Pension Reform in Latin America Experience & Lessons (*) Guillermo Arthur E. FIAP President September, 2005 * Presented at the 2005 Pension Seminar 2005 – Netherland Antilles, September 1, 2005

Contents I. Reforms in Latin America II. Why were the reforms necessary? III. Characteristics of the reforms IV. Findings V. Lessons from the experience

Latin America Chile (1981) Peru (1993) Argentina (1994) Colombia (1994) Uruguay (1995) Bolivia (1997) Mexico (1997) El Salvador (1998) Costa Rica (2000) Dominican Rep. (2003) Ecuador (*) / Nicaragua (*) Central & Eastern Europe Hungary (1998) Hungary (1998) Poland (1999) Poland (1999) Latvia (2001) Latvia (2001) Bulgaria (2002) Bulgaria (2002) Croatia (2002) Croatia (2002) Estonia (2002) Estonia (2002) Kosovo (2002) Kosovo (2002) Russian Federation (2003) Russian Federation (2003) Slovakia (2005) Slovakia (2005) Macedonia (2006) Macedonia (2006) Ukraine (2007) Ukraine (2007) Lithuania (2004)** Lithuania (2004)**Asia Kazajstán (1998) Kazajstán (1998) India (2004) India (2004) Africa Nigeria (2005) Nigeria (2005) I. Pension reformed countries (*) Approved but suspended reforms (**) Voluntary System

II. Why were the reforms necessary? The financial situation of the traditional systems deteriorated mainly because of the impact of three (3) phenomena: Population aging Inefficient public management of pension funds Sharp salary & employment cycles as a result of successive economic crises continues...

Population aging Percentage of the population over 60 (1990 and 2030) WORLD Central & South Africa Middle East & North Africa Asia (without China) Latin America & the Caribbean China Socialist economies in transition OECD Source: James 1998

Inefficient public management of pension funds Venezuela-5.7%-26.0% Ecuador-3.6%-9.0% Guatemala-3.0%-5.0% Costa Rica-1.1%-7.0% Jamaica-0.5%-1.5% Perun.d.-41.5% Source: Palacios e Iglesias (2000) Country (Public Funds yields - Bank rates of deposit) (Public Funds yields - Per capita income growth

II. Why were the reforms necessary? As a consequence of the deterioration of the traditional financial systems, one observed: Increased public spending for pensions Increased social security debt High level of membership contribution rates continues...

Aging & public spending Source: James 1998

Estimate of social security debt increase without reforms 0% 50% 100% 150% 200% 250% 300% 350% 400% ChilePeruColombiaArgentinaUruguayMexicoBoliviaEl Salvador Explicit debt as % of GDP Source: The World Bank (2004)

Social security membership contributions InsuredEmployerState Argentina Bolivia 3.520,01.5 Brasil (*) Colombia (*) Costa Rica Cuba 010.0(*) Chile (*) Ecuador 9,09.5(*) El Salvador (*) Guatemala (*) Haití Honduras Mexico Nicaragua 4, Panama (*) Paraguay Peru 5, (*) Dominican Republic Uruguay (*) Venezuela (*) Taxes, deficit financing and other subsidies Legal membership contributions as % of salary, around 1980 Source: Social Security Development in Latin America (ECLA, 1985)

II. Why were the reforms necessary? Additionally, the traditional systems proved to be “soft” when confronted with sector interest group pressures. All of this translated into: Program fragmentation Inequity (discrimination) between worker groups Negative impact over income distribution continues...

IIWhy were the reforms necessary? Consequently, the objectives of the reforms were: To stop the growth of social security deficit & pension debt. To improve pensions (without increasing contributions or minimizing whatever increase might be necessary). To eliminate the inequities of the social security systems. To shield social security systems from “political risks”. To minimize the economic distortions generated by the operation of a mandatory pension system.

III. Characteristics of the reforms The initial conditions of the reforms were not the same from one country to the other. Pension Spendings Implicit pension Debt as % As % GDPof GDP Argentina6.2None0.6305Moderate Bolivia2.5 Some 3.031High Colombia1.1 Some Low Costa Rica1.6Significant6.694Moderate Chile5.7None2.5131High Dominican Republic0.8 None Low Ecuador2.0 Some 5.619Low El Salvador0.4 Some 11.69Low Mexico1.0None8.037Low Nicaragua2.5 Some 4.814Low Peru1.2None4.345Moderate Uruguay15.0None1.4290Low (*) Contributors/ Pensioners Source: Palacios (2003). Country Level of reserves Rate of dependency (*) Degree of fragmentation continues... Previous situation of the reforms

III. Characteristics of the reforms All pension reforms share at least three (3) fundamental characteristics: Individual Capitalization Systems, managed by the Private Sector, that finance pensions with a combination of predefined contributions (old age pensions) and insurance policies (disability & pension renewal). All the reformist countries introduced “Parametric Reforms” to their traditional programs. “Multi-pillar Systems”: (non-contributive, publicly-managed programs of predefined benefits for the poorest) + mandatory pension system, predefined contribution & capitalization systems – in some cases combined with contributive programs of predefined & Pay-as-you-go schemes - for those persons with savings power) + voluntary contributive programs. However, the “starting point” differences and the specific conditions that prevailed in each country generated some of the more specific characteristics of these reforms.

Social Security Organizations Old System First Pillar Non-contributive & public Second Pillar Contributive, public & pay- as-you-go. Predefined benefits. Third Pillar Contributive. Capitalization. (Incipient development) New System First Pillar Non-contributive & public Second Pillar Alt. 1 Private and of Capitalization + Public and Pay- as-you-go Public and Pay- as-you-go. (Predefined benefits) Alt. 2 Private and of Capitalization (Predefined benefits) Third Pillar Contributive and voluntary. Private and of Capitalization (Personal & Occupational)

Characteristics of the Second Pillar of Latin America’s new pension systems

Latin America: Proportion of the pension system financed on a Pay-as-you-go basis Source: Whitehouse (2003) Peru Mexico Chile El Salvador Colombia Dominican Republic Argentina Uruguay Costa Rica Percentage of the weighted average pension wealth derived From the Pay-as-you-go component.

IV. Findings Pensions must be evaluated over a long period of time. Consequently, one cannot yet arrive at final conclusions. Nevertheless, there are three (3) very significant findings: 1. The Fund’s rates of return exceed the rate of growth of real salaries and per capita incomes. continues...

Latin America: the Funds’ yields Country Funds real returns from the beginning Growth Real of wages (same period) Difference Funds Returns - Growth wages Growth Real Income Per-capita (same period) Difference Funds Returns - Growth income Per-capita (1)(2)(3)=(1)+(2)(4)(5)=(1)-(4) Argentina 11,70%-0,80%12,50%-0,40%12,10% Bolivia 16,20%8,80%7,60%0,40%15,80% Colombia 11,80%1,40%10,40%-0,30%12,10% Chile 10,50%1,80%8,70%4,50%6,00% El Salvador 11,30%-0,20%11,50%0,50%10,80% Mexico 10,60%0,00%10,60%2,80%7,80% Peru 5,70%1,80%3,90%2,40%3,30% Uruguay 9,50%3,60%5,90%-0,30%9,80% Source: Palacios (2003).

IV. Findings 2. The economic impact of the reforms has been very positive. Particularly, the accumulation of pension funds (and of the reserves of life insurance companies) has directly affected: Savings The development of capital markets The labor market As a result of these effects, the reforms have contributed to economic growth. continues...

Chile: economic effects of the reform EffectsSavings Labor market Capital markets development Total effect Iinvestments Economicgrowth Chile: (Growth Average : 4,6%) +0,03% (Min) +0,32% (Max) Employment Formalization Factorproductivity Economicgrowth +0,05% (Min) +0,15% (Max) Factorproductivity Economicgrowth +0,13% (Min) +0,27% (Max) +0,21% (Min) +0,74% (Max) Source: Corbo; Schmidt-Hebbel (2003)

IV. Findings 3. The reforms have enabled a substantial reduction of non-financed liabilities of social security systems Fuente: World Bank, Regional Studies Program “Keeping the Promise of Ol d d Age Income Security in L.A.” (2003) % PGB Fuente: World Bank, Regional Studies Program “Keeping the Promise of Ol d d Age Income Security in L.A.” (2003) % PGB Estimated implicit pension debt, with & without structural reforms continues...

IV. Findings Additionally, one may observe: A rapid growth of the pension funds '00'01'02'03'04 Total (Dec. 31, 2004): US$ 147,005 million Chile Argentina Mexico Peru Colombia Uruguay C. Rica El SalvadorBolivia Pension funds growth (Dec.2004) continues...

A rapid increase in PF membership Pension Funds and GDP (Dec.2004) continues...

Latin America: PF membership Source: FIAP

IV. Findings The main pending challenges ahead are: To further investment diversification (improved regulations). Latin America Investments diversification ( Dec.2002) Source: Palacios 2003

To increase the coverage & density of member contributions (greater labor market flexibility) To increase the coverage & density of member contributions (greater labor market flexibility) Pension system reform coverage has been reformed in a structural way Pension system reform coverage has been reformed in a structural way Source: Household surveys between 1997 and 2002, analysed by Todd Pugatch

V. Lessons derived from the experience… Lesson 1: In the long-run, the purely Pay-as-you-go pension systems are not sustainable. The solution to this crisis lies in introducing a capitalization component into social security systems. Lesson 2: Introducing capitalization programs is not only necessary – it is also possible. Lesson 3: The decisions regarding the design of each Pillar, the relative size of each Program within the Second Pillar; and the Manner in which the new Capitalization Program is introduced are indeed crucial (the gradualism of the reform; a greater relative size of the capitalization program; and the non-competition between programs appear to have been beneficial in most cases). continues...

V. Lessons derived from the experience. Lesson 4: The detailed design of the Capitalization Program requires the maximum attention (although capitalization programs can be designed in many forms, not all of them yield the same results). Lesson 5: Pension fund investment regulations must promote the diversification of portfolios and avoid forced investments (or “earmarked investments”). Lesson 6: In order to maximize the positive economic impact of a pension system reform, it should be closely coordinated with a capital markets reform (and, eventually, tax and labor market reforms). Lesson 7: An effective & independent supervision of the various programs is crucial for the success of all pension reforms.