple products: –Few and homogeneous options. –A fee structure that is easy to understand and to compare. Adequate incentives: –Key decisions for the worker’s pension should be made by the most financial-literate and price sensitive person. –Costs of those decisions should be born by the decision maker in order to align interests. Relevant and readily available information: –Specially, one that highlights the impact of fees and returns differences in the worker’s pension. –Easy to access through different channels.

27 Source: Consar. Estimates with an affiliate who earns three minimum wages (constant salary), initial balance of $20, Pesos, a term of 40 years, and the current fee structure. Balance invested at a real annual rate of 5% for every Afore. Relevant and readily available information... Final Balance of the Retirement Savings 0 10,000 20,000 30,000 40,000 50,000 60,000 Banamex ING Bancomer Principal Tepeyac XXI Banorte Allianz Profuturo Inbursa Santander US Dollars % Fees differentials might have a significant impact on pensions

28 Relevant and readily available information (Cont) An example is our internet-based pension’s calculator Actual Fund Manager (Afore) Nominal monthly salary Last pension fund balance Number of expected additional working years Expected annual wage increase Expected rate of return INPUT DATA

29 Content Overview of the Pension System for Private Sector workers Desirable Characteristics of an Individual Capitalization Account System –Effective checks and balances –Sufficient contributions –High risk-adjusted returns –Low costs –Competitive fees –Broad coverage or a National Pension System Conclusions

30 The system should aim to achieve the broadest possible coverage A broad coverage: Reduces the number of non-contributing workers that can become a dead weight cost to the system and thus an obstacle for decreases in fees. Diminishes the fragmentation of rights when workers change of employment.

31 Unfortunately, in Mexico 60% of the Employed Labour Force does not have a formal pension plan 1. Employed Labour Force. 2. IMSS (private sector employees). July ISSSTE (Federal Government employees). May Ham Chande, Roberto; “The Future of the Pensions”. UNAM 5. Includes: ISSFAM, PEMEX, CFE, LFC, Universities (80). Sources: INEGI 2000 Census, Social Security Institutions and First Governmental Address to the Nation ELF 1 IMSS 2 ISSSTE 3 STATE INSTITUTIONS 4 OTHERS 5 NOT COVERED Millions of inhabitants The other 40% has a pension plan but within unrelated systems

32 To increase Pension Coverage, the System will be opened to the rest of the population on a voluntary basis Individual accounts will be available to:  State workers who want to transfer their complementary pension savings to an Afore.  Independent workers who want to make voluntary savings for retirement.  Private, State, Municipal and Public Agency's workers who want to make retirement complementary contributions in the Afore who manages their employer’s Pension Plan based on individual accounts.

33 The coexistence of different pension schemes calls for the creation of a National Pension System (NPS) Pension System for Private Sector Workers Pension System for State Service Workers Pension Plans for Public Entities, Municipalities, and States Universities Pension Plans Occupational Pension Plans The main goal of a NPS is the preservation of pension rights among different employers regardless of the full completion of pension prerequisites

34 The financial feasibility and the portability are key elements in the construction of a National Pension System ElementImplicationImportance Financial feasibility Portability Matches the benefits, contributions, and requirements Recognition, preservation and transfer of rights when the worker switches pension plan Gives certainty to the worker and avoids fiscal contingencies for an actuarial imbalance Does not allow the loss of rights because of being affiliated to different plans through worklife

35 Content Overview of the Pension System for Private Sector workers Desirable Characteristics of an Individual Capitalization Account System Conclusions

36 Conclusions ICA are, in our opinion, the best option to reform a pension system The outcome depends on the specific design of some key elements Desirable characteristics include: –Effective checks and balances –Sufficient contributions –High risk-adjusted returns –Low costs –Competitive fees –Broad coverage or a National Pension System

National Commission for the Retirement Savings System The Mexican Pension System for Private Sector Workers Adapting India’s Financial Sector to a Globalizing World November 2002