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Commission structutre in an AFP System *

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1 Commission structutre in an AFP System *
Augusto Iglesias P. May 28, 2008 PrimAmérica Consultores *Presented in the FIAP Seminar “The Future of Pensions”, Lima, Peru. May 28-29, 2008.

2 Index Types of commissions used Why are AFP prices regulated?
Comparative commissions analysis Is there an “optimum” price structure for the AFPs? Final comments Context of the discussion: individually funded pension systems in which the account and fund management functions have been integrated

3 I. Types of Commissions Used
In the majority of countries: Management of active funds and the payment of pensions are charged for (there are, furthermore, a variety of other services for which some kind of charge is authorized) The management of inactive accounts is not charged for It is mandatory to apply the same commission rates uniformly to all members (in some cases discounts for permanence are accepted) In a few countries: Commissions are charged on profitability results A fixed commission is charged Differences between Latin America and Central and Eastern Europe: The majority of Latin American countries apply commissions on flow The majority of central and Eastern European countries apply commissions on flow and balance

4 II. Why are AFP prices regulated? (1)
The following are regulated in all reformist countries : The type of service that can be charged for (account and fund management, the payment of pensions, transfers etc.) The type of price and the charge base: fixed amount; percentage of salary; percentage of the contribution; percentage of the balance; percentage of profitability; percentage of the pension The source of the payment: balance, salary, contribution Who pays: the employer and/or the worker The possibility of offering “differentiated prices” or not (for example for minimum permanence) In some cases, price levels (maximum) and price formation are also regulated Expenses that can be charged to the pension fund The implicit regulation assumption is that free competition would not lead to an optimum price structure from a social standpoint

5 II. Why are AFP prices regulated? (2)
Objectives (usually not explicitly declared) of price regulation: Lower the cost of the pension system for “social priority” groups Promote commission transparency (lower information costs for members) Encourage the AFPs to develop attributes valued by the regulator (e.g. investment profitability) Avoid problems due to possible mismatches between costs structures and income Encourage the AFPs to cover the entire potential market and not concentrate their marketing efforts on certain segments of members Reduce the financing needs of the AFPs during the initial development stage of the new systems Assure prices “at competitive levels”

6 III. Comparative commission analysis (1)
Fixed commission Characteristics The price does not depend on the amount of income or the accumulated balance in the individual account Collection grows over time according to the number of contributors (with price at a constant level) The price will or will not affect the final pension depending on whether the commission is charged on the contribution, balance or salary

7 III. Comparative commission analysis (2)
Commission on flow (income or contributions)) Characteristics Contributors pay up front Commission collection trend over time depends mainly on salary and contributor growth Prices paid by members depend on their incomes (generates crossed subsidies in favor of non-contributors and possibly lower income contributors) Depending on the way charges are levied, the commission rate affects the salary or the net contribution rate to the individual account. In the latter case, the amount of the commission affects the final pension

8 III. Comparative commission analysis
Commission on the balance (or profitability) Characteristics The payment is deferred over time (at the same rate) Prices paid by members depend on the accumulated balance Therefore, at a constant rate, collection would grow over time in proportion to the increase of the accumulated balances (consequently, it would be reasonable to suppose that the rate would tend to drop over time) Due to the way it is usually charged, the commission level affects the balance of the individual account. Thus, this price level affects the final pension

9 III. Comparative commission analysis (4)
Annual collection of commissions on incomes and the managed balance (rates constant over time) 200 400 600 800 1.000 1.200 1.400 1.600 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 YEARS OF PERMANENCE Nuevos Soles Commission on Income Commission on balance Source: PrimAmérica Consultores Assumptions: Commission on monthly income: 1,80% Commission on balance: 1,09% Real Annual Profitability : 5% Monthly income: System average Annual income growth: 0% Contribution Density: 100% Monthly contribution rate: 10%

10 III. Comparative commission analysis (5)
Commission on the annual equivalent balance (For each accumulation year) Source: PrimAmérica Consultores Assumptions: Contribution period: 30 years Commission on monthly income: 1,80% Real Annual Profitability : 5% Monthly income: System average Monthly contribution rate: 10%

11 III. Comparative commission analysis (7)
Commission on flow (incomes or contributions) Potential advantages Greater transparency potential (if discounted from the salary) Lower capital requirement for entering the industry when there are no accumulated funds Effective if the purpose is to benefit lower income workers (and it is “consistent” with the social security tradition) Potential disadvantages It does not adjust to the cost structure (if there is a sole rate and there are no other commissions, it generates incentives for seeking members with greater incomes) Since members pay up front, less incentive for encouraging permanence Inflexibility: it is difficult to charge inactive accounts (the contributors’ costs increase)

12 III. Comparative commission analysis (8)
Commission on balance (or profitability) Potential advantages Encourages investment management aimed at maximizing profitability Lower capital requirements for entering the market when there are already accumulated funds Flexibility: enables charging inactive accounts Worldwide practice of charging for asset management services Potential disadvantages Low sensitivity of the demand: if it does not come “out of the pocket” its impact on members is deferred over time (until retirement) and some members will never pay it (disability and survival pensioners; beneficiaries of guaranteed minimum pensions) It can encourage short term investment strategies It reduces the incentive of members with a larger balance to pay It does not adjust to cost structures (if there is a sole rate and there are no other commissions, incentives to seeking members with a larger balance: older and with larger incomes. It can encourage a “transfer war”).

13 III. Comparative commission analysis (9)
Fixed commission Potential advantages It adjusts to the structure of account management costs (not necessarily to the total AFP costs structure) It encourages universal coverage Simple and transparent If discounted from salaries, greater sensitivity of the demand Potential disadvantages Adversely affects lower income workers (and is not “consistent” with the social security tradition) It does not adjust to cost structures for asset management If it is discounted from the balance, low sensitivity of the demand

14 IV. Is there an optimum price structure for the AFPs? (1)
There is no commissions structure that meets all the objectives of the regulations: Benefit to low income workers: Commission on flow Transparency: Simple structure and the member pays “from his pocket” (Fixed commission discounted from the salary?) Incentives for profitability: Commission on the balance or profitability Extension of coverage: Fixed commission Costs adjustment: Fixed commission + Commission on salary (Cost of the SIS) + Commission on balance (and price rates differentiated between members) Reduction of “financial barriers” on entry: Commission on flow (or fixed) at the outset; commission on the balance when funds have been accumulated

15 IV. Is there an optimum price structure for the AFPs? (2)
Characteristics of the commissions regulations will depend on what objectives are being pursued Priority of objectives depends on the regulator’s preferences and other characteristics of the pension system. For example: If prices are formed in bidding, the objective of “transparency in price structures” is less important If members choose separately between account managers and fund managers, using two different types of commission would be efficient (the same if the disability and survival insurance is separated) The objectives of price regulation may very possibly change over time, but changing the commissions structure is not easy: Problems for the fund managers Different effects on different groups of members

16 V. Final comments (1) The regulation of the price structure must establish: What services can be charged for What kind of commission can be charged Who will pay the commissions What is the payment source Whether or not prices can be differentiated between members The effect of the price structure on members and fund managers cannot be evaluated without at the same time considering the characteristics of the regulations on the financing of AFP expenses (for example, some arguments in favor of a commission on the balance become weaker if the AFPs can charge the investment management expenses to the pension fund)

17 V. Final comments (2) Some of the objectives that have been imposed on commissions regulation could be better achieved through other economic policy instruments (for example: subsidies for low income workers) The definition of the initial commissions structure must be undertaken with extreme care: it will not be easy to change it later Trends in the organization of the AFP industry could lead to an increased use of the commission on the balance to pay the fund management service, and a fixed commission (or % of salary) to pay the account administration service As long there is no agreement with respect to the objectives of price structure regulation, debate will not be avoided


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