PrimAmérica CONSULTORES Investment of Pension Funds: Challenges for the Regulation* Augusto Iglesias Palau PrimAmérica Consultores May, 2004 * Presented at the Seminar “Pension Reform in Eastern Europe: Experiences and Perspectives”, organized by FIAP. Kiev, Ukraine, May 27-28, 2004.

Index I. Preliminary remarks II. Why pension funds investments should be regulated? III. Two regulation models for pension funds investments: which one works better? IV. Challenges for a regulation model based on “Portfolio Limitations” V. Final remarks PrimAmérica Consultores

I. Preliminary remarks D.C. and funded pension systems have become an integral part of social security systems in many countries of the world. “Adequate” regulations for pension funds investments are critical for the success of this kind of pension reform:  Different investment regulations will have different impact on pension funds returns and so, on pensions.  Capital market effects of pension reform (and so, their impact on economic growth) can be significant and depend on the characteristics of investment regulations. PrimAmérica Consultores

Personal Savings Accounts Source: PrimAmérica Consultores PrimAmérica Consultores

Impact of pension reform on economic growth: the case of Chile (average , %) Source: Schmidt-Hebbel (2003) PrimAmérica Consultores

II. Why pension funds investments should be regulated? When the State imposes a mandate to pay contributions it becomes –at least in part- responsible for the results of the pension system. Because of asymmetric information and agency problems, there are some investments risks that could prevent the pension system to attain its goals. So, investment regulation should help to:  Minimize the risk of the rate of replacement being lower than some “targeted” level.  Minimize supervision costs.  Minimize information costs.  Minimize the risk of fraud.  Minimize investment return variance ? PrimAmérica Consultores

To organize the discussion about regulation of pension funds investments, two “benchmarks” can be used: Prudential regulation  Full disclosure  Fiduciary responsibility  Licenses to managers  Custodian/Depositary  Asset valuation rules  Control of potential conflicts of interest  Accounting plans  Prohibitions to invest in some assets. Portfolio Limitations  Prudential regulation +  Authorized instruments  Maximum/Minimum investment limits in some instruments and asset classes  Minimum return requirements PrimAmérica Consultores III. Two regulation models for pension funds investment: which one works better?

Both models are under criticism. Objections against “Portfolio Limitations”:  The “efficient frontier” (made of investment portfolios which, for each level of return, minimize risks) is “shrinked”.  Risk is not limited in the most optimal way.  Expected returns may be “limited” in a disproportionate measure.  Differences in investment preferences among individuals are not recognized.  Portfolio managers “herd behavior” is incentivated. III. Two regulation models for pension funds investment: which one works better? PrimAmérica Consultores

Objections against “Prudential Regulation”:  The success of this model depends a lot on the capacity of the system to prevent mismanagement of funds and to punish those who commit fraud. However: In many countries the legal system does not provide an efficient instrument to punish those persons which do not fulfil with their fiduciary responsibility. Expected gains from fraud could be much greater than expected costs from punishment and/or future market losses (in many cases, portfolio managers will not have a “reputation” to protect: in “young” systems there may be no “brand name capital”). (Continue) PrimAmérica Consultores III. Two regulation models for pension funds investment: which one works better?

 High information costs and low financial education of the public.  High supervision costs.  Some potential conflicts of interest can be controlled only by using investment limits. III. Two regulation models for pension funds investment: which one works better? PrimAmérica Consultores

Most (all) countries which have introduced DC/funded pension programs into their social security systems use “Portfolio Limitations”. Although we do know the investments results in those countries, we don’t have the “counterfactual”. So, we can not compare them with the results “ceteris-paribus” under a different kind of regulation model. Looking at the actual results, the costs of “Portfolio Limitations” are not evident. PrimAmérica Consultores III. Two regulation models for pension funds investment: which one works better?

Source: PrimAmérica Consultores on the basis of Palacios (2003) and Chlon-Dominczak (2003) PrimAmérica Consultores

Pension Funds Rates of Return Source: Palacios (2003) PrimAmérica Consultores

Lessons from the practical experience of “reformist” countries:  In some cases, “Portfolio Limitations” are unavoidable: Under-developed capital markets (limited supply of financial assets; poor quality of financial information; low liquidity; high transaction costs; poor corporate governance practices). Weak political support to pension reforms. Low “financial and pension education” of the population.  In these circumstances, “Prudential Regulation” may not be enough, and “Portfolio Limitations” help to: Decrease information and supervision costs. Decrease risks of fraud and limit the opportunities for agency problems. (Continue) III. Two regulation models for pension funds investment: which one works better? PrimAmérica Consultores

“Portfolio Limitations” can be designed in a way that their potential costs are minimized. “Portfolio Limitations” should be gradually softened as the pension system matures and capital market develops. In practice the issue is not if “portfolio limitations” should or should not be used, but what should be their characteristics and how they should change over time. III. Two regulation models for pension funds investment: which one works better? PrimAmérica Consultores

Four challenges:  How to balance the need for “Portfolio Limitations” with the potential cost of investment limits?  How to avoid the risk of “Portfolio Limitations” being used to do “industrial policy” or to promote “social investments”?  How to avoid the risks of “herd behaviour”?  How to design “Portfolio Limitations” when the capital market is underdeveloped? IV. Challenges for a regulation model based on “Portfolio Limitations” PrimAmérica Consultores

How to balance the need for “Portfolio Limitations” with the potential costs of investment limits?:  Limits must always give room for portfolio diversification among different classes of assets and different issuers.  Mandatory investments in any kind of asset or issuer should be avoided (exception in the case of government debt to finance “transition costs”?). IV. Challenges for a regulation model based on “Portfolio Limitations” PrimAmérica Consultores

Pension Funds Investment Portfolio December 2003 Source: FIAP PrimAmérica Consultores

How to avoid the risk of “Portfolio Limitations” being used to do “industrial policy” or to promote “social investments”?  Avoid mandatory investments in any kind of asset or issuer.  Only investments in “financial assets” should be authorized.  Only investments in “commonly traded financial assets” should be authorized.  All transactions should be done in formal secondary markets.  Fiduciary responsibility of pension fund managers with pension fund members should be stressed.  Supervision should be professional and independent. IV. Challenges for a regulation model based on “Portfolio Limitations” PrimAmérica Consultores

How to avoid the risks of “herd behavior”?:  Multiple types of funds per manager help to accommodate individual preferences.  If minimum rate of return requirements are used, too short periods of measurement and too narrow bands should be avoided. IV. Challenges for a regulation model based on “Portfolio Limitations” PrimAmérica Consultores

Chile: Experience with Multiple Funds (March, 2004) Source: PrimAmérica Consultores PrimAmérica Consultores

Rate of return guarantees * Apply to state owned management companies. Source: Palacios (2003) and PrimAmérica. PrimAmérica Consultores

How to design “Portfolio Limitations” when the capital market is underdeveloped?:  International diversification of pension funds.  Create new institutions: existing institutional arrangements in the capital market may not be appropriate for mandatory pension funds.  Coordinate improvements in capital markets and tax rules and regulations with pension fund reform.  Use industry (and not market) benchmarks. IV. Challenges for a regulation model based on “Portfolio Limitations” PrimAmérica Consultores

PrimAmérica Consultores

The selection of the appropriate regulation model for pension fund investments is a critical decision. However, the capacity of the regulators and supervisors to adjust the regulation according to the actual results of the system and to adapt it to changing conditions of the environment may be even more important. So, there is not such a thing as an unique “optimal” set of rules and regulations for pension funds investments. On the contrary, pension fund investment regulation is an ever evolving instrument. V. Final remarks PrimAmérica Consultores