Public vs Private Management of Pension Funds* Augusto Iglesias P. PrimAmérica Consultores March, 2000 * Presented at the Regional Conference on Social Security Reform for the Middle East and North Africa.

I.Preliminary remarks Because of the wave of pension reform in the world, an increasing number of mandatory pension systems are accumulating funds. Funded systems can have different characteristics:  “Traditional” defined benefit systems which are partially funded.  Centrally managed defined contribution systems (African and Asian Provident Funds)  Privately managed defined contribution systems (the latin american AFP’s).

Funded systems in selected countries (by type of funding) Source: Palacios and Pallares (1999.).

Who should manage these funds? The government or the private sector? The question is important since in funded pension systems investment returns may be the most important source of financing. Also, investment decisions of pension funds may have an impact on the macroeconomic performance of the country and on capital and labor markets. The objective of this presentation is to offer some evidence on the international experience of public vs private management of pension funds and to draw some policy lessons based on this evidence.

II.Models of government intervention in pension fund investment decisions Pension funds can be managed by the government or the private sector. The government will always regulate and supervise pension fund investments:  In the case of mandatory programs, usually there are government guarantees (both implicit and explicit) over the results of the system and the cost of those guarantees is related to investment returns;  There may be agency problems with fund managers (either public or private);

 Investment decisions have consequences over fiscal policy; rates of exchanges; international reserves; the performance of capital markets; relative costs of debt and equity financing; etc.;  Regulation may be used to decrease information costs for members. Both elements - management and regulation - can be combined in several ways so different models of government intervention in investment decisions can be identified:

Role of government in management of pension reserves Direct government management, monopoly Government management with market-based criteria Minimal regulation of privately- managed, decentralized “Draconian” regulation of privately-managed, decentralized Source: Iglesias and Palacios (1999).

III.Public management of pension funds: the evidence Most common practices are:  To do everything “in-house” (Most public systems don’t use external managers);  Members of the Board of the pension plans are usually politically appointed (and they are not independent from the government);  Investment guidelines steer the portfolio toward so called “social and economic development objectives” and toward public debt.

Direct investment of publicly managed pension funds Source: Iglesias and Palacios (1999).

III.Public management of pension funds: the evidence Most common practices are:  To do everything “in-house” (Most public systems don’t use external managers);  Members of the Board of the pension plans are usually politically appointed (and they are not independent from the government);  Investment guidelines steer the portfolio toward so called “social and economic development objectives” and toward public debt.  Investment portfolios are not well diversified (This mean that members are taking more risk than necessary).

Source: Palacios and Pallares (1999). Note: Provident funds in bold. Publicly managed pension fund portfolios

What have been the results of public systems?:  Investment returns of publicly managed pension systems have been low (compared to private systems and to benchmarks).

Annual compounded real return in publicly managed pension fund vs bank deposit rates Source: Iglesias and Palacios (1999).

Annual compounded real return in publicly managed pension fund vs real income per-capita growth Source: Iglesias and Palacios (1999).

Annual real rate of return in private pension funds vs real income per-capita growth Source: Iglesias and Palacios (1999).

What have been the results of public systems?:  Investments decisions have had some negative impacts on macroeconomic performance.

Why these poor results of public systems?: –Public systems are not well protected against political risks; –There is no separation of management and supervision functions; –Usually management is “in house”, so the benefits from scale and scope economies can not be reached. –Public opinion does not help to control the management of the plan:  Most systems are “defined benefits” and public opinion “believes” in the government guarantees.  High information costs.

IV. Lessons from the evidence Most of the problems of public management of reserves seem to be the result of political intervention in investment decisions. If investment regulation can be easily changed by political authorities, then there will be no insulation of investment decisions against political risk. Then, how to make investment rules stable?:  There should be some restrictions to initiate parliamentary actions aimed to change social security laws and regulations;  High quorums in Congress for changing the rules;  Independent and technical supervision of the system.

Private and competitive systems seems to offer better protection against political risk. Why?:  Management and supervision functions are almost automatically separated.  Benefits of specialization.  Decentralization of investment decisions (competition).  Individual accounts and selection of managers by individuals. But privatization of portfolio management does not guarantee that investment decisions will not be affected by political intervention (investment regulation and supervision will always be in the hands of government).

So, to have good and stable regulation and “technical” supervision are also necessary conditions in a system which is privately managed. Some guidelines for public management of pension reserves:  The objectives of pension fund investment policy should be that the funds are to be managed only in accordance with the interest of the pension plan; and that no decision should be taken contrary to that principle.  These objectives should be made explicit and included in the pension law.  Make the Board and the managers of the plan personally liable for pursuing this objective.

 Separate the functions of the Board from the functions of the investment managers. The role of the Board should be limited to: the selection of portfolio managers; the selection of external auditors; definition of investment guidelines; evaluation of managers performance; and selection of custodians.  Set limits, in the law, to the discretionary decisions by the Board. Make investment rules stable.  If possible, use private portfolio managers, and more than one, so they will compete and their performance could be compared.

 If possible, let members of the plan to select portfolio managers from a list of authorized managers (To reduce marketing costs this list could be formed using a public bidding process. Also, the use of “blind accounts” may be considered).  Use best practices rules for issues like conflicts of interest; valuation; and custody.

V. Final comments Private management + individual selection of managers + individual accounts + stable rules + specialized supervision; seem to work well as protection against political risk in investment decisions, and help portfolio decisions to be market oriented. Pension funds returns are not only influenced by investment regulation and the quality of management. Capital market conditions and regulations also have a strong impact on investment performance.