Pension Reform and Financial Markets: Encouraging Households Savings

for Retirement

Anita Tuladhar

International Monetary Fund

June 2007

Conference on International Forum on Pension Reform: Exploring the Link to Labor and Financial Market Reforms

The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management.

Background

Rapidly ageing populations Unsustainable pension system and public finances in

the long run Introduction of funded pensions system with

mandatory private individual account and voluntary supplemental accounts, including in the region.

– 1998 (Hungary, Kazakhstan); – 1999 (Poland); – 2001 (Latvia); – 2002 (Croatia, Estonia, Bulgaria); – 2003 (Russia); – 2005 (Macedonia, Slovakia);

Shifting of responsibility for old-age income to households (by working more or higher financial savings)

Question: How to encourage household financial savings for retirement?

Outline of this presentation: Examination of household financial savings

– in particular, pension savings in some emerging and mature markets

Factors affecting pension fund savings – Descriptive analysis using cross country data– Empirical analysis using more detailed pension fund data

from Latin America.

Policy implications for pension fund regulations

Household balance sheets: Share of financial assets in total wealth varies considerably.

Composition of Household Wealth in Household Balance Sheets, 2000

0

20

40

60

80

100

120

Poland

Czech R

epublic

Singapore

Taiw

an

South A

frica

Spain

New

Zealand

France

Germ

any

Australia

Italy

Portugal

Japan

UK

Netherlands

Denm

ark

Canada

US

A

Average - E

M

Average - M

M

Non-financial assets Financial assets

Source: Davies, Sandstrom, Shorrocks and Wolff (2006)

Household balance sheets: Share of liquid assets in financial assets significantly larger in emerging markets.

Composition of Financial Assets in Balance Sheets, 2000

0

20

40

60

80

100

120

Bu

lga

ria

Cro

atia

Ro

ma

nia

Slo

vakia

Tu

rkey

Ko

rea

Cze

ch R

ep

ub

lic

Po

lan

d

La

tvia

Slo

ven

ia

Sin

ga

po

re

Hu

ng

ary

Ta

iwa

n

Lith

ua

nia

Esto

nia

So

uth

Africa

Be

lgiu

m

Jap

an

Po

rtug

al

Gre

ece

Sp

ain

Ne

w Z

ea

lan

d

Ge

rma

ny

Fra

nce

Ca

na

da

Italy

Au

stralia

Au

stria

UK

De

nm

ark

Sw

itzerla

nd

Ne

the

rlan

ds

US

A

Ave

rag

e - E

M

Ave

rag

e - M

M

Liquid assets Shares and equities Other (including pensions)

Source: Davies, Sandstrom, Shorrocks and Wolff (2006)

Household balance sheets (contd.)The low share of pension fund savings also observed in the OECD.

Select OECD Countries: Composition of Household Financial Assets (In percent)

0

0.2

0.4

0.6

0.8

1

1.2

CZE POL HUN SVN JAP FIN NOR AUS

Others

Equities

Loans

Securities except shares

Insurance reserves (inclpensions)

Currency and deposits

Source: OECD.

Factors Affecting Pension Fund Assets: A Cross-Country Comparison

Pension Fund Assets to GDP, 2005

0 20 40 60 80 100 120 140

Netherlands Iceland

Switzerland United States

Total OECD United Kingdom

Finland Chile

SingaporeAustraliaMalaysia

Ireland Canada

Non-OECDSouth Africa

DenmarkKenya

HongKongJapan

ColombiaSweden Portugal

UruguaryPeru

New Zealand Bolivia

Spain (6)El Salvador

PolandHungary

MexicoNorwayFrance

IndiaThailand

AustriaArgentina

BelgiumCzech Republic

KazakhstanGermany

EstoniaCroatia

ItalyBulgariaSlovenia

KoreaCosta Rica

LatviaPakistan

Dominican RepublicRussia

Slovak Republic China

LuxembourgLithuania

Turkey

Source: OECD.

Pension fund assets in non-OECD countries remains relatively low.

Pension Fund Assets in Selected Non-OECD Countries, 2005 (In percent of GDP)

0 10 20 30 40 50 60 70

Chile

Singapore

Malaysia

South Africa

Kenya

Hongkong

Colombia

Uruguay

Peru

Bolivia

El Salvador

India

Thailand

Argentina

Kazakhstan

Estonia

Croatia

Bulgaria

Slovenia

Costa Rica

Latvia

Pakistan

Dominican Republic

Russia

China

Lithuania

Indonesia

Ukraine

Weighted Average: 37 percent

Source: OECD.

Financial Market DevelopmentInvestment Opportunities

Liquidity constraints

Financial Market DevelopmentInvestment Opportunities

Liquidity constraints

PreferencesPreferences DemographicsDependency ratio

DemographicsDependency ratio

Alternative Income SourcesPublic pensions

(features and financing)Public transfersHousehold size

Alternative Income SourcesPublic pensions

(features and financing)Public transfersHousehold size

Macroeconomic conditionsIncome Wealth

Real Interest RatesInflation

Unemployment

Macroeconomic conditionsIncome Wealth

Real Interest RatesInflation

Unemployment

Household savings1. Level

2. Composition

Household savings1. Level

2. Composition

Theoretical foundations on determinants of household savings

Per Capital Income: Pension fund savings are positively correlated with income levels.

Per Capita GDP vs. Pension Assets

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

0 20 40 60 80 100 120 140

In percent of GDP

in U

SD

Full Sample

Non-OECD

Non-OECD

Source: OECD ; and IMF WEO.

Demographics: An older population or a faster pace of ageing Is not related to significantly higher pension fund savings

Old Age Dependency Ratio vs. Pension Fund Assets, 2005

0

10

20

30

40

50

60

70

0 20 40 60 80 100 120 140In percent of GDP

In t

ime

s

Full Sample

Non-OECDNon-OECD

Source: OECD; and United Nations.

Alternative income sources: Public pension policy affects incentives to save in pension funds.

Public Pensions Expenditure vs. Pension Fund Assets

0

2

4

6

8

10

12

14

16

0 20 40 60 80 100 120 140In percent of GDP

In p

erce

nt o

f GD

P

Full Sample

Non-OECD

Source: OECD.

Alternative income sources: Generosity of public pensions likely reduces incentives to save in pension funds.

Net Replacement Rate vs. Pension Fund Assets

0

20

40

60

80

100

120

140

0 20 40 60 80 100 120 140In percent of GDP

In p

erc

ent Full Sample

Non-OECD

Non-OECD

Sources: IMF staff; and OECD.

Pension Reforms: The maturity of the mandatory funded system is a significant determinant of the size of pension fund savings.

Pension Assets, 2005 (In percent of GDP)

0 20 40 60 80 100 120 140

Netherlands (1)Iceland

Switzerland (1) (8)United States (10)

Total OECD United Kingdom (1)

Finland (2)Chile

SingaporeAustraliaMalaysia

Ireland (4)Canada (1)Non-OECD

South AfricaDenmark

KenyaHongKongJapan (5)Colombia

Sweden (7)Portugal

UruguaryPeru

New Zealand Bolivia

Spain (6)El Salvador

PolandHungary

MexicoNorway

France (1) (3)India

ThailandAustria

ArgentinaBelgium

Czech Republic Kazakhstan

GermanyEstoniaCroatia

ItalyBulgariaSlovenia

KoreaCosta Rica

LatviaPakistan

Dominican RepublicRussia

Slovak Republic (1)China

LuxembourgLithuania

Turkey

Financial market development: Pension fund savings shows a strong positive relation with financial market development. Direction of causality?

Market Capitalization vs. Pension Fund Assets

0

50

100

150

200

250

300

0 20 40 60 80 100 120 140In percent of GDP

In p

erc

ent of G

DP

Full Sample

Non-OECD

Non-OECD

Source: Bloomberg; and OECD.

Financial market development: Pension fund savings are inversely related to financial market volatility. Market stability or preference for safer assets?

Equity Market Volatility vs. Pension Fund Assets

0

20

40

60

80

100

120

140

160

180

0 20 40 60 80 100 120 140In percent of GDP

Std

. dev

(In

per

cent

)

Full Sample

Non-OECD

Non-OECD

Source: Bllomberg; and OECD.

Financial market development: Pension fund savings are inversely related to risk adjusted returns in the equity market. Investment limitations or lack of deep liquid markets?

Risk Adjusted Return vs. Pension Fund Assets

0.0

0.5

1.0

1.5

2.0

2.5

0 20 40 60 80 100 120 140

Full Sample

Non-OECD

Non-OECD

Empirical analysis

Question: What factors enhance participation and pensions savings?

Equations:1. Change in pension fund participation =

f (fund performance, years since reform, change in income, change in unemployment rate)

2. Change in pension fund assets per participant = f (fund performance, change contribution rate, change in income,

rates of return on alternative investments) Data:

– Pension fund data: FIAP on Latin American countries – Macroeconomic data: WEO– Financial Market data: IFS, World Development Indicators,

Bloomberg Unbalanced Panel Data with 8 countries

Results: Equation 1

Fixed Effects EstimationDependent Variable: D(Number of Participants)

Explanatory Variables:Constant 0.06 0.06 0.05 0.04 0.42 0.32 0.02Lagged Dependent Variable -0.36 -0.36 -0.44 -0.48 -0.48 -0.46 -0.45Annual Rate of Return 0.002 0.002 0.001 0.002 0.002 0.002 0.003Lag Annual Rate of Return 0.000Dummy (Reform Years) 0.10 0.09 0.08 0.08 0.09D(Unemployment Rate) -0.23 -0.19 -0.21 -0.23Income Per Capita -0.05 -0.04D(Income Per Capita) 0.04Annual Rate of Return*D(Income Per Capita) 0.002 0.004

R-Squared 0.16 0.15 0.26 0.31 0.33 0.33 0.33F-Stat 1.02 0.78 1.67 1.93 1.88 1.49 1.68

Sample (adjusted) 1984 2005 1984 2005 1984 2005 1984 2005 1990 2005 1990 2005 1990 2005Included observations after adjustments 22 22 22 22 22 22 22Cross-sections included 8 8 8 8 8 8 8Total pool (unbalanced) observations 59 56 59 59 59 59 59

Results: Equation II

Fixed Effects EstimationDependent Variable: D(Pension Funds Per Participant)

Explanatory Variables:Constant 0.07 0.05 0.10 0.06 0.07 0.08Lagged Dependent Variable 0.04 -0.06 -0.19 0.07 0.14 0.08Annual Rate of Return 0.014 0.02 0.01 0.01 0.01 0.01Lag Annual Rate of Return 0.004D(Income Per Capita) 0.38 0.36 0.36Fund Contribution Rate (Net of Fees) -0.40Stock Market Return 0.00Government Bond Rate 0.00

R-Squared 0.47 0.58 0.47 0.54 0.82 0.54F-Stat 4.97 6.18 2.25 5.67 13.5 3.97

Sample (adjusted) 1984 2005 1984 2005 2000 2005 1984 2005 1996 20051993 2005Included observations after adjustments 22 22 6 22 10 13Cross-sections included 7 7 7 7 5 7Total pool (unbalanced) observations 54 51 33 54 33 45

Key Factors and Challenges to Pension Fund Savings

Structural factors limit pension fund coverage – high unemployment rate– low income levels

Pension savings on a voluntary basis low reflecting – still generous public pension system– level of financial sector development that limits investment

opportunities or low financial awareness thereof, or – myopia

Improved performance on pension funds encourage savings Other variables: savings incentives, other income sources,

demographic factors

Policy Implications

Enhancing coverage of pension income:– creates a need for non-contributory social safety net for

retirees (minimum public pensions or the zero pillar)– make pension fund savings mandatory or require automatic

enroll enrollment as default option to improve participation In CEC’s generally, participation to funded pensions is

designed as a carve-out of existing public pension contribution which is mandatory for younger workers. (~20 yrs for SVK, EST, MKD, HUN, ~30 yrs POL and LVA, ~40 yrs CRA, BLG, all for KZK)

– awareness/financial literacy

Policy Implications

Regulations for improving fund performance/net risk-adjusted returns:

– Investment in an optimum portfolio: regulations on asset allocation. For eg - shift from quantitative

investment limits to prudent person rule or loosen tight regulations taking into consideration the development of local securities markets

regulations on guarantees: For eg – minimum guaranteed return relative to industry

– Tax incentives on voluntary pension savings– Minimizing fees and costs: regulations on fees, industry

structure

Pension portfolios mostly in government bonds, reflecting both regulatory restrictions and lack of investment opportunities

Portfolio Allocation in Select Latin American Pension Funds, 1999-2006

0

10

20

30

40

50

60

GovernmentDebt

FinancialInstitutions

Non-financialInstitutions

Equities Mutual Funds ForeignInvestments

Others

Jun-99 Dec-06

Pension portfolios are shifting from bank deposits towards capital markets and international investments

Shift in Portfolio Composition of Pension Funds, 1999-2006

Government Debt

Financial Institutions

Non-financial

Institutions EquitiesMutual Funds

Foreign Investments Others

(In percent of total funds) Argentina 9.3 -15.6 -0.7 -4.6 5.1 9.5 -2.9Bolivia 8.8 -22.9 9.3 0.1 0.2 2.7 1.9Chile -24.2 -4.9 4.3 4.3 0.9 19.6 0.0El Salvador 10.5 -16.3 5.8 0.0 0.0 0.0 0.0México -24.2 4.7 8.0 1.8 0.0 9.6 0.0Perú 12.5 -30.1 -6.2 4.9 1.7 8.5 7.3Uruguay -4.1 3.4 1.1 0.1 0.0 0.0 -0.7

(In percent of total funds)

Investment limits: Need to enable diversification, and also allow life-cycle investing

Equity Foreign InvestmentUnited Kingdom PPR 1/ PPRUnited States PPR PPRGermany 30 20Japan 30 30Canada No limit 30Italy PPR 20

Argentina 50 20Chile 39 30Mexico 15 20Peru 35 10.5Colombia 30 20El Salvador n.a. 7

Slovakia n.a. 50Hungary 50 30Latvia n.a. 30Macedonia 30 20Croatia 30 15Kazakhstan 30 10Poland 40 5Bulgaria 5 5Sources: Poirson (2007), Chlon Dominczak (2003), Rutkowski (2006)1/ Prudent Person Rule (PPR)

Investment Limits

Policy Implications

Gradual easing of investment limits, especially on foreign investments

– facilitates diversification gains especially in lack of domestic investments, limits foreign exchange market volatility

Public debt management: – Longer term instruments, inflation hedge, establishing liquid

benchmark instruments, – ensuring pension funds don’t become captive markets for

government financing that provides cheap financing. Measures to strengthen capital market development

– Privatization, increasing available investment instruments, corporate governance regulations to improve supply

– Liquidity of these instruments also important

Minimum Return Guarantees (MRG): Significantly affects asset allocation and leads to herding behavior

Relative to the Pension Industry– Kazakhstan, Poland, Croatia, Slovakia

Relative to a benchmark– Hungary

No guarantees– Bulgaria, Latvia, Estonia, Macedonia

If MRG invoked, requires paying up from reserves, guarantee funds, etc.

Regulations on Guarantees: Flexibility in parameters of Minimum Return Guarantees, including setting of benchmark and portfolio choice

Country Benchmark and ReturnsAssessmet Period

Frequency of Evaluation

Full Disclosure of Portfolios

Argentina Min( 70 percent of ARS, ARS-2 percent) 1/ 12 months Monthly

Colombia Minimum Return = (A+B)/2 36 months Quarterly After 30 daysA = 70 percent of ARSB = 70 percent of Return on Synthetic Portfolio 70 percent of Return on Bogota stock exchange index 70 percent of return of S&P 500

Chile Risky Funds = Min (50 Percent of ARS, ARS-4 percent) 36 months Monthly After 10 daysConservative Funds = Min (50 Percent of ARS, ARS-2 percent)

Uruguay Min( 2 percent real, ARS-2 percent) 12 months Monthly

Poland Min( 50 percent of ARS, ARS-4 percent) 36 months Bi-annually YearlySource: IMF/World Bank (2007).1/ ARS = Weighted Average Return of the System

Minimum Guaranteed Return in Select Countries

Other considerations: Tax incentives for voluntary savings not very effective for lower income and liquidity constrained individuals.

No evidence of an increase in overall savings while mixed evidence of impact on composition of savings

Effectiveness of tax incentives depend on the substitutability of different savings alternatives. Non-substitutability could arise from the motivation for

– (i) precautionary savings if liquidity constrained – (ii) bequest to heirs

Strong distributional effects with benefits accruing to older and richer individuals who face higher marginal tax rates.

Fiscal costs

Industry structure: trending towards consolidation requiring a balance between competition in returns and scale economies to keep costs low

Number of Pension Fund Administrators

0

5

10

15

20

25

30

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

ARGENTINA BOLIVIA COLOMBIA COSTA RICA CHILE

EL SALVADOR MÉXICO PANAMÁ PERÚ Dominican Rep.

URUGUAY BULGARIA Kazakhstan Poland

Minimizing fees and costs are important to ensure high net returns

High fixed costs has more distributional impact on low-income savers.

Centralization of basic services with scale economies such as account management, collections. This is already the case in most CECs.

Minimizing costs from regulatory burden (for reserves, reporting, etc) and initial marketing costs.

Regulatory ceilings for fees on contributions/assets which decline over time as asset size grows.

Balance the costs with high concentration in the industry.

Financial Awareness

Financial education and awareness particularly if given choice of portfolio

Greater need if low-income savers Dynamic default portfolio for passive investors Public information including availability of simulation

models to analyze potential net replacement rates at retirement

Easy access to account information Transparency and Accountability of pension funds

– Publication of investment results and financial statements

Conclusions

Share of pension savings in household balance sheets are relatively small but growing rapidly.

Factors affecting pension fund savings – Pension reform, mandatory savings, fund performance, – Macro/Structural factors – Financial sector development

Policy implications for pension fund regulations– Enhancing coverage through mandatory forms of savings, default rules

and other social safety nets– Enhancing net risk-adjusted returns through increasing flexibility for

diversification gains, – Reducing costs by harnessing economies of scale and minimizing other

burdens– Investor protection through information and education