Juan Yermo

Keeping the Promise of Social Security in Latin America

Nations around the world (both large and small, rich and poor) are engaged in debate over how to reform their social security systems and care for the aged. For many countries this debate requires speculation on hypothetical scenarios, but in Latin America a rich body of experience on social security reform has been accumulating for more than a decade (for Chile, more than two decades). This report, entitled, Keeping the Promise of Social Security in Latin America, takes stock of those reforms, evaluates their successes and failures, and considers the lessons that can be drawn for the future of pension policy in the region. The authors draw on a series of background papers and surveys commissioned specifically for this inquiry, as well as existing research conducted by themselves and other pension experts. In the debate on pension reform there is no orthodoxy, as reflected in major differences of opinion among leading experts. Despite more than a decade of experience with pension reform in Latin America, although undoubtedly a major step forward, reforms are still works in progress. This report furthers enrich the policy dialogue that is of crucial importance to the future of the region.

Evaluating the Financial Performance of Pension Funds

Since the early 1980s, the structure of arrangements to provide retirement income has gradually moved from defined benefit (DB) systems to various types of arrangements in which the provision of pensions is backed by assets, either in individual accounts or in collective schemes. This change has been motivated principally by governments seeking to lessen the fiscal impact of aging populations and to diversify the sources of retirement income. One of the key results is that many pension systems are now in the process of becoming asset backed. This increasingly links retirement incomes to the performance of these assets, resulting in participants being exposed to the uncertainties of investment markets to determine the level of benefits that they will ultimately receive. The potential consequences of this have never been more evident than during the recent global financial crisis. This introductory chapter provides an overview of the issues and motivation for this work and summarizes the studies that were conducted and their main findings. It concludes with policy-related observations that arise from the overall consideration of the research program. The remainder of the volume contains a selection of the studies undertaken through the partnership that focus on developing approaches to evaluate performance of pension funds and concludes with observations and commentary from four noted experts in the field on the issues raised by this work and the interpretation of the findings.

Implications of Behavioural Economics for Mandatory Individual Account Pension Systems

In individual account pension systems, members bear the risks and consequences of their investment decisions. If participants behave as predicted by economic theory, such responsibility would be welfare-enhancing as members would invest and hold a portfolio of financial assets with a risk-return combination consistent with their investment horizon, degree of risk aversion and the portfolio of other assets they hold, including their human capital and, where relevant, their home. Behavioural economists and empirical researches have shown that in reality members are not particularly good at handling their retirement savings, either because they lack the necessary cognitive ability to solve the optimization problem, because they have insufficient will power to execute it, or even sometimes because they are overconfident. This paper describes the extent to which plan members make active investment decisions in these systems and assesses the policy solutions that have been put forward to facilitate choice. The paper offers a comparative analysis of ten countries that have implemented investment choice in the accumulation stage of their individual account pension system.

The Impact of the 2007-2009 Crisis on Social Security and Private Pension Funds: A Threat to Their Financial Soundness?

Social security and pension funds were affected on an unparalleled scale by the recent financial crisis. They reported massive unrealized investment losses and their governance mechanisms have been challenged, therefore endangering their financial soundness and questioning their capacity to deliver adequate benefits. The year 2009 ended with financial markets recovering, but also with portfolio reallocations and traditional risk management approaches being revisited. Governments have reacted to the crisis and implemented recovery plans that could issue a warning about the mid-term fiscal situation. Post-crisis fiscal stress may generate a trade-off between a re-establishment of a sound fiscal situation and a reduction in social expenditure. This article analyses the impact of the crisis on social security and pension funds and address all the aforementioned issues.

Pension Fund Governance

Good governance is increasingly recognized as an important aspect of an efficient private pension system, enhancing investment performance and benefit security. Yet, despite regulatory and industry initiatives, governance weaknesses persist across OECD and non-OECD countries. This paper highlights the main governance challenges faced by policymakers (particularly with trust-based pension systems), and draws on recent policy initiatives to propose possible solutions to strengthen governance arrangements. The paper suggests that some of the more serious cases of governance failures could be solved through a more balanced representation of stakeholders in the governing body, higher levels of expertise (which may be achieved via training or the use of independent trustees) and the implementation of codes of conduct addressing conflicts of interest. The absence of governance arrangements for defined contribution style pension plans also needs to be addressed, potentially via management committees, increased fiduciary responsibility for relevant parties or via a strengthened role for pension supervisory authorities. Consolidation of the pension industry in some countries may also be required to achieve economies of scale and reduce costs, which in turn would allow pension funds to dedicate more resources to strengthening their internal governance.

Funding Regulations and Risk Sharing

This paper provides a description of the risk sharing features of pension plan design in selected OECD and non-OECD countries and how they correspond with the funding rules applied to pension funds. In addition to leading to a better understanding of differences in funding rules across countries with developed pension fund systems, the study considers the trend towards risk-based regulation. While the document does not enter the debate over the application of riskbased quantitative funding requirements to pension funds (as under Basel II or Solvency II), it identifies the risk factors that should be evaluated and considered in a comprehensive risk-based regulatory approach, whether prescriptive or principles-based. The three main risk factors identified are the nature of risks and the guarantees offered under different plans designs, the extent to which benefits are conditional and can be adjusted, and the extent to which contributions may be raised to cover any funding gap. In addition, the strength of the guarantee or covenant from the sponsoring employer(s) and of insolvency guarantee arrangements should be carefully assessed when designing funding requirements.

Funding in Public Sector Pension Plans: International Evidence

Most countries have separate pension plan for public sector employees. The future fiscal burden of these plans can be substantial as the government usually is the largest employer, pension promises in the public sector tend to be relatively generous, and future payments have to be paid out directly from government revenues (pay-as-you-go) or by funded plans (pension funds) which tend to be underfunded. The valuation and disclosure of these promises in some countries lacks transparency, which may be hiding potentially huge fiscal liabilities that are being passed on to future generations of workers. In order to arrive at a fair comparison between countries regarding the fiscal burden of their DB public sector pension plans, this paper gathers more evidence on public sector pension plans regarding the type of pension promise and quantifies the future tax burden related to these pension promises. The reported liabilities are recalculated using both a fair value approach (local market discount rates) and a common, fixed discount rate across all countries which reflects projected growth in national income. We also estimate for a number of plans from a sample of OECD countries the size of the net unfunded liabilities in fair value terms as of the end of 2008. This fiscal burden can also be interpreted as the implicit pension debt in fair value terms.

Implicit debt in public sector plans : An international comparison

Most countries have separate pension plans for public-sector employees. The future fiscal burden of these plans can be substantial as the government usually is the largest employer, pension promises in the public sector tend to be relatively generous, and future payments have to be paid out directly from government revenues (pay-as-you-go) or by funded plans (pension funds) which tend to be underfunded. The valuation and disclosure of these promises in some countries lacks transparency, which may hide potentially huge fiscal liabilities to be passed on to future generations of workers. In order to arrive at a fair comparison between countries regarding the fiscal burden of their public-sector pension plans, this article recommends that unfunded pension liabilities should be measured and reported according to a standard approach for reasons of fiscal transparency and better policy-making. From a sample of Member countries of the Organisation for Economic Co-operation and Development, the size of the net unfunded liabilities as of the end of 2008 is estimated in fair value terms. This fiscal burden can also be interpreted as the implicit pension debt in fair value terms.

Evaluating the Design of Private Pension Plans: Costs and Benefits of Risk-Sharing

The principal purpose of this paper is to analyse the trade-off between the uncertainty in contributions on the one hand and benefits on the other that is embedded in different pension arrangements. The paper employs the funding ratio (ratio of assets to liabilities) and the replacement rate (ratio of benefits to salaries) as key criteria for evaluating the risk sharing characteristics of a private pension plan from the perspective of the plan member. The stochastic simulations performed show that hybrid plans (those in between traditional DB and individual DC) appear to be more efficient and sustainable forms of risk sharing than either of the other two. Of the three main hybrid plans analysed, conditional indexation plans appear to have the greatest potential as sustainable forms of risk sharing.

Pension Fund Regulation and Risk Management

This paper provides a stylised assessment of the impact of investment-relevant pension fund regulations and accounting rules on contribution and investment strategies within the context of an asset-liability model (ALM) specifically designed for this purpose. The analysis identifies a substantial impact of regulations which, in a simplified way, resemble those in place in Germany, Japan, the Netherlands, United Kingdom and the United States. The ALM model shows that regulations affect funding costs primarily through the choice of investment strategy. Strict funding regulations may force sponsors to make up funding shortfalls in bad economic times and lead them to invest more conservatively, which ultimately raises net funding costs. The paper also shows that fairvalue accounting standards (with immediate recognition of actuarial gains and losses) can contribute to higher funding levels than required by regulators.