Managing Public Pension Reserves Robert Palacios World Bank Conference on Public Pension Fund Management Washington D.C. September 24, 2001

Structure of presentation  Managing public pension reserves – why is it important?  The failure of public management  Policy options for reform

Managing public pension reserves – why is it important?

Reserves exist in 60+ DCs

Socio-economic impact can be large Social welfare and labor market policy Sustainability of pension benefit promises Need to raise taxes on labor Fiscal policy Short run – increase in public consumption Long run – intertemporal constraint Financial sector development Positive vs distortionary impact or nil?

Social policy impact - pension levels

Fiscal policy impact – pension debt

Financial sector development impact

The failure of public management

Abundant indirect evidence Deteriorating funding ratios – there are no fully funded public DB schemes Low balances in provident fund accounts Likely increase in government consumption due to captive credit No evidence of positive capital market impact, some distortions likely Stories of corruption and waste

Some direct evidence – returns

Some direct evidence – returns (vs bank deposit rates)

Some direct evidence – returns (vs income per capita growth)

What lies behind this failure? Mandates and restrictions Deficit financing by forced purchase government debt social investments (e.g., housing) development projects and ETIs support for particular firms or whole market prohibition on foreign investments Governance Tripartite boards have been ineffective Political appointees have conflicting objectives Lack of accountability and monopoly power Lack of transparency

Result is poor asset allocation

Policy options for reform

Three key areas must be addressed  Institutional arrangement  Investment policy  Governance system  Country-specific conditions

Institutional arrangement - options  Centralized, public managers  Centralized with private managers chosen by independent authority  Centralized with private managers chosen by individual members  Decentralized with private managers chosen by individuals or employers

Institutional arrangement - options  Centralized, public management Tripartite boards with executive control exerted through political appointments Monopoly in-house public management Bureaucrats with little incentive to take risks and no competition This traditional approach has widely failed

Institutional arrangement - options  Centralized with private managers chosen by independent authority with private sector expertise  Relevant country examples include:  The CPP Investment Board  Irish Reserve Fund  Norwegian Petroleum Fund  Untested but promising under the right conditions

Institutional arrangement - options  Centralized with some individual choice of provider or portfolio or both  Choice of provider:  Bolivia ’ s AFP concession  India ’ s recent OASIS proposal  Choice of portfolio, not provider  Hong Kong ’ s industry funds  US Thrift Savings Plan

Institutional arrangement - options  Decentralized with private managers chosen by individuals or employers  The most popular structure for new funded pension schemes; minimizes political risk although not eliminated  Examples include:  Chile and other Latin America  Hungary, Poland, Sweden and the UK  Australia and Hong Kong  Singapore ’ s individual opt out

Investment policy  Clear statement of objective: invest for the best interest of the plan, explicitly prohibit other criteria  Some strategies to avoid conflicts of interest & discretion  Passive management  Don ’ t set minimum for government bonds  Prohibit illiquid investments  Allow significant foreign investment  Avoid active corporate governance

Investment policy  Transparent rules for evaluating performance of asset managers  Set clear monitoring targets for risk and returns  Benchmarks: Contracts with external managers can specify deviation allowed from indices

Governance  Trustees with clear competence in related fields, no public officials  Adequate remuneration  Minimize conflicts of interest  Transparent selection process with appropriate checks and balances  Appropriate assignment of liability  Clear mandates and limited discretion

Governance  Unless subject to scrutiny, this won ’ t have the desired effect  Reporting and disclosure of decisions made by Board and results needed  Ultimately, public awareness and understanding is the best discipline  If not, then governance problem may be too endemic to overcome

Country specific conditions  Size of fund relative to markets  Size of fund relative to other institutional investors  Absolute size and multiple fund case  Depth and quality of capital markets  Capacity to regulate, standards of accounting, trust law etc.  Human resources available  General governance quality

Summary More than 60 low and middle income countries have significant public pension reserves with dozens more considering establishing them Good management can have important impact on the social, fiscal and financial sector conditions To date, traditional public management practices have produced poor results in each area Improvement will depend on institutional design, investment policy, governance and how well these are adapted for country specific circumstances

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