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PERU’S PRIVATE PENSION SYSTEM: AN ANALYSIS OF ITS EVOLUTION, CURRENT MARKET STRUCTURE AND RECOMMENDATIONS FOR REFORM
Finance, Private Sector and Infrastructure Department
Latin America and the Caribbean Region
The World Bank
July 2003
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Contents
Section I: Introduction
Market Structure
Regulatory Environment
Pending Issues
Section II: Operational Aspects of the SPP
Recent Performance
Cost Reduction Strategies......
Commissions
Account Transfers
Processing the Recognition Bond
Collections
Information and IT Requirements......
Development of Specialized Firms
Section III: Management of Affiliate’s Assets
Investment Portfolio
Minimum Rate of Return
Foreign Investment Limits
Multi-Funds
Development of the Capital Market
Section IV: Enhancement of Pension System Performance through Increased Competition and Market Innovations
New Entrants
New Marketing and Distribution Channels
New Products
Section V: Coverage of Pension and Insurance Benefits
Options for Pension Benefits
Role of Insurance Companies
The Technical Discount Rate for Insurance and Pension Coverage.
References
This report on second generation reforms in Peru’s private pension system was written by John Pollner (LCSFF) and Manuel Lasaga (Consultant).
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Section I:Introduction
Market Structure
1.The Private Pension System (SPP) was created in 1992 by Law Number 25897 and accompanied by the principal norms Decree Number 206-93-EF. In only a short span of time, about ten years, the Private Pension System (SPP) has made substantial progress. Nevertheless, the sustainability of this system hinges on continued reforms, further strengthening of its institutional structure, and more aggressive innovations by the private pension firms (AFPs) to engage more participants and to promote greater savings. With a small capital market, and with limited capacity to seek investment opportunities overseas, due to the foreign exchange constraints, Peru’s SPP must also become more efficient in the management of its operations and in the allocation of its investments. At the same time, the government needs to play a more proactive role in its promotion of the system.
2.While much progress has been achieved in pension reform, the public pension system continues to impede the development of the private pension system and represents a huge future financial liability to the government. When the SPP was established in 1993, there was a firm decision by the government not to close the public system. The two systems are very different, the SPP is based on defined contributions and the public pension system (SNP) is based on defined benefits. As long as the SNP offers a guaranteed benefit, especially to lower income individuals, the present value of its benefits will continue to exceed that of the private pension system, at the cost to future taxpayers.
3.The public pension system is comprised of two programs: Law 19990, which includes about 1.1 million affiliates and is essentially a social security type system which can cover both the public and private sector, and Law 20530, which is known as the Cedula Viva (CV) and includes about 0.3 million affiliates employed by public sector agencies. Individuals can still sign up with the SNP system. When an individual starts employment, the default option offered by the employer is the private SPP system; however, the individual can still request to join the SNP. While earlier pension reforms sought to close the CV system, it is not apparent whether this closure has indeed been effective. Affiliates in the CV system represent the public sector companies and autonomous entities. The benefits under the CV are exceedingly generous, whereby a pensioner receives the equivalent amount that an individual in that position is currently being paid.
4.The National Pension Office (ONP), which supervises both the CV and SNP, was granted the authority to supervise the system. Each public sector entity administers the CV regime for affiliates who work there. Under Law 26835, ONP could disqualify any individual who did not meet the requirements for benefits, and to take these cases to court if necessary. In 1998, a class-action suit before the Constitutional Tribunal resulted in the annulment of these provisions as contained in Law 26835. In addition, the Constitutional Tribunal ruled that ONP was not qualified to represent the government in any pension cases brought to court. This ruling has jeopardized ONPs ability to supervise the public pension system and update the data base of affiliates.
Regulatory Environment
5.The SPP is a highly regulated system, based on the government mandate to save. The principal regulator of the system is the Pensions Intendency in the Superintendency of Banking and Insurance. An independent Pensions Superintendency (SAFP) had been established in 1992 and was then merged with the Superintendency of Banking and Insurance (SBS) in 2001, as part of a major restructuring of the SBS. The merger of SAFP with its counterpart SBS contributed to economies of scope in supervision. The Pensions Intendency now in SBS is charged with implementing the corresponding rules and regulations govern the SPP. The organizational chart of the SBS shows the Pensions Indentency as one of the three pillars of the system, the other two are banking and insurance.
Source: Supertintendencia de Banca y Seguros, Memoria Anual 2001.
6.While the pension regulators perform a critical function in terms of enforcing the rules and safeguarding the safety and soundness of the pension system, the focus of this study is on the performance of the SPP and on the options for enhancing system performance and efficiency. In accordance with this objective, the analysis of the supervisory process is highlighted in the relevant sections dealing with various aspects of the SPP.
7.As part of the overall regulatory framework, taxation of the pension industry plays an important role in resource allocation and the promotion of savings in the economy. In general, taxation of the pension industry occurs at the source of income to the affiliate. All pension contributions by affiliates are on an after-tax basis, both mandatory and voluntary contributions. Affiliates’ taxes are retained, when applicable, on the basis of their total compensation. Thus, after withholding the tax liability, employers withdraw the affiliates’ corresponding monthly contribution to the SPP. On the other hand, all pension benefits, whether for retirement, disability or death, are exempt from income tax. With respect to the individual’s pension fund account, all income and capital gains generated by those investments, whether realized or not, are not considered taxable income. From the perspective of the inter-temporal value of money, and individuals’ preferences for present consumption, it would be desirable to re-arrange the tax liabilities as they apply to the SPP. Allowing affiliates to contribute to their pension fund account on a before-tax basis, would not only encourage greater participation by registered but non-contributing affiliates, but it would also give an incentive for voluntary contributions. Correspondingly, the pension benefits would be taxable when distributed. This recommendation is based on the premise that increasing the savings rate would contribute to greater investment and lower cost of capital in the medium to long-term, and this would offset the negative short-term impact in terms of reduced fiscal revenues.
Pending Issues
8.The purpose of this analysis is to discuss some of the principal recommendations to improve the efficiency of the SPP. The focus is on specific steps that can be taken in order to maximize the benefits to affiliates. This analysis also relies on extensive research work undertaken during the past five years. While the reform agenda is very extensive, this analysis covers three basic areas: reduction of costs; enhancement of benefits; and greater competition.
9.One area that has received little attention so far has been the protection of affiliates’ interests. The SPP is a complicated financial structure that is not well understood by many consumers. At the same time, many individuals who transfer from the SNP to the SPP are unaware of the value of their Recognition Bonds or how to qualify for this benefit. Part of the reason for the transfer of accounts by affiliates is that the sales representatives have been able to convince them to change perhaps without divulging all the relevant details of the financial consequences. As AFPs begin to develop new funds it is important that affiliates be well informed of their options. For these reasons, it is important to develop a standardized set of information that all affiliates should review, and when applying to a particular AFP they should be asked to sign forms which explain their benefits as well as risks.
Section II:Operational Aspects of the SPP
Recent Performance
10.The SPP has moved quickly up the learning curve since it was founded in 1992. The industry has successfully adapted to a changing environment. Initially there were five AFPs: El Roble, Horizonte, Integra, Profuturo, and Union. After the initial period, three more were established: Megafondo, Nueva Vida, and Providencia. Starting in 1994, several AFPs merged: Horizonte purchased Megafondo, and Nueva Vida purchased Providencia; in 1996 Profuturo merged with El Roble; and in January 2000, Union and Nueva Vida merged, leaving four firms: Horizonte, Integra, Profuturo, and Union Vida.
11.The three principal components of an AFP’s operations are: sales, operations, and investments. The main distribution channel is the sales representative, who visits prospects. Beneficiaries usually do not go to an AFP branch to sign up. The operations area deals with the management of the individual accounts and the computing system. It includes registration, collections, communications with affiliates, handling of benefits, and coordination of the affiliate’s retirement benefits through the corresponding insurance company.
12.Since its founding in 1992, the SPP system has achieved significant improvements in efficiency. The number of sales representatives has fallen from 3,153 in 1995 to 861 in 2002. Initially though, the magnitude of start-up costs for the AFPs resulted in significant losses during the first several years. Nevertheless, the commission structure, which is based on a percentage of income, assured the AFPs a notable increase in revenues during the start-up phase of development.
Peru AFPs: Selected Indicators(percent, except where indicated)
1996 / 1997 / 1998 / 1999 / 2000 / 2001 / 2002
Earnings
ROE / NA / 21.1 / 29.0 / 22.1 / 38.0 / 63.1 / 59.6
ROA / NA / 7.3 / 13.8 / 16.8 / 30.3 / 45.1 / 43.1
Efficiency
Operational Expenses / Income / 120.6 / 95.9 / 92.2 / 74.5 / 55.1 / 48.1 / 47.8
Administrative Exp. / Income / 54.8 / 45.1 / 40.3 / 36.6 / 29.7 / 27.6 / 28.5
Sales Exp. / Income / 65.9 / 50.7 / 51.9 / 37.9 / 25.4 / 20.5 / 19.3
Operational Expenses / # Affiliates (S/.) / 175.17 / 194.40 / 185.98 / 155.87 / 109.26 / 88.96 / 84.89
Operational Expenses / Fund Assets / NA / 10.2 / 7.7 / 5.0 / 3.0 / 2.2 / 1.8
Memo Items:
Fund Assets ( Mill New Soles) / 2,478 / 4,114 / 5,473 / 8,451 / 9,721 / 12,475 / 15,956
Fund Assets ( Mill US$) / $ 953 / $ 1,507 / $ 1,732 / $ 2,408 / $ 2,756 / $ 3,626 / $ 4,541
Note: ROE is return on equity and ROA is return on assets, where assets and equity are the averages of end of period balances.
Source: Pension Intendency in the Intendency of Banking and Insurance
13.Since 1995, the AFPs appear to have gathered momentum in terms of market size and profitability. In dollar terms, funds under AFP management have grown at an average annual rate of 29.7 percent during 1996-2002. At the same time, profitability has surged, with ROE of 59.6 percent in 2002, and a period average of 38.8 percent. Compared to other AFP systems in Latin America, the Peruvian system has achieved consistently higher profitability. In Chile, AFPs have averaged 26.9 percent ROE, while high, it is significantly below the rate in Peru. Since the Chilean system dates back to 1980, the rates of return in that market would appear to approximate “normal” returns in the industry. If so, the Chilean figures also indicate an unusually high rate of profitability in pension industry compared to returns in other areas of the financial system.
Latin American AFP's : Return on Equity (ROE)(%) / 1998 / 1999 / 2000 / 2001 / 2002
June
Argentina / 6.0 / 25.2 / 14.7 / 2.6 / -31.8
Bolivia / 7.8 / -1.8 / 88.6 / 14.4 / 24.6
Chile / 17.8 / 24.3 / 40.6 / 27.4 / 24.6
Costa Rica / 42.1 / 12.8 / NA / -34.8 / -11.5
El Salvador / -33.4 / -11.5 / 4.9 / 17.9 / 29.6
Mexico / -1.7 / 19.2 / 21.6 / 30.5 / 32.3
Peru / 23.0 / 13.4 / 55.5 / 58.2 / 80.9
Uruguay / -61.0 / -12.3 / 1.3 / 30.8 / 28.4
Total / 5.0 / 21.3 / 24.0 / 22.5 / 21.7
Source: AIOS Statistical Bulletin.
14.Operational efficiency has improved in the SPP. Operational expenses as percent of income of the AFPs has fallen from 120.6 percent in 1996 to 47.8 percent in 2002. Lower sales costs have accounted for most of the improvement. As a proportion of funds under management, operational expenses have fallen from 10.2 percent in 1997 to 1.8 percent in 2002. This trend also supports the existence of substantial economies of scale in this industry.[1] Administrative costs include record-keeping, investment management, and amortization of start-up cots. Despite the progress in terms of system productivity, the SPP is still considered a high cost system when compared to other Latin American countries. At the same time, the cost reductions that have been achieved appear to have flowed through to greater profits and not necessarily to lower commissions charged by the AFPs.
Cost Reduction Strategies
15.Historically, costs in the SPP are deemed to be higher than in other private pension systems in the region. Whether in terms of total operational costs, commissions, assets under management per employee, or other cost indicators, Peru is considered to be at the upper range of the scale. Several studies deploying varying methodologies have confirmed this conclusion.[2] On the other hand, the comparison of the Peruvian SPP with those in other countries is obfuscated by differences in institutional arrangements, in the stage of development of each system, by the scale of the markets, as well as currency and other macroeconomic factors. One fundamental difference is the co-existence of a public and private pension system, where the public pension system (SNP) provides a minimum guaranteed pension, not offered by the SPP. Nevertheless, the comparison to the pension systems in other countries is helpful in establishing feasible targets for improved performance.
Latin American AFPs: Operational Expenses / Net Commissions(%) / 1998 / 1999 / 2000 / 2001 / 2002
June
Argentina / 23.3 / 15.3 / 16.2 / 17.6 / 22.1
Bolivia / 3.0 / 2.9 / 5.6 / 2.3 / 2.2
Chile / 12.8 / 10.5 / 9.2 / 8.4 / 7.9
Costa Rica / NA / NA / NA / 133.3 / 18.0
El Salvador / 37.0 / 21.1 / 19.3 / 33.3 / 23.2
Mexico / 5.8 / 5.0 / 7.4 / 8.5 / 6.5
Peru / 27.4 / 24.3 / 17.1 / 15.0 / 14.5
Uruguay / 18.2 / 14.9 / 16.0 / 10.1 / 9.6
Total / 11.7 / 9.8 / 10.2 / 10.9 / 9.5
Source: AIOS Statistical Bulletin.
16.This section reviews some of the key elements in the cost structure of the SPP and recommends changes in the operational structure that have the potential for cost savings. In 2002, operational expenses of the AFPs as percent of net contributions by affiliates were 14.5 percent, compared to a regional average of 9.5 percent.[3] Argentina and El Salvador were the highest, with 22.1 percent and 23.2 percent respectively; while Chile and Mexico were the lower cost systems, with 7.9 percent and 6.5 percent respectively. On the other hand, commissions charged by AFPs in Peru were the highest, 30 percent of net contributions by affiliates, considerably above the regional average of 15 percent. Chile and Mexico reported 15.0 percent and 12.0 percent respectively. Thus the AFPs in the Peruvian system are able to operate profitably based on the relatively high commission income; but if the system were able to adopt new cost saving practices, then it would be reasonable to expect a commensurate reduction in commissions. Several specific areas have been identified in this analysis for cost improvement within the SPP: fees and commissions, transaction and collection costs, information requirements, and regulations.
Commissions
17.Commissions charged by AFPs in Peru are very high when compared to other countries in the region. Since 1998, they have averaged consistently about 30 percent of affiliates’ net contributions. The minimal variation in that percentage across all four AFPs during the past five years may indicate a lack of competitive market forces and the high costs of reaching prospective affiliates. Peru has one of the lowest participation rates in terms of number of affiliates per economically active population, which would imply higher costs to convince an affiliate to register in the SPP in terms of a narrower population base, greater efforts needed to convince affiliates to switch from the SNP system, and greater geographical dispersion of the working population.
18.An affiliate’s periodic contribution to their AFP is comprised of three components expressed as a percent of the individual’s income (POI): the amount channeled directly into the individual’s capitalization account, which is fixed at 8.0 percent; the commission charged by the AFP, which is currently about 2.35 percent; and the premium for disability and term life insurance, which is currently about 1.3 percent, where the life policy includes funeral expenses. Based on these figures, an individual contributes 11.65 percent of income into the SPP. While the share of the contribution that is allocated to the individual capitalization account is fixed, the percentage for the other two components is variable. Nevertheless, commissions and the insurance premiums have exhibited minimal fluctuations. As of December 2002, the variable commissions charged by the four AFPs were as follows: Horizonte, 2.25 percent; Integra, 2.10 percent; Union Vida, 2.27 percent; and Profuturo, 2.45 percent. While not much different as a percent of income, in terms of the effective rate as a percent of the affiliate’s contribution, the rates are somewhat more distinguishable, for example, the lowest is 18.34 percent for Integra, and the highest is 21.08 percent for Profuturo.
Peru AFPs: CommissionsDecember 2002
(percent)
Variable Commission / Insurance Premium (1) / Individual's Contribution to the Fund / Total Contribution Percent of Income (2) / Variable Commission / Fund Contribution / Variable Commission / Total Contribution (2)
Horizonte / 2.25 / 1.25 / 8.00 / 11.50 / 28.13 / 19.57
Integra / 2.10 / 1.35 / 8.00 / 11.45 / 26.25 / 18.34
Profuturo / 2.45 / 1.17 / 8.00 / 11.62 / 30.63 / 21.08
Unión Vida / 2.27 / 1.18 / 8.00 / 11.45 / 28.38 / 19.83
System Average / 2.27 / 1.24 / 8.00 / 11.51 / 28.34 / 19.71
(1) Based on the maximum insurable income, S/- 6,037.25
(2) Based on the assumption that income is less than or equal to the maximum insurable amount.
Source: Pensions Intendency in the Intendency of Banking and Insurance
19.The low participation rate in the Peruvian system contributes to the high cost of attracting new affiliates to the SPP. About 27.0 percent of the economically active population belonged to the SPP, compared to 55.0 percent in Argentina, 68.2 percent in Mexico; and 110.6 percent in Chile. As mentioned above, the low percentages reflect the importance of the parallel public sector pension, although there were not available statistics on participation in the SNP system. Nevertheless, the figures show that of those Peruvians counted as part of the labor force, few are covered by a formal pension system. In the case of Chile, the percentage exceeds 100 percent due to the fact that a significant number of workers not included in the economically active population are registered in the pension system.[4]