Contractual savings and emerging securities markets

Contractual savings institutions - pension funds and life insurance companies - have long been important institutions in several developing countries. But, with notable exceptions, they have been weak and underdeveloped. Some of this is attributable to low levels of income in developing countries and some of it to the negative impact of repressive regulations and the existence of pay-as-you-go social security systems. The author briefly reviews the size of contractual savings institutions in selected developed and developing countries and assesses their role in the development of the financial sector - especially in the development of securities markets. He stresses five points : 1) the structure of a country's financial system depends on the organization of the country's pension system; 2) contractual savings do not increase the rate of saving but shift the composition of total savings toward long-term financial assets; 3) the role of contractual savings institutions in securities markets reflects historical traditions and differences in regulation; 4) investment regulations mustaim at ensuring the safety and profitability of contractual savings; encouraging investment prudence and developing effective supervision should be basic objectives of public policy; and 5) contractual savings institutions can have a great impact on securities markets.Insurance&Risk Mitigation,Insurance Law,Contractual Savings,Environmental Economics&Policies,Financial Intermediation

The role of non-bank financial intermediaries (with particular reference to Egypt)

Non-bank financial intermediaries (NBFIs) comprise a mixed bag of institutions, ranging from leasing, factoring, and venture capital companies to various types of contractual savings and institutional investors (pension funds, insurance companies, and mutual funds). The common characteristic of these institutions is that they mobilize savings and facilitate the financing of different activities, but they do not accept deposits from the public. NBFIs play an important dual role in the financial system. They complement the role of commercial banks by filling gaps in their range of services. But they alsocompete with commercial banks and force them to be more efficient and responsive to the needs of their customers. Most NBFIs are also actively involved in the securities markets and in the mobilization and allocation of long-term financial resources. The state of development of NBFIs is usually a good indicator of the state of development of the financial system. The author focuses on contractual savings institutions, namely pension funds and life insurance companies, that are by far the most important NBFIs. He also offers a brief review of the role and growth of other NBFIs, such as leasing and factoring companies, as well as venture capital companies and mutual funds. The author covers developments in selected countries in different regions of the world. He also examines the recent growth of NBFIs, especially contractual savings institutions and securities markets, in Egypt. He discusses the necessary regulatory and other policy reforms for promoting NBFIs--in particular, the openness to international markets and foreign presence that is essential for the transfer of skills and technologies.Banks&Banking Reform,Payment Systems&Infrastructure,International Terrorism&Counterterrorism,Insurance&Risk Mitigation,Financial Intermediation,Banks&Banking Reform,Financial Intermediation,Insurance&Risk Mitigation,Contractual Savings,Non Bank Financial Institutions

The role of occupational pension funds in Mauritius

Mauritius belongs to a select group of developing countries where contractual savings-savings with insurance companies and pension funds-exceed 40 percent of GDP and represent a major potential force in the local financial system. Pension funds account for 75 percent of contractual savings. Contractual savings institutions invest in government securities, housing loans, corporate securities, real estate and bank deposits. They currently hold 35 percent of government securities and also account for 36 percent of total outstanding housing loans.Given their strong demand for long-duration assets, they can stimulate the issue of long-term government bonds (both inflation-linked and zero-coupon) and the development of corporate debentures, mortgage bonds, and mortgage-backed securities.Mauritius has a balanced and well-managed multipillar pension system. In addition to several public components, such as the Basic Retirement Pension, the National Pensions Fund (NPF), the National Savings Fund, and the Civil Service Pension Scheme, there are over 1,000 funded occupational pension schemes that play an increasingly important part in the whole system. The funded schemes are divided into two main groups-those insured and/or administered by insurance companies, and those that are self-administered and are registered with the Registrar of Associations. Coverage of the funded schemes is estimated at about 10 percent of the labor force. Together with the unfunded civil service scheme, occupational pension schemes cover about 100,000 employees or 20 percent of the labor force. All types of pension funds, including the public ones, report low operating costs. This reflects the absence of marketing and selling costs and, in the case of large private pension funds, the assumption of some costs by sponsoring employers. The investment performance of the self-administered funds was less than fully satisfactory in the late 1990s, reflecting poor returns on the local and foreign equity markets. Funds insured or administered by insurance companies as well the NPF performed better during this period because of their heavier allocations in government securities and housing loans. However, over a longer period, the private pension funds probably outperformed the NPF. The regulatory framework, though fragmented, is not unreasonable. It has many important provisions, such as observance of internationally acceptable accounting and actuarial standards and minimum vesting and portability rules, and it does not impose prescribed limits on investments. However, consolidation and modernization of the regulatory framework is required, while supervision, which is currently nonexistent, needs to be developed and to be proactive.Insurance Law,Non Bank Financial Institutions,Pensions&Retirement Systems,Payment Systems&Infrastructure,Banks&Banking Reform,Non Bank Financial Institutions,Pensions&Retirement Systems,Insurance Law,Banks&Banking Reform,Contractual Savings

Swiss Chilanpore : the way forward for pension reform?

Many countries are considering far-reaching pension reform. This is happening in response to growing demographic pressures in some countries (especially in Western and Eastern Europe), to unsustainably generous benefits in others (especially in Latin America), or to failure to ensure the profitable investment of accumulated funds (as seems to be true with national provident funds in African countries). Given the worldwide interest in reform, one could ask: Is there a blueprint for pension reform? Can lessons learned in different countries be combined in a best-practice structure usable in different countries'pension systems? The author reviews the experience of Switzerland, Chile and Singapore, countries with relatively successful economies and pension systems. He suggests a multipillar pension system - which he dubs Swiss Chilanpore - that would blend the hard-headed softness of the Swiss, the expensive yields of the Chilean scheme, and the ruthless efficiency of Singapore. He emphasizes that: there is no perfect pension system - all systems suffer from the problems of moral hazard, adverse selection agency costs, and free riders; and all well-functioning pension systems require good government and good management. All pension systems have to cope with the problems of long-term uncertainty. For these reasons, the author favors a multipillar approach that diversifies across different providers. Swiss Chilanpore would have two compulsory and two voluntary pillars: a first pillar (drawn from the Swiss model) consisting of two parts, a flat-rate pension proportional to the length of a person's career and an earnings-related pension based on annual actualized lifetime earnings; a second pillar consisting of a central agency, which could be public or private, for record-keeping and other centralized functions, and private fund management companies for investing funds, the point being to keep operating costs down and achieve high investment returns; and third and fourth pillars based on occupational pension schemes and personal savings. The proposed structure would aim to combine the strengths and avoid the weaknesses of the three countries'systems, but the author cautions that no reform proposal would apply equally well in all countries, regardless of local circumstances and conditions.Environmental Economics&Policies,Economic Theory&Research,Banks&Banking Reform,Information Technology,Pensions&Retirement Systems

Policies to promote saving for retirement : a synthetic overview

The author argues that public and private pillars are essential for a well-functioning pension system. Public pillars, funded or unfounded, offer basic benefits that are independent of the performance of financial markets. Since financial markets suffer from prolonged, persistent, and large deviations from long-term trends, they cannot be relied on as the sole provider of pension benefits. Funded pillars provide benefits that are based on long-term capital accumulation and financial market performance. But they need to be privately managed to minimize dependence on public sector institutions and avoid government dominance of the economy and financial markets. The author focuses mainly on the promotion, structure, and regulation of funded pillars. He discusses the case for using compulsion and tax incentives, for exempting some categories of workers such as the very young (under 25), the very old (over the normal retirement age), the very poor (those earning less than 40 percent of the average wage), and the self-employed, and for offering a credit transfer to be added to individual capitalization accounts to encourage participation by lower-income groups. A robust regulatory framework with a panoply of prudential and protective rules covering"fit and proper"tests, asset diversification and market valuation rules, legal segregation of assets and safe external custody, independent financial audits and actuarial reviews, and adequate disclosure and transparency would be essential. An effective, proactive, well-funded, and properly staffed supervision agency would be necessary. Tight investment rules could initially be justified for countries with weak capital markets and limited tradition of private pension provision. But in the long run, adoption of the"prudent expert"approach with publication of"statements of investment policy objectives"(SIPOs) would be preferable and more efficient. Various guarantees covering aspects such as minimum pension levels and relative investment returns need to be provided to protect workers from aberrant asset managers and insolvency of annuity providers, but care must be taken to address effectively the risk of moral hazard. The author also argues for greater individual choice, including the creation of a dual regulatory structure. One part would involve heavy regulation with constrained choice of investment funds, limits on operating fees and on account switching, and strong government safeguards and guarantees. This would cater to those workers with low risk tolerance. The other part would be more liberal but based on strong conduct rules. It would offer greater choice of investment funds, allowing multiple accounts andliberal account switching, impose no limits on operating fees, and providing no or fewer state guarantees. This would cater to workers seeking a higher return and who are willing to tolerate a higher level of risk.International Terrorism&Counterterrorism,Payment Systems&Infrastructure,Banks&Banking Reform,Pensions&Retirement Systems,Public Health Promotion,Banks&Banking Reform,Environmental Economics&Policies,Economic Theory&Research,Health Economics&Finance,Pensions&Retirement Systems

Private pension funds in Argentina's newintegrated pension system

Argentina implemented a major reform of its pension system in 1994. The new system has a mixed public-and-private two-pillar structure. Its main elements are an unfunded, defined benefit pillar operated by the state and paying a basic pension to all workers who meet the minimum eligibility period, and a fully funded defined-contribution individual capitalization pillar managed by specially authorized companies (AFJPs). The second pillar also has a public defined-benefit component, which is operated on an unfunded basis. The new system replaced the old public pay-as-you-go pension system, which was facing immense financial pressures. The author assesses the performance of the funded component of the second pillar. He finds that: 1) The private pillar had attracted (by June, 1996) 67 percent of all workers participating in the new integrated system. It also represents 60 percent of those who are active contributors. It has attracted many younger workers and has begun to mobilize a large, fast, growing pool of long-term financial resources. 2) The AFJPs have earned very high real investment returns, offset by very high operating costs. Individual affiliates have so far earned negative real returns because of high commission charges. But in the long run, net returns are likely to be positive as assets accumulate and operating costs are better controlled. 3) Effective coverage is quite low. Affiliates represent fewer than 60 percent of eligible workers and only about 40 percent of the labor force. Fewer than 30 percent of eligible workers and only about 20 percent of the labor force actively contribute. 4) Because the new system is young, the number of beneficiaries is small, mostly recipients of survivorship and disability pensions. 5) Market concentration is high, although lower than in Chile. The top three companies account for 47 percent of affiliates and assets; the top six account for 78 percent. 6) In March, 1997, asset allocation was 51 percent government bonds, 23 percent corporate inquiries and mutual fund shares, 17 percent bank deposits, and 7 percent corporate bonds. Equity holdings share has been rising, mainly at the expense of bank deposits. 7) Real rates of return average over 15 percent a year, although high commission charges substantially reduce the net real returns to individual workers. But costs are coming down sharply as a percentage of average assets. Net real returns for a worker's full career are expected to be highly positive so long as gross investment returns remain strong. The AFJP system faces three main challenges: how to contain operating and marketing costs; how to increase effective coverage; and how to relax the draconian regulations while maintaining a stable, transparent, and safe system.Banks&Banking Reform,Payment Systems&Infrastructure,Pensions&Retirement Systems,Information Technology,Public Health Promotion,Pensions&Retirement Systems,Information Technology,Banks&Banking Reform,Health Monitoring&Evaluation,Environmental Economics&Policies

Institutional investors and securities markets : which comes first?

Institutional investors comprise pension funds, insurance companies, and mutual funds. Should a country promote their creation if it lacks well-developed securities markets? The answer to this question, says the author, varies by type of investor. He argues that private pension funds and insurance companies are promoted for their own sake and for their potential economic, fiscal, and financial benefits, whether or not a country already has well-developed securities markets. Mutual funds, by contrast, are unlikely to thrive without strong and well-regulated securities markets. A limited supply of financial instruments should not be a major obstacle to the creation of pension funds and insurance companies. Such institutions build up their financial resources gradually but steadily, giving reforming governments ample time to develop securities markets. More important than the prior development of securities markets is a strong and lasting political commitment to holistic reform: macroeconomic, fiscal, banking, and capital market reform, as well as pension and insurance reform. Institutional investors need to attain critical mass and to be supported by conducive regulations. The author reviews Anglo-American experience since the 1940s. This shows that institutional investors can serve as a countervailing force to commercial and investment banks, helping to stimulate financial innovation, modernize capital markets, enhance transparency and disclosure, strengthen corporate governance, and improve financial regulation.Financial Intermediation,Payment Systems&Infrastructure,International Terrorism&Counterterrorism,Infrastructure Finance,Non Bank Financial Institutions,Financial Intermediation,Infrastructure Finance,Infrastructure Finance,Non Bank Financial Institutions,Insurance&Risk Mitigation

The simple(r) algebra of pension plans

Chile's success with pension reform in the early 1980s and the continuing financial pressures facing the social security systems of many developing (and some industrial) countries have elicited considerable interest in the mechanics of pension systems that are based on fully funded individual capitalization accounts. The author sets out the simple(r) algebra of both defined contribution and defined benefit plans. The author notes the following results: (a) unless the real rate of interest exceeds the growth rate of real wages by a significant margin, payment of a reasonable pension rate requires a high contribution rate or a high active worklife ratio (the ratio of working life to retirement life); (b) it is more difficult for a high-growth economy to provide a high pension rate, although the absolute level of the pension could be higher than the pension level in a low-growth economy with a high pension rate; (c) when pensions are indexed to prices, the level of interest rates and growth rates affects positively the level of the pension rate. But when pensions are indexed to wages, only the difference between interest rates and growth rates has an effect on pension rates. In all cases, the active worklife ratio has a positive effect on the pension rate; (d) the timing of contributions, and therefore the pattern of earnings over a person's full career, has a significant but not major effect on pension rates; (e) employer-based, final-salary, defined-benefit plans penalize early leavers and favor late high-fliers; (f) full funding with universal coverage and full lifetime careers would lead to a massive accumulation of capital, especially if the demographic structure resembles a pillar rather than the more traditional pyramid. This would have major implications for the productivity of capital and the functioning of financial systems; (g) a mixed system -- combining a redistributive first pillar and a fully funded defined-contribution second pillar -- represents a more prudent, perhaps more equitable, approach to reforming pension systems; (h) variable contribution and pension rates, within specified limits, might be preferable and more consistent with greater reliance on personal choice.Environmental Economics&Policies,Insurance&Risk Mitigation,Pensions&Retirement Systems,Economic Theory&Research,Banks&Banking Reform

Options for pension reform in Tunisia

Tunisia's pension system provides old age, survivorship, and disability benefits to retired and disabled workers and their dependents. It is a partially funded system based on solidarity between generations. It is designed to provide insurance against loss of income in old age, especially for people who live longer than average, and to redistribute income more favorably toward low-income retired workers. Only to a limited extent does it achieve a third objective: compulsory long-term saving. The author analyzes the structure of Tunisia's pension system, assesses its financial condition, and sets out options for pension reform. He finds that the current system: a) is fragmented, comprising several schemes with different rules and conditions; b) promises generous benefits, with high targeted replacement rates that may be unsustainable; c) despite high benefits, operates with low contribution rates, because both the system and the labor force are young; d) only weakly links contributions and benefits - it suffers from evasion of contributions and inflated benefit claims and redistribution (from capricious favoring of workers with low incomes and short credited service); and e) faces increasing financial pressures because it is maturing and expanding benefits, but its reserves show poor investment performance and it has failed to adjust contribution rates. The author proposes the following main reforms: a) in the short run, reallocating social security contributions from family allowances to pensions and improving the financialperformance of reserves; b) in the medium term, rationalizing benefit formulas through gradual use of lifetime actualized earnings, indexing pensions, gradually increasing the normal retirement age, and exanding the use of proportional pensions for workers with short careers; and c) in the longer term, a more radical program to create a fully capitalized pillar that complements a redistributive pillar paying basic benefits. This would generate long-term savings, stimulate the development of capital markets, and facilitate the privatization program. A third pillar, voluntary savings encouraged by tax savings, would cover self-employed people not covered by occupational schemes.Environmental Economics&Policies,Banks&Banking Reform,Economic Theory&Research,Pensions&Retirement Systems,Health Monitoring&Evaluation

The use of"asset swaps"by institutional investors in South Africa

Leading financial economists have proposed the use of international asset swaps (Merton 1990, Bodie and Merton 2002) as a way of efficiently achieving international diversification without eroding the level of foreign exchange reserves and weakening local market development. International asset swaps entail limited foreign currency flows (only net gains or losses need to be exchanged). They protect foreign investors from market manipulation and expropriation risk and have much lower transaction costs than outright investments. But asset swaps are constrained by the attractiveness of local markets to foreign investors, and by various regulatory issues covering counterparty risk and collateral considerations, and accounting, valuation, and reporting rules. Institutional investors are well developed in South Africa. Their total assets corresponded in 2001 to 159 percent of GDP, a level that was surpassed by only four high-income countries. But because of the imposition of exchange controls, they lacked international diversification. In July 1995 South Africa was the first developing country that explicitly allowed its pension funds and other institutional investors to make use of"asset swaps."But the South African authorities did not authorize the use of properly specified swap contracts as described by Bodie and Merton, but rather permitted institutional investorsto"obtain foreign investments by way of swap arrangements."As the author argues in this paper, the asset swap mechanism turned out to be cumbersome and inefficient. However, it did allow institutional investors to attain some level of international diversification. Other developing countries should consider authorizing their institutional investors to engage in international asset swaps. But they should authorize the use of properly designed swap contracts, preferably based on baskets of liquid securities, permit only global investment banks to act as counterparties, require the use of global custodians, properly monitor credit risk, maintain adequate collateral, and adopt market-to-market valuation rules. Asset swaps are clearly a second-best option compared to the lifting of exchange controls. However, they may facilitate risk diversification in the presence of such controls. And they may even have a role to play in their absence.Economic Theory&Research,International Terrorism&Counterterrorism,Settlement of Investment Disputes,Payment Systems&Infrastructure,Fiscal&Monetary Policy,International Terrorism&Counterterrorism,Economic Theory&Research,Settlement of Investment Disputes,Insurance Law,Non Bank Financial Institutions