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This paper was written as part of my TAP at WHD. Thanks are due to WHD for its hospitality and to HRD for financial support. Special thanks also to Roberto Benelli, Ravi Balakrishnan, Stephanie Eble, Chris Faulkner-MacDonagh, Roberto Garcia-Saltos, Gil Mehrez, Alejandro Lopez Mejia, Wendell Samuel, Calvin Schnure, and Esteban Vesperoni, for invaluable input on the specifics of country reforms, and to Caroline Atkinson, Charles Collyns, Jose Fajgenbaum, Chris Towe, Tim Lane, and Ben Clements for useful comments at different stages of the project. Zlatko Nikolski provided excellent research assistance.
Most countries still saw the need to continue the PAYG system for older workers during a transitional period, and the compromise was to move to what the World Bank refers to as the multi-pillar framework (Holzmann, 1999).
In broad terms, the first pillar constitutes the mandatory, safety net part of the pension system, usually organized as PAYG. The second pillar is a mandatory, individual savings program, while the third is a voluntary, complementary savings program.
Catalan, Impavido and Musalem (2000) show that in some cases this association reflects causality from pension funds to the growth of securities markets.
The main strategies to reduce the amount of debt made explicit, and implications for the path of government cash flow deficits, are discussed in Holzmann (1998).
Although the initial reforms in Argentina were also aimed at improving fiscal solvency, subsequent reductions in employers contributions to the PAYG programs, and the federal government assumption of the liabilities of generous pension plans for civil servants at the provincial level pension, increased the implicit pension debt.
Fees are high when considered relative to current contributions, but are much lower as AUM grow and they are spread over more years. In Colombia, for instance, fees are 13.3 percent of contributions and 2.4 percent of AUM (Rudolph and others, 2006), while in Chile they are around 1 percent of AUM (close to what U.S. mutual funds charge on average, but twice as much as what large occupational pension funds in the U.S. charge).
See Holzmann and Hinz (2005). For El Salvador, for instance, Fletcher and Schipke (2006) estimate that real rates of return of less than 5 percent would likely lead to replacement rates of 17-30 percent.
Exposure to the sovereign may be larger if one were to consider central bank securities; in the case of Uruguay, for instance, this would bring exposure to the sovereign to almost 85 percent of assets.
Recent reform proposals in Chile will increase the limits on foreign investments even further, with a long-term limit of 80 percent.
The Superintendency of Pension Funds (SAFJP, 2002) notes, however, that the pension fund administrators has managed to prevent to a large extent the fall in asset values in real terms, even when the dollar value of AUM declined substantially. As of end-2005, restructured debt accounted for around 40 percent of AUM, the bulk of which are quasi-par bonds that are not valued at market prices.
The fact that pension funds could not hold more than 10 percent of their assets in Mexican external debt, combined with their inability to engage in cross-currency swaps and restrictions on short-selling the local bonds, prevented the convergence of both curves. The fact that other market participants exploited these differentials contributed to a gradual convergence of the curves later in the year, as shown in the lower panel of the figure (see IMF, 2004, for further details).
The most natural instruments are global mutual funds, and it is sometimes difficult to obtain a detailed composition of the assets of a mutual fund at the frequency required by the regulators.
These types of calculations do not take into account factors such as human capital, housing assets, and the risks of low interest rates at retirement, which can significantly affect estimates of the optimal portfolio. Baxter and King (2001), for instance, show that since human capital is correlated with returns in local assets, the optimal portfolio with human capital should incorporate a higher share of foreign assets.
Solnik (1998) estimates that the optimal portfolio would be the world market portfolio partly hedged against currency risk, but recognizes that there is no simple practical solution and no theoretically unquestionable benchmark for currency hedge ratios.
In dollarized economies such as Argentina, Bolivia, Peru and Uruguay, foreign currency exposure largely exceeds foreign investments (see Table 6).
This co-movement across equity market returns and exchange rates has been documented for a large number of countries and time periods (see Fooladi and Rumsey, 2006).
In both cases, however, the depreciations were also associated with a deterioration in non-energy commodity prices.
This could be achieved by allowing only a fraction of their holdings to be traded per month, or by auctioning off a given amount for all PFs each month. Zahler also recommends the establishment of investment and trading accounts in PFs, with incentives to keep a large share in the former (“buy and hold” accounts) to reduce trading in the foreign currency market.
The lack of recognition bonds in the Uruguay case is not relevant, since the old system will pay contributors a minimum first pillar pension even if they participate in the second pillar.
The other peak of 4 percent of GDP in 1983 was due in part to the sharp recession in that year.
Minimum and non-contributory pensions increase add around 0.5 percent of GDP to the deficit numbers estimated in Corbo and Schmidt-Hebbel (see ECLAC, 2006).
The value of the original recognition bonds resulted in low pensions for early retirees of the new system, and supplementary bonds were issued in 2003 to compensate for this disadvantage of the new system. However, payments are been stretched out to minimize the increased costs (see Samuel, 2006).
The shock is assumed to produce a decline in GDP and employment of 4 percent, and a fall in real wages of 3 percent, for five years, then reversed over the following five years. I thank Yvonne Sin, Asta Zviniene and their team at the World Bank Social Protection Division for producing these simulations for this project.
This would also facilitate a future shift towards an internal risk-based regulatory framework for PF managers.
The argument of early adopting of legislation also applies to instruments that are critical for the pay-out phase of pension systems, and as such are not the focus of regulatory authorities until late in the process, such as annuities (see World Bank, 2006, b).