1. June 1st, 2007 Fiscal Policy and Pension Reform Joaquín Vial Chief Economist, Global Trends Unit, Research Department BBVA FIAP Conference, Varna, Bulgaria

2. 2 Research Department What is involved in Pension Reform Move from Defined Benefit to Defined Contributions: -Pensions linked to saving efforts over a lifetime -Shifts risks from the government to the individuals Move from State Managed Funds to Private Pension Funds Move from Centralized Pooling to Individual Accounts Move from unregulated pensions management to state supervision of private firms Move from Implicit Fiscal commitments to Explicit fiscal compromises with First Pillar as well as with the transitional generation. Not all reforms entailed all five elements, but most of them did

3. 3 Research Department Fiscal effects of Pensions Reform look very different, depending on the accounting of pension liabilities Cash Flows (one – period horizon): -Government receipts fall, due to the transfer of affiliates to the new system -Government outlays rise, due to transfer of previous contributions to individual, privately managed accounts (Recognition bonds) -Government deficit rises Net Wealth of the Government (infinite- horizon): -Unfunded (implicit) Pension Liabilities of current and future generations disappear -Pension liabilities of the transitional generation are made explicit (and probably rise to induce the transfer to the new system). -New debt might be contracted to finance the cash flow deficit caused by the transition. -Most likely the reduction in the Implicit Pension Debt of the government will be large enough to compensate the increase in the explicit debt to finance the transition.

4. 4 Research Department One example: the cash fiscal impact of the Chilean Pension Reform Cash flows associated to the transition costs are still negative and in the range of 3% of GDP, after 20 years of the reforms (they reached 6% of GDP in the early 80s)

5. 5 Research Department However, the change in Fiscal Net Worth in Chile looks very different from the cash flows If the Fiscal Net Worth improves, then the government can finance part of the cash costs through borrowing (beware of currency mismatches)

6. 6 Research Department Fiscal considerations for Pension Reform How to fund the cash flow problem during the transition? Changes in the First – Pillar associated to the reform, and fiscal impacts over time What will be the final fiscal Net Worth position after the transition? First – Pillar design and incentives to Labor Market formality Fiscal position over time and Pension Funds portfolios One “non consideration”: Fiscal cash flows should not be the deciding factor, if Fiscal Net Worth improves due to Pension Reform

7. 7 Research Department Typical path of fiscal (cash) outcomes of the transition Time: years Fiscal impact (%GDP) Contributions Old System Recognition Bonds Pension benefits in Old System (ex-ante) 07 25 35 45 60? Pension Benefits in Old System are attractive focal points for politicians: high risk of departure from ex-ante fiscal path. Pension benefits in Old System (ex-post)

8. 8 Research Department But accounting can make a big difference, especially for Recognition Bonds

9. 9 Research Department Fiscal costs of the transition: valuation Transfers to the new system: voluntary or mandatory? If voluntary: What is the best estimate for the number of transfers? (Be ready to update your calculations after the transfer window closes) Number of Transfers*average salary* contribution rates = Monthly loss of revenue in the Old System. Estimate the number of people as well as their pensions for those remaining in the Old System (do not forget beneficiaries of Death and Disability Insurance) Estimate the number, value and maturities of Recognition Bonds. This is a key component for actuarial calculations as well as for the estimate of the path of fiscal outlays linked to the transition. If there are minimum pension guarantees or other first pillar components, estimate the number of beneficiaries as well as a realistic path for the value of minimum pensions. This requires good actuarial projections (income, contributions, rates of return).

10. 10 Research Department Fiscal costs of the transition: preparation Key decision: How much will be funded through fiscal adjustments and how much will be covered by borrowing In some lucky cases, countries can sell assets to help finance the transition (privatization of state owned enterprises, for instance) There are key issues of accounting involved here: -Recognition bonds: Are they public debt? Chile and the IMF agreed to compute accrued interests as current expenditure and principal repayments as debt reductions (below the line operations) -Minimum Pension Guarantees: identify expenses due to beneficiaries in old and new system (Good actuarial projections are the key). -Evaluate the change in total public debt (explicit and implicit) before and after the transition. The importance of the initial position: issuing debt might not be an available option (small domestic market, large external debt). Macroeconomic effects of the reform will depend critically on how much the transition cost is funded out of fiscal adjustment (maximum) or debt (minimum).

11. 11 Research Department Some lessons from the Chilean transition (1) Fiscal adjustment came before the Pension Reform Year of Pension Reform

12. 12 Research Department Some lessons from the Chilean transition (2) Number of transfers was known quickly. Old System was unable to provide accurate records and/or the newly created institution (INP) was unable to process them: big uncertainty about the Size and Number of Recognition Bonds (not to mention the demographics of RB recipients) No good records about the demographics of those who transferred neither of those who remained. The number of beneficiaries of Minimum Pension Guarantees was overestimated, because of overly optimistic assumptions on contributions densities (in fact far few people has been able to fulfill the 20 years of contributions required). The value of the Minimum Pension has risen much faster than expected. Most of pensioners in the Old System are beneficiaries of MPG (70%?) The number of non-contributory pensions has been higher than expected (A consequence perhaps of low density of contributions?).

13. 13 Research Department Fiscal Situation and Pension Funds Investments Weak fiscal positions tend to translate into too much public debt in Pension Funds. This could be a major source of risk for workers.

14. 14 Research Department Summarizing… Pension Reform will put a lot of pressure on fiscal cash flows If cash flows are a constraint, then a fiscal adjustment must go hand in hand with a Pension Reform Privatization might help bridge short-term cash problems, but proceeds must go to the public sector. Pension Funds will absorb part of the Public debt required to finance the transition… But they cannot bailout an insolvent public sector (neither an insolvent financial system, by the way…) Pension Reform requires good institutions (good handling of rights of the transition generation) Ex-ante calculations might show long-term gains in Fiscal Net Worth, but… Beware of the evolution of short-term benefits during the transition, Beware of lack of adequate coverage of the First Pillar, Beware of excessive concentration of PF portfolios Moving from DB to DC introduces great flexibility and allows better handling of fiscal problems of ageing societies.

15. June 1st, 2007 Fiscal Policy and Pension Reform Joaquín Vial Chief Economist, Global Trends Unit, Research Department BBVA FIAP Conference, Varna, Bulgaria