Augusto Iglesias P. PrimAmérica Consultores November, The impact of mandatory pension funds on corporate governance: the L.A. experience * Presented at the World Bank Conference on “Contractual Savings: Supervisory and Regulatory Issues in Private Pensions and Life Insurance” (Washington D.C., November 3 –7, 2003).

PrimAmérica Consultores I. Preliminary remarks Since the early eighties, as a consequence of radical reforms to the social security system, mandatory pension funds have become important players in the capital markets of many L.A. countries. Since the early eighties, as a consequence of radical reforms to the social security system, mandatory pension funds have become important players in the capital markets of many L.A. countries. What has been the impact of mandatory pension funds on corporate governance in these countries? What has been the impact of mandatory pension funds on corporate governance in these countries?

Pension Reform in Latin America Country Year of Reform Pension Fund (MMUS$) Dec 2002 Argentina Bolivia Colombia Chile Costa Rica El Salvador (1) Mexico Peru Uruguay Total (1) Pension Fund Source: FIAP. PrimAmérica Consultores

PrimAmérica Consultores II. The impact of pension funds on corporate governance: the theory Pension funds can have a positive influence on corporate governance through many different channels. Among these the most important are: Pension funds can have a positive influence on corporate governance through many different channels. Among these the most important are: Monitoring: Pension funds hold both equity and debt issued by corporations. They should monitor these firms activities to minimize the risk of actions by the management (or controlling shareholder) against the interest of bondholders and shareholders (or minority shareholders). Monitoring can be done trough “internal” and “external” channels: Monitoring: Pension funds hold both equity and debt issued by corporations. They should monitor these firms activities to minimize the risk of actions by the management (or controlling shareholder) against the interest of bondholders and shareholders (or minority shareholders). Monitoring can be done trough “internal” and “external” channels: Internal: Appointment of board members; participation in shareholders meetings and bondholders meetings. Internal: Appointment of board members; participation in shareholders meetings and bondholders meetings. External: Greater scrutiny of corporations and higher standards of information for firms where pension funds invest. External: Greater scrutiny of corporations and higher standards of information for firms where pension funds invest. Continue

PrimAmérica Consultores II. The impact of pension funds on corporate governance: the theory Better regulations: The development of pension funds can have an effect on the design of capital market regulations. In turn, better regulations should have a positive impact on corporate governance: Better regulations: The development of pension funds can have an effect on the design of capital market regulations. In turn, better regulations should have a positive impact on corporate governance: Mandatory pension funds are created by law and they are part of the social security system. Therefore, there are some implicit – and explicit – state guarantees over the results of the system. Eventually, capital market regulations will need to be reformed with the purpose of reducing the cost of these guarantees. These changes in regulations will benefit not only pension funds, but also small investors and minority shareholders. Mandatory pension funds are created by law and they are part of the social security system. Therefore, there are some implicit – and explicit – state guarantees over the results of the system. Eventually, capital market regulations will need to be reformed with the purpose of reducing the cost of these guarantees. These changes in regulations will benefit not only pension funds, but also small investors and minority shareholders.

PrimAmérica Consultores II. The impact of pension funds on corporate governance: the theory Capital market development: The accumulation of pension funds should have a positive impact on the size of capital markets (total market intermediation). In turn, the increase in trading volumes can have positive indirect effects on corporate governance since: Capital market development: The accumulation of pension funds should have a positive impact on the size of capital markets (total market intermediation). In turn, the increase in trading volumes can have positive indirect effects on corporate governance since: There are economies of scale in the process of placing debt and equity. So, as the volume of trading increases, the cost of market financing for companies decrease. There are economies of scale in the process of placing debt and equity. So, as the volume of trading increases, the cost of market financing for companies decrease. Increased liquidity allows investors to use the “exit” mechanism (or “voting with their feet”) as a way to protect themselves in case of firms performing below expectations. Increased liquidity allows investors to use the “exit” mechanism (or “voting with their feet”) as a way to protect themselves in case of firms performing below expectations. There are economies of scale in the process of collecting and processing information about companies. There are economies of scale in the process of collecting and processing information about companies.

PrimAmérica Consultores III. Evidence from L.A. The economic significance of pension funds (measured as PF/GDP) has been growing but, with the single exception of Chile, is still low compared with most OECD countries (simple average: 31,7%) The economic significance of pension funds (measured as PF/GDP) has been growing but, with the single exception of Chile, is still low compared with most OECD countries (simple average: 31,7%) Pension funds investment in shares and private debt (excluded debt issued by financial intermediaries) are very low in many L.A. countries, both as a percentage of their total investments and as a percentage of total market capitalization Pension funds investment in shares and private debt (excluded debt issued by financial intermediaries) are very low in many L.A. countries, both as a percentage of their total investments and as a percentage of total market capitalization Continue

Pension funds as a share of GDP PrimAmérica Consultores Argentina2.9%3.4%5.4%7.0%7.9% Bolivia2,1%4.1%7.4%10.0%12.4%15.5% Colombia1.3%1.9%3.0%4.2%5.3%7.3% Chile46.0%39.6%51.2%53.9%52.7%51.9% Costa Rica 2.2%3.3%4.2% El Salvador 0.5%2.2%4.3%5.6%7.4% Mexico3.6%4.6%6.3%7.8% Peru2.6%3.3%4.9%5.2%6.6%7.1% Uruguay0.8%1.5%2.6%3.9%6.0% Source: Palacios (2003)

Pension Funds: actual portfolio allocation by type of asset PrimAmérica Consultores Source: PrimAmérica Consultores

Pension Funds in Capital Markets (December 2002) PrimAmérica Consultores

PrimAmérica Consultores III. Evidence from L.A. So, at least from this perspective, it seems that in the LA region the impact of pension reform on corporate governance could not have been substantial. So, at least from this perspective, it seems that in the LA region the impact of pension reform on corporate governance could not have been substantial. However, in most of these countries pension fund accumulation is a rather new phenomena. What has happened in the country -Chile- where pension funds do have a larger economic significance? However, in most of these countries pension fund accumulation is a rather new phenomena. What has happened in the country -Chile- where pension funds do have a larger economic significance? Continue

PrimAmérica Consultores III. Evidence from L.A. Circumstantial evidence from Chile shows that: Circumstantial evidence from Chile shows that: Pension funds participation in capital markets is significative. Pension funds participation in capital markets is significative. At least some changes in capital market laws and regulations which improve corporate governance standards are the result of pension reform (new rules to control for conflicts of interest; higher information standards for firms which issue stocks and debt; Audit Committees as part of the Board structure; etc.). At least some changes in capital market laws and regulations which improve corporate governance standards are the result of pension reform (new rules to control for conflicts of interest; higher information standards for firms which issue stocks and debt; Audit Committees as part of the Board structure; etc.). Pension funds managers do monitor the activities of the firms where they invest (they have been active in shareholders and bondholders meetings; have elected independent board members; have initiated legal actions against the management of some firms when decisions have been taken that could hurt minority shareholder interests; etc.). Pension funds managers do monitor the activities of the firms where they invest (they have been active in shareholders and bondholders meetings; have elected independent board members; have initiated legal actions against the management of some firms when decisions have been taken that could hurt minority shareholder interests; etc.).

Chile: Pension fund (*) significance in capital markets (MM US$ 2002) PrimAmérica Consultores (*) Include LICO’s Investments Assets Growth Pension funds (times) in the market Public and Central Bank Debt ,975,00% Mortgage backed securities ,697,50% Bonds ,575,00% Shares ,18,20% Time deposits ,335,40% Investment funds n/a89,50% Other ,737,20% Total ,237,80% Total intermediation (Debt) ,5 Total intermediation (Shares) ,9 Source: Palma (2003)

Chile: Impact of pension funds on the election of board members (1999) PrimAmérica Consultores Type of firm Board members (Total) Board members elected with pension fund votes Chapter XII (37.5%) Other (6.5%) Total (10.0%)

PrimAmérica Consultores IV. Determinants of pension funds impact on corporate governance L.A. experience shows that the impact of introducing mandatory pension funds on corporate governance should not be taken for granted. Besides the maturity of the new funded systems, this impact will depend on: L.A. experience shows that the impact of introducing mandatory pension funds on corporate governance should not be taken for granted. Besides the maturity of the new funded systems, this impact will depend on: Capital market conditions prior to pension reform. Capital market conditions prior to pension reform. Characteristics of pension funds investment regulations. Characteristics of pension funds investment regulations. Capacity to control for potential conflicts of interest between pension fund managers and pension fund members. Capacity to control for potential conflicts of interest between pension fund managers and pension fund members. Continue

PrimAmérica Consultores IV. Determinants of pension funds impact on corporate governance Capital market conditions: Capital market conditions: In “iliquid markets”, it’s likely that pension fund managers will have a “bias” in favor of a more active role in shareholders and bondholders meetings, and that they will try to appoint independent board members. In “iliquid markets”, it’s likely that pension fund managers will have a “bias” in favor of a more active role in shareholders and bondholders meetings, and that they will try to appoint independent board members. The ownership structure of firms has an influence on the role of pension funds as shareholders and bondholders. When ownership is concentrated, pension fund managers should monitor potential conflicts of interest between mayority and minority shareholders; when ownership is atomized, pension fund managers should monitor potential conflicts of interest between the firm managers and its shareholders. The ownership structure of firms has an influence on the role of pension funds as shareholders and bondholders. When ownership is concentrated, pension fund managers should monitor potential conflicts of interest between mayority and minority shareholders; when ownership is atomized, pension fund managers should monitor potential conflicts of interest between the firm managers and its shareholders. Continue

PrimAmérica Consultores IV. Determinants of pension funds impact on corporate governance Continue In countries with a well developed capital market (and in capital markets which are well integrated to international capital markets) the impact of the new pension funds on corporate governance will be relatively small, compared to their impact on a less developed (and less integrated) capital market. In countries with a well developed capital market (and in capital markets which are well integrated to international capital markets) the impact of the new pension funds on corporate governance will be relatively small, compared to their impact on a less developed (and less integrated) capital market.

PrimAmérica Consultores IV. Determinants of pension funds impact on corporate governance Continue Pension funds investment regulations: Pension funds investment regulations: Investment limits do shape pension funds portfolios. Investment limits do shape pension funds portfolios. Other types of investment regulations also have an impact on the way in which pension funds monitor the companies where they invest. Other types of investment regulations also have an impact on the way in which pension funds monitor the companies where they invest.

Portfolio limits by type of asset (2002) PrimAmérica Consultores

Latin America: regulation on the vote of pension funds in shareholders meetings PrimAmérica Consultores * When their participation exceeds some ** The pension fund industry has adopted a Code for self regulation Chile ArgentinaColombia Peru 1. Are pension funds allowed to participate in shareholders meetings? YesYesYesYes 2. Are pension funds forced to participate in shareholders meetings? Yes * Yes No 3. Election of board members: NR · Can pensions funds vote in the election of members of the board YesYesYes · Board of the pension fund must select the candidate to the board YesYes · Pension funds must make their vote public YesNoYes · Is it possible to vote for: NR ** - Candidates related to mayority shareholders? NoNo - Candidates related to the pension fund management firm? YesNo

PrimAmérica Consultores Controlling pension funds managers: Controlling pension funds managers: Good corporate governance practices within the pension funds are needed to avoid the risk of pension fund managers acting against the interest of pension fund members: Good corporate governance practices within the pension funds are needed to avoid the risk of pension fund managers acting against the interest of pension fund members: Limits to use of privileged information. Limits to use of privileged information. Disclosure of information. Disclosure of information. Prohibition to invest in firms where pension fund managers have an interest. Prohibition to invest in firms where pension fund managers have an interest. Valuation of assets at market prices. Valuation of assets at market prices. Legal separation between pension fund assets from pension company assets. Legal separation between pension fund assets from pension company assets. In some countries, there are concerns for the possibility of pension fund companies controlling the firms in which the pension fund invest. In some countries, there are concerns for the possibility of pension fund companies controlling the firms in which the pension fund invest. IV. Determinants of pension funds impact on corporate governance

PrimAmérica Consultores V. Final comments The accumulation of pension funds which follows the creation of a mandatory funded pension program, can have a positive impact on corporate governance. The accumulation of pension funds which follows the creation of a mandatory funded pension program, can have a positive impact on corporate governance. However, the magnitude of this impact will be strongly correlated with: the quality of pension fund investment regulations; the characteristics of local capital markets; and with the capacity of the supervisors to control for potential conflicts of interest between pension fund managers and pension fund members. However, the magnitude of this impact will be strongly correlated with: the quality of pension fund investment regulations; the characteristics of local capital markets; and with the capacity of the supervisors to control for potential conflicts of interest between pension fund managers and pension fund members. Even under the appropriate regulatory framework, pension fund influence over corporate governance will evolve gradually and will depend on the portfolio decisions of pension fund managers. Even under the appropriate regulatory framework, pension fund influence over corporate governance will evolve gradually and will depend on the portfolio decisions of pension fund managers.