Improving price competition among AFPs: Two alternative Chilean bidding proposals LCR Pensions Seminar The World Bank February 15, 2006 Heinz P. Rudolph OPD

2 Structure of Presentation Background Bidding Proposal (SAFP) Double Bidding Proposal (Valdes (2005))

3 After 25 years of the Pension Reform: 1. Commissions in Chile are approximately 1% of the assets or 18% of the contributions ….Too high!! 2. Even after the introduction of Multifunds in 2001, portfolios of each class seem similar. 3. Concentration: In 2005 international assets managed by six pension funds are higher than international reserves.

4 A number of ideas in Chile are in embryonic discussion: a. Bidding System b. Swedish Model c. AFPs as Bank subsidiaries d. State AFP

5 Background: information 93% of people confessed not to know the commissions that are being charged by the pension funds (3.4% of people believes that AFPs do not charge commissions) 10% of the people say that uses the personal quarterly report ( “ cartola ” ) to take social security decisions. Source: First Survey of Social Security 2002

6 Low elasticity of demand High costs of getting information Moderate switching cost Low contributions each month: incentives to postpone decisions Contributions are discounted from the salaries and not from the pocket of workers: low sensitivity Lack of effective institutional support to advise contributors to choose AFP …. BIDDING is the answer … IS IT????

7 Bidding SAFP: Mechanism Optional for entrants and incumbents AFPs Voluntary for contributors: a. Voluntary contributors b. Randomly chosen by SAFP c. Limited ex-post participants selected by chosen AFP. d. New entrants Simple structure: allocated to AFP that offers the lowest commission (BC). Regular biddings. There is no public document. Information taken from October 2005 presentation of Superintendent Larrain and bilateral conversations

8 Bidding SAFP: Incentives Entrant: possibility of reaching a critical mass of contributors (break even) Currently main entrance barrier is the treat of price war (fat cat) Contributor: CASH. Upfront rebate for minimum holding period Some penalties applies if contributor leaves before the end of the period Externalities. Linkages with regular commissions (hook): maximum difference between BC and regular commission (RC).

9 Bidding SAFP: Comments Excessive concentration on commissions: missing the focus on returns and quality of asset managers Low interest in participating and transaction costs Participants opted for not being informed. However, cash proved to be an incentive (gifts) Gifts were supply driven Low interest in participating 2 Voluntary: small number but OK Random selection of contributors by AFPs: 60% of people reads the quarterly “ cartola ” and proposals are not binding. Ex-post offers: It requires sales force (expensive). You need to know your portfolio of contributors before bidding

10 Bidding SAFP: Comments (cont.) Adverse selection Workers with low density of contributions know that they will never contribute enough to offset the rebate Workers with high density of contributions will subsidize workers with low density. Administrative cost Cost of providing the rebates is expensive. Linkage with regular commissions It reduces the incentives to participate in the bidding (free rider) Further concentration: Larger AFPs may offer the lowest bids.

11 Bidding SAFP: Comments (cont.) Controversy if there is a bias towards low income or high income workers Low income workers value the rebate (credit constraints) High income workers have more access to internet and can move qiuickly. Variant: only for new entrants to the labor market Commissions may end up being more expensive (low income workers).

12 Double Bidding (Valdes 2005): Mechanism Separation between Account Manager (Operador B á sico), Portfolio Manager (AFP pura) and Provider of Insurance of Invalidez and Sobrevivencia. Account manager: Regional bidding every 10 years. Process carried by a Board (Board 1) Board 1 is integrated by members of Boards of AFPs and some IT experts. Board 1 would set the contracts with account managers that would be allocated through bidding processes.[1][1] Account managers are financed separately from account managers. Tariff regulation is imposed only in the case of monopoly. [1][1] There are some contradictions in the text.

13 Double Bidding: Mechanism (cont.) Presumption: All workers whose assets are below certain threshold will need the support of the Search Service of least expensive portfolio manager. No more than 50% of the total assets of pension funds would be subject to presumption Search Service will be managed by another Board (Board 2) of 5 experts (not affiliated to any political party), appointed by “ long periods of time ” and can not be removed. Board 2 will set the bidding guidelines.

14 Double Bidding: Mechanism (cont.) Search Service will allocate packages of about contributors to lowest bidders for a three year period. Workers that are not comfortable have the option of moving back Portfolio managers will serve with same multi-funds to contributors selected individually and in the bidding process. Banks will be allowed to have AFP subsidiaries, including BancoEstado.

15 Double Bidding: Comments Too complicated. You should not use a machinegun to kill a fly Scale Economies: The missing argument Argument is based on the use of scale and scope economies and end up with many basic operators (by regions!). New system may be more expensive. Strong ideological component: No role for Government Role of Board 1 and Board 2 replace the role of SAFP. Board 2 has the mandate to define the fit and proper requirements for authorizing new entrants.

16 It reduces concentration by creating artificial quotas No portfolio manager can have more than 15% of the market. Merges of portfolio managers that imply market shares above 15% causes end of concession contract. Conflict of Interest It assumes the absence of conflict of interest between portfolio manager and account manager. NO clear consideration of conflict of interest of getting banks involved in social security business. Not clear how commissions for account managers are set. Double Bidding: Comments

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