CONTENTS

  1. The Individual Capitalization System.
  2. Necessary conditions to establish the System of Individual Capitalization.
  3. The Supervisory role in the Pension System.
  4. Financial management of the Pension System.

4.1.Authorized Markets.

4.2.Appraisal of Instruments.

4.3.Minimum Rate of Return .

4.4.The Value of a Pension Fund Share.

4.5.Share Yield

  1. Information for the Affiliate
  2. Summary

  1. The Individual Capitalization System
  • In the Individual Capitalization System each affiliate has an individual account where his/her pension contributions are deposited, and these are cumulative as successive contributions are paid and as instruments of the Funds by the Pension Fund Management Companies produce yields. Upon completion of his/her active working life, this capital is then returned to the affiliate or to his/her surviving beneficiaries as some type of Pension. The Pension is financed by the resources saved by the affiliate, and by the transfer of funds to a Life Insurance Company which assumes the financial risk and the survival risk of the pensioner and his/her family group. The amount of the pension will depend on the amount of the savings, and there is, therefore, a direct relationship between personal effort and the pension obtained.
  • A key factor regarding the Individual Capitalization System is that the pension reform is not an insulate reform, it is only one element in a big social security reform that at the end will impact different aspects of the national life.
  • In the transition process, the existence of adequate incentives is crucial with regard to the importance of the changes that are needed and the political impact of them, and also the need and the strong willingness to perform them.
  • There are three aspects that define the essence of the system of individual capitalization:

- selection of the particular system;

-determination of the way it will be managed; and

-destination of the funds while they are not used for pension payments, i.e., to stipulate the types of assets in which the Pension Fund resources may be invested, whose main common feature is that they are financial assets on public offer.

  • Definitions of all these aspects is crucial for all the agents involucrated because there is a need for permanent incentives to keep the convergence between the interest of the system and of the agents.
  • This is valid for the legislators, regulators, administrators and the beneficiaries of the system.
  1. Necessary conditions to establish the System of Individual Capitalization.
  • One concept that summarizes the mentioned convergence, is the “role separation” of the players of the Pension System.
  • This separation can be observed between the Pension Fund Superintendence - SISD, the Securities and Exchange Superintendence, as regulators and supervisors; the Pension Fund management companies and the custodian banks, as actors of the system; and the Pension Funds that represent the individual ownership of all contributors.
  • The Pension Fund Superintendence - SISD and the Securities and Exchange Superintendence are organizations independent from the Pension Fund management companies, therefore their regulative and supervision activities are not compromised with the Pension System administration.
  • Regarding the State role within the Individual Capitalization System, it is necessary to bear in mind, that given the fact that contributions are compulsory in this scheme, there ought to exist a commitment from the State to guard the safety of the resources accumulated in the Pension Funds. This commitment is reflected on the controlling and supervising task of the State within the System.
  • One crucial requirement for the efficiency of the system of individual capitalization, is the separation between the equity of the Pension Fund and the management company.
  • This separation between the Pension Fund and the management company allows for the correct supervision and control of the resources and their investments.
  • When the equity of the Pension Fund is absolutely separated from the equity of the management company, one can assure to the affiliates that their contributions will achieve a clear objective.
  • After the independence of the regulation and supervision and the equity separation are established, there is a need for an additional condition.
  • This condition establishes that the independent management of the system of individual capitalization must be performed by private institutions, in a competitive environment whose sole purpose is to manage a Pension Fund and other activities strictly related to social security matters.
  • The condition mentioned above forces the private institutions to focus their interest only in the efficient management of the resources of the Pension Fund.
  • The competition between the different Pension Funds and the possibility of the workers to move from one Pension Fund to another whenever they want to, will force to an efficient management of the business.
  • Since legislation should stipulate freedom of affiliation and empower workers to transfer their Pension Fund savings at any time from one Pension Fund to another, the management companies are forced to search for ways of keeping their affiliates by using various competitive strategies.
  • Normally, there are three variables in which the Pension Fund can compete: yield, price and service.
  • Due to the fact that Pension Funds receive the affiliates’ contributions, deposit them in each affiliate’s individual account and invest their resources so as to subsequently award any benefits that might apply, there is a need of another condition of the system of individual capitalization, that is, the Pension Fund resources must be invested with a view of securing adequate yield and safety.
  • The system of individual capitalization must meet diversification requirements that are stricter than those required of other investment funds, since they are composed of obligatory worker’s contributions.
  • In defined contribution plans workers assume the investment risk and may not have the information and expertise to monitor the investment performance of different funds.
  • Investment rules and procedures need to be stricter under the mandatory system in order to protect the big number of unsophisticated and inexperienced affiliates who are forced to participate.
  1. The Supervisory Role in the Pension System
  • Since the State’s function in relation to the Pension System is essentially supportive, there must exist a body of regulations (law, rules and guidelines), which must be constantly controlled and supervised by the Pension Fund Superintendence - SISD. This is how the Pension Funds must be protected and how it must be ensured that affiliated workers will receive the benefits stipulated by the Pension System in due time and manner.
  • The reason for the above argument is due to the fact that salaried workers are obliged to pay percentage of their salaries and earnings into the Pension Fund. Therefore, the obvious counterpart to being obliged to pay is that the State should be committed to watching over the security of the recourses accumulated in the Pension Funds. The State makes it mandatory to belong to a social security regime, but together with that obligation, is assumes duties. One is to protect the individual property rights over the accumulated recourses. But, in addition, the State acts as a supervisor so that funds are duly administrated by private Pension Funds - asset management companies, and their utilization in the capital markets must be transparent and subject to the least possible risk for given return.
  • The regulatory activity of the State is increased as compared with standard public systems, where the function of supervision and operation have not been separated explicitly.
  • The regulatory activity could be interpreted under two different lights: as a protection of the ownership of individual capitalization accounts, or as a result of delegation by the community of its aspiration to share the responsibility in the faces of States of need of its own members.
  • The regulation governing the operation of the Pension System may be classified into three main areas:

a)The investment process of Pension Fund resources, i.e.:

Eligible instruments stipulated by law, risk rating, investment limits, authorized markets, custody of financial instruments, conflicts of interest, minimum yield, appraisal of instruments and transaction costs;

b)The operation of the Management Companies and granting of benefits stipulated by law;

c)The administration of the individual accounts of affiliates, collection of contributions, clearing and transfer processes when the affiliate decides to switch from one Pension Fund to another, recovery of late contributions, collection of commissions and morose contributions.

  • The Individual Capitalization System emphasizes individual responsibility and provides incentives and instruments with which to maximize individual interests. In it, the individual does not consider him/herself to be protected by the State from birth to death. Instead, he/she demands from the State the juridical instruments and freedom necessary to preserve his/her property, understood as an extension of him/herself and a product of his/her work. In addition, due to the role separation between the duties of the Pension Fund Superintendence - SISD and the Pension Fund management companies, there is a need to create a formal bridge between both.
  • In setting up a long-term relationship for an investment portfolio, both mentioned parties need to communicate certain information to each other.
  • There is a need to understand the realistic expectations for each type of investment and each asset class, for both the short-term and long-term investment horizon.
  • Also, there is a need to understand the probable and possible “chaotic events” that occur within the long, long term. Participants should know what the long-term average rate of return is and what the distribution of events is around the long-term average. In other words, what are those risks, what are the uncertainties, and what is the long-term average return achieved in the past? And what is most important, how may the future differ from the past?
  1. Financial Management of the Pension System
  • Due to one of the major effects of Pension Funds on the capital markets, it is to optimize the allocation of resources, therefore, the Pension Funds investment goal must be the efficient commit of their affiliates’ money in financial instruments affording the best yield/risk combinations. The former, in addition to be a legal obligation, is also due to the fact that affiliates have the right to move one Pension Fund to another, with yield being one of the prime considerations for such transfers.

4.1 Authorized Markets

  • The first step in order to assure the above concept is to impose that the trading of financial instruments involving Pension Funds resources must be carried out only in markets expressly authorized for that purpose, and which comply with certain minimum requirements, basically involving the simultaneous presence of buyers and sellers of the investments when determining the price, information readily available to the general public, instrument negotiation mechanisms, the necessary infrastructure, and internal rules of procedure.
  • The above is based on the need for transparency and fairness when trading financial instruments using Pension Fund resources.
  • All trading of financial instruments using Pension Fund resources must be carried out in a legally instituted secondary market. However, purchasing of debt and capital instruments in primary markets must be allowed, provided that these markets meet the requirements stipulated in the regulations governing legally instituted primary markets. Likewise, investment to single instruments issued by national financial institutions, and which have not been traded previously, may be made directly in the issuing institution.
  • Additionally, the Pension Funds Superintendence must be empowered to monitor all the trading in authorized markets that involves Pension Fund resources.

4.2 Appraisal of Instruments

  • The second step in order to protect Pension Funds’ contributors is to establish that the value of the pension assets must be determined on a daily basis on the grounds of economic or market value of investments.
  • Although market values are subject to continuous, and sometimes large fluctuations, using them is better than using book values, which may result in large deviations from the true value of various assets and would tend to generate hidden reserves and therefore complicate account transfers.
  • The methods for appraising the various instruments belonging to the Pension Funds, according to the criteria of economic or market values of investments, through which undesired transfers of resources among the system’s affiliates as a result of inflows and disbursements of resources from the individual accounts are prevented, could be divided into three groups: single, fixed income serials and capital.

a)Single Instruments – Single financial instruments with redemption and interest payment upon maturity, not longer than one year, are appraised on a daily basis according to their earned value, using the purchasing rate as the rate of return;

b)Fixed Income Serial Instruments – These instruments are appraised at the current value of future cash flows discounted at the relevant market rate. The relevant rate is that which applies to the same issuer, type of instrument and category. In this regard, generic types of instruments must be taken into consideration, and the categories must be determined based on term conditions, systems of indexation, nominal coupon interest rate, and other warranties of similar nature.

Thus, every time an instrument of the same type, issuer and category is traded in legally instituted secondary markets, if the total amount of mentioned trading is more than a minimum of USD 500 (for example), all instruments of that type, issuer and category are appraised using the operations’ weighted average IRR (internal rate of return), and the price of the instrument for that day, the price for the last working day of the month, and the daily amount earned are calculated, or re-calculated (if it has been traded previously).

If on a particular day no instrument of the same type, issuer and category is traded, the instruments are appraised using the IRR with which the mentioned instruments were appraised on the previous day and applying the aforementioned earning factor.

If no instruments of the same type, issuer and category have been traded during the course of a calendar month, the IRR used for the appraisal is reviewed in accordance with whatever variations the reference rate for the respective category has experienced.

Thus, on the first working day of each month, the IRR used for appraising those categories that were not traded during the course of a calendar month is reviewed. The review is made by comparing the observed average interest rate structure of the last month with that of the previous month. The estimation of the interest rate structure for the period under study is determined by means of a linear regression, using the method of least squares.

Subsequently, the results are checked for significant changes in the parameters of the last month compared to the prior one. If no significant changes are discovered in the parameters, the last IRR used for appraising the instruments in those categories, which were not traded during the last month, is maintained. Conversely, if at least one significant change is discovered in the indicators when compared to the previous month, this means that the interest rate structure in that month differs substantially from that of the month before, and therefore, the last IRR used for appraising the instruments in those categories, which were not traded during the previous month, is modified.

c)Capital Instruments – Stocks are appraised on a daily basis at the weighted average price over the last ten days of trading. Days of trading when operations were carried out for less than a minimum of USD 5,000 (for example) per issuer are not taken into consideration. The share price is re-calculated on every day that trading above the minimum margin occurred. If no trading occurs on a given day, or if trading does not exceed the minimum margin, the previous day’s price is maintained.

4.3 Minimum Rate of Return

  • The aim of the minimum rate of return or minimum yield system is to protect small and unsophisticated investors, not only form fraud and/or manipulative exploitation by Pension Fund managers, but also from large disparities and fluctuation in returns.
  • The above mentioned concept is based on the idea that there are two types of risks that regulators would attempt to limit.
  • First, the principal-agent problem, i.e. the concern that the Pension Fund manager may invest so as to optimize some private objective function, at the expense of the affiliate.

And the second risk, the inherent risk of investment, arising from return volatility.

  • Due to the compulsory nature of the Pension System and the fact that Pension Fund members lack familiarity with capital market investments, an additional element is necessary in order to allow the safeguard of Pension Funds, i.e. it is the demand of a minimum rate of return.
  • A minimum rate of return would protect Pension Fund members from aberrant Pension Fund managers, without necessarily causing inefficiencies in investment policies.
  • A minimum yield system would tend to cause Pension Funds to follow more uniform, and perhaps, more conservative investment policies. But even without this rule, asset managers would tend to bunch their investments to similar securities, because if any of them underperforms the market, the price will be a loss of business.
  • A minimum rate of return should not be expressed in absolute terms. This could distort incentives and encourage management companies to adopt risky investment policy. Nobody can guarantee an absolute level of interest rate.
  • Measuring the minimum rate of return in relative terms, i. e. relative to the average for the industry, makes more sense, because it would protect workers from large deviations in return. The average for the industry will be determined by the behavior of the economy.
  • But which average?
  • Normally, in the financial literature we can find two methods for determining the actual return of the Pension System over some specific time period:

i)The Arithmetic Average Rate of Return, that can be expressed is as follows: