Social Protection Discussion Paper Series
Regulating Private Pensio n Funds’ Structure, Performance and Investments: Cross-country Evidence P.S. Srinivas Edward Whitehouse Juan Yermo July 2000
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Regulating private pension funds’ structure,
P.S. Srinivas, Edward Whitehouse and Juan Yermo*
n. 1. pe´nsion i.1. make (institution, procedure n.1. elementary book to
* Srinivas is a Financial Economist with the Finance, Private Sector and Infrastructure Sector Management Unit of the Latin America and Caribbean Regional Office of the World Bank. Whitehouse is Director of Axia Economics, London. Yermo,
formerly with the World Bank, is now in the Directorate for Financial, Fiscal and Enterprise affairs at the OECD. We are
grateful to participants at two World Bank seminars for their comments. The views and opinions in the paper are the
authors’ own, and do not reflect those of any of the World Bank or any of its members.
Comments and suggestions: Srinivas: +1 202 473 8939, e-mail [email protected]; Whitehouse: +44 171 274 3025,
e-mail [email protected]; Yermo: e-mail: [email protected].
This paper is part of the World Bank’s pension reform primer: a comprehensive, up-to-date resource for people designing
and implementing pension reforms around the world. The series is edited by Robert Palacios of the World Bank and
Edward Whitehouse. For more information, please contact Social Protection, Human Development Network, World
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[email protected]. All Pension Reform Primer material is available on the internet at
Because defined-contribution systems expose pensions to a number of risks, reforming governments have often strictly regulated the pension fund industry’s structure, performance, and investments. This paper compares the rules in the new systems of Latin America and eastern Europe with richer OECD countries. The authors argue that the benefits of competing pension funds and individual choice can only be achieved if regulations are loosened in the medium term.
1. Pension funds' supervision and regulation . 7 2. Risks in pension funds. 8
2.1 Systematic market risk. 9 2.2 Systemic risks . 10 2.3 Agency risks . 10
3. Regulating industry structure . 11
3.1 Rationale . 13 3.2 Adverse effects of structural regulations . 14 3.3 Issues in member choice of investments. 15 3.4 Empirical evidence of concentration in fund management. 17
4.1 Rationale . 20 4.2 Adverse effects of performance regulation . 21 4.3 Empirical evidence. 22 4.4 Performance regulation and herding . 23
5. Regulating asset allocation . 25
5.1 Rationale of asset allocation regulations. 29 5.2 Adverse effects of asset allocation regulations . 30 5.3 Empirical evidence of portfolio limits and asset allocations. 32
5.3.1. Latin American countries . 33 5.3.2. OECD countries . 35
5.4 Empirical evidence of pension fund returns . 36
5.4.1 Latin American countries . 37 5.4.2 OECD countries: cross-national comparisons. 38 5.4.3 United Kingdom and United States. 39
6. Conclusions and policy implications. 40 7. Bibliography. 47
Table 1. A taxonomy of investment risks in pension funds . 9 Figure 1. Asset allocation in member-directed 401(k) pension plans . 16 Figure 2. Concentration curves for fund managers in Latin America and the United Kingdom . 18 Table 4. Pension fund performance regulations and government guarantees in Latin America. 19 Table 5. The herding effect in Chile (per cent of assets of pension funds) . 22 Table 6. Correlation of pension fund returns. 23 Table 7. Peru: Average pension fund portfolio and standard deviation, 1995-8. 24 Figure 3. Limits on foreign investments in OECD countries . 26 Figure 4. Limits on domestic investments in OECD countries . 27 Figure 5. Pension fund portfolio limits, 1998 . 28 Figure 6. Evolution of portfolio limits in Chile, 1982-1998 . 29 Figure 7. Pension funds’ equity holdings as a percentage of total stockmarket
Figure 8. Equity investments as a percentage of total pension-fund portfolios . 33 Table 13. Pension-fund portfolios and limits in Argentina, Chile and Peru. 34 Table 14. Asset allocation of funds in Chile, 1981-97. 35 Table 15. Portfolios relative to regulations in eight OECD countries. 36 Table 16. Returns on pension funds and balanced portfolios: Latin America. 38 Figure 9. Returns on pension funds and balanced portfolios: OECD countries . 39 Table A.1. Asset allocation in member-directed 401(k) pension plans. 42 Table A.2. Concentration of fund managers in Latin America and the United Kingdom . 42 Table A.3. Pension asset regulations in OECD countries . 43 Table A.4. Pension fund portfolio limits, 1998 . 44 Table A.5. Evolution of portfolio limits in Chile, 1981-1998 . 45 Table A.6. Pension fund portfolios, selected countries . 45 Table A.7. Returns on pension funds and balanced portfolios: OECD countries . 46
Regulating private pension funds’ structure,
P.S. Srinivas, Edward Whitehouse and Juan Yermo
‘Risk is risk. It cannot be legislated away. It can only be diversified away.’
George Russell, financier, quoted in de Ryck (1998)
A number of countries have implemented or proposed fundamental reforms of their pension
systems, including eight in Latin America and five in Europe1. These reforms emphasise the role
of individual, privately managed defined-contribution accounts, where the value of the pension
benefit will depend on accumulated contributions and investment returns. They are, by definition, fully funded. The new pension plans substitute for the old, public, defined benefit schemes where
the pension depended on some measure of earnings and years of coverage. Public schemes are
usually financed on a pay-as-you-go basis, where current workers’ contributions pay for current
The new defined contribution systems expose workers’ future pension benefits to a number
of different risks. To try to mitigate these risks, reforming governments have often strictly
regulated the pension fund management industry’s structure, performance, and asset allocation.
Often, a new fund management industry has been established, consisting of multiple competing
pension funds, separated from other financial institutions. In the majority there are restrictions on
the type of investments that can be made and sometimes regulations specify the returns that the
These fundamental reforms of pension systems aim to:
• enhance individual choice and responsibility through the freedom to select a fund manager;
1 Chile (1981), Peru (1993), Argentina (1994), Colombia (1994), Uruguay (1995), Bolivia (1997), Mexico (1998), El Salvador (1998), Czech Republic (1998), Hungary (1998), Poland (1999), Sweden (1999) and the United Kingdom (1988). Schwarz
and Demirguç-Kunt (1999) provide a global survey of pension reforms of the last six years.
• ensure good service and performance through competition between fund managers and so
deliver reasonable pension benefits; and
• limit risk through competition and investment restrictions.
However, in practice, ‘Draconian’ regulation of pension funds has prevented the
achievement of many of these objectives. Regulations have generally focussed on three aspects:
industry structure, asset allocation, and performance. Structural regulations force workers to
choose only one manager and one fund. So, workers are unable to diversify investments across
funds, exposing them to aberrant behaviour by fund managers, and preventing portfolio
adjustments according to the individual’s age, household characteristics, career profile and attitude
to risk. Strict asset-allocation rules and relative performance criteria mean that pension funds
often invest and perform almost identically, removing any substantive choice for workers over the
allocation of their pension fund’s assets and the portfolio’s risk and returns.
This paper provides evidence for some of the effects of structural, investment and
performance regulation of pension funds in emerging economies and compares them with evidence
from more developed OECD countries. Concentration in the pension fund management industry
is found to be higher in the new pension systems of Latin America and Eastern Europe than in
most OECD countries. Concentration might be because the new pension markets are smaller than
in countries with more established funded pension systems, but it could also be because of
restrictions on industry structure. In Latin America, asset allocation and performance is nearly
identical across pension funds. So-called ‘herding’ behaviour is almost a defining characteristics of
these pension regimes. Again, this reflects, at least in part, asset allocation restrictions and strict
performance regulation. There is also evidence that pension funds have often under-performed
simple portfolios composed of market indices of stocks and bonds.
All the rules imposed in the new systems of Latin American and Eastern Europe2 seem to
be more stringent than in the OECD, with one exception: portfolio limits. Some OECD countries
have a tighter investment regime than countries such as Argentina, Chile, Colombia, Peru and
Poland. But OECD countries tend to have fewer barriers to entry and impose fewer constraints
on performance than Latin American and Eastern European countries.
2 The countries in Europe considered are Poland, Hungary and the Czech Republic. These countries are actually part of the OECD, but for the purposes of the study they are discussed together with Latin American countries, because they have
established very similar private pension industries.
The rest of the paper is structured as follows. Section 1 reviews investment supervision
and regulation in practice. The subsequent section looks at risks in pension funds. Sections 3, 4, and 5 review the adverse effects of structural, performance and portfolio restrictions respectively.
Pension funds, supervision and regulation Pension funds have shown an impressive growth pattern. In Chile, which reformed its
system in 1981, pension funds are the leading institutional investors, managing a total of $32
billion at the end of 1997, worth some 44 per cent of GDP. Only five countries have
proportionally larger pension fund sectors — Ireland, the Netherlands, Switzerland, the United
Kingdom and the United States — where funds average 75 per cent of GDP. In these five
countries, the value of funds has been growing rapidly: by 56 per cent between 1987 and 1996.3
Intersec, a financial data firm, expects world pension fund assets, currently $11,000 billion, to
grow by 40 per cent over the next five years.
In other Latin American countries and in Eastern Europe, reforms were more recent, and
so funds are much smaller. The next largest system after Chile is Argentina, where assets are
worth 3 per cent of GDP. But funds in other countries are forecast to grow rapidly. Goldman
Sachs, an American investment bank, expects the value of Argentine funds to increase from
$8.8bn in 1997 to $33bn in 2003, or 6.4 per cent of GDP.4
Mexico has the largest number of workers covered by the new plans – about 14 million.
Around 6 million workers each in Chile and Argentina, 2½ million in Colombia, just over 1 million
in Peru and fewer than half a million in Bolivia and Uruguay are covered.5 In the United Kingdom,
5.7 million workers (28 per cent of total employees) are covered by the new personal pensions. A
further 10 million are covered by longer-established employer-provided plans (of which more than
90 per cent are defined benefit). In Hungary, 800,000 workers have so far announced their
intention to switch to the new funds. Poland and Croatia will implement their reforms during
3 OECD (1998), table V.1. 4 Mariscal (1998a) 5 However, only 54 per cent on average of these members actually contribute to the schemes, ranging from 44 per cent in Peru to 65 per cent in Mexico. See Queisser (1998b).
In Hungary, Poland and most of the Latin American countries, a new agency was
established to supervise the new pension funds. The exceptions are in Colombia and Uruguay, where this responsibility falls on the Central Bank.6 These agencies ensure compliance with
regulations on capital, disclosure and reporting, commissions, transfers between funds, rates of
return and investment allocation. In other countries, such as Australia, Switzerland and the United
Kingdom, existing financial regulators expanded to cover pension funds.
Risks in pension funds Government intervention in markets can be justified by market failures. In financial
systems, externalities, asymmetric information and monopoly are the three main types of market
failure. Pension funds pose a different set of risks than other financial institutions, such as banks.
Pensions are long-term contracts and they involve a sizeable proportion of the individual’s wealth.
However, the existence of assets in pension funds avoids the danger of the type of runs that can
occur in banking crises (i.e., externalities). Monopoly, too, is likely to be less of a problem in the pension fund industry, as barriers to entry are low compared with banking.7
Asymmetric information — the fact that it is costly for the buyer of financial services to
obtain sufficient information to assess the quality of that service — is likely to be the most serious
problem for pension funds. Lack of information means that the buyer is vulnerable to fraud,
negligence, incompetence and unfair treatment by the provider. Clearly, the desire for providers to
maintain a good reputation offers a high degree of protection, but there remain three risks in
• Systematic (undiversifiable) market risk: current generations cannot trade with unborn
ones, so efficient intergenerational risk sharing cannot take place
• Systemic risk: Asymmetric information problems in banking systems can lead to bank runs,
• Agency risks: in financial markets, trading often takes place between parties with different
information, creating problems of moral hazard and adverse selection8
6 The issue of supervision is covered in Demarco, Rofman and Whitehouse (1998). 7 See, however, section 5.1 below for evidence of high concentration in pension fund management in Latin America. Also, Altman (1992) shows the monopoly problem that arises with employer-provided plans. 8
There is some overlap between the first and the other two forms of market failure risks. Whenever there are systemic
and agency risks, systematic market risk for the investor is created.
Table 1 gives a taxonomy of these investment risks as they affect funded, defined
contribution pensions plans. It also shows the mechanisms to reduce risks that might be used and the new risks that might be created. We describe these risks in turn.
2.1 Systematic market risk Once market-based ways of reducing systematic risks (such as diversification and risk
pooling) are exhausted, investors are left with some rate-of-return uncertainty. This systematic
market risk can only be reduced further through intergenerational risk sharing, pooling returns of
investors across time. Example policies include issuing indexed bonds or offering government
guarantees.9 Some observers (such as Heller, 1998) have argued that the mandatory nature of the
new pension systems means that governments retain a responsibility for ensuring adequate
pensions beyond the guarantees specified by legislation, producing ‘contingent’ or ‘conjectural’
Table 1. A taxonomy of investment risks in pension funds
reasonably priced insurance not universally available
9 Defined-benefit pensions might also reduce this kind of risk, but exposes the worker to other forms of uncertainty over, for example, job tenure and earnings profiles (see Disney and Whitehouse, 1994 and 1996 and Bodie, Marcus and
Government intervention in the form of guarantees may not necessarily be a panacea for
risk. Guarantees create a moral-hazard problem: for example, a pension guarantee creates an
incentive for informal sector workers to contribute to the system for the minimum number of years
to qualify for the minimum pension. Investment managers may take excessive risks knowing that
the member’s pension is underwritten by the government. In general, guarantees reduce one type
2.2 Systemic risks Investment in capital markets depends crucially on the option to exit into the safe-haven of
liquid money markets. If banks take excessive risks, impairing their solvency, the solidity of the
whole financial system is put at risk by the potential for a run on the banks. Hence, a sound
banking system and a secure pension system go hand in hand.
The regulatory framework should ensure that the moral hazard from deposit guarantees is
mitigated. Latin American countries are still trying to make accounting and supervisory standards
stringent enough to evaluate risks more effectively than in the past (Rojas-Suarez and Weisbrod,
2.3 Agency risks Intervention to limit agency risks takes the form of prudential rules and guarantees applied
to financial markets and intermediaries generally, not just to pension funds. This framework
• avoid fraud through setting accounting and auditing standards, information disclosure and
• reduce overexposure to specific risks by requiring minimum levels of diversification by issuer
• mitigate conflicts of interest through limits on self-investment
• limit market power by restricting concentration of share ownership
Government might also choose to go further and guarantee individuals against these risks.
The contrast between the regulatory regime for pension funds and other financial
intermediaries in many developing countries is startling. While pension funds are subject to strict prudential controls, such as capital, disclosure, fiduciary and diversification standards
requirements, the regulatory and supervisory framework of other financial institutions is often
weak. Valuation is also a widespread problem. The strengthening of prudential controls is a basic
precondition for the successful development of financial markets and expanding the investment
Regulating industry structure In Latin America and Eastern Europe, reforming countries restricted the industry structure
• investment was limited to one instrument, the specially created private pension accounts
• administration of funds was restricted to companies exclusively dedicated to pension fund
management and managers were restricted to one fund each
• ownership of pension fund managers was not open to existing financial institutions in some
countries (Bolivia, Chile, Mexico, Peru)
The structure of the industry in many reforming countries is limited to specially created
pension fund managers, which must be independent of other financial institutions. Colombia is
one exception: severance funds were allowed to manage pensions as long as this activity was kept
separate from other businesses. But in other countries, too, there are strong economic ties
between pension fund managers and other companies. For example, Maxima, the largest fund in
Argentina, has Banco Quilmes, the Argentine subsidiaries of Deutsche Bank and HSBC (two of
the world’s largest banks) and New York Life as shareholders.
Pension fund managers are usually restricted to pensions-related activities, such as
collecting contributions, asset management, reporting results, and benefit payments. Associated
activities — such as custody of assets, provision of life and disability insurance, etc. — are often
carried out by separate institutions for economic or prudential financial reasons. In Eastern
Europe and Latin America, each manager may usually administer only one fund. In Poland, the
regulations allow managers to offer two funds from 2005: one with a relatively liberal investment
régime, the other restricted to fixed-income securities. In Mexico too, the regulations contemplate
allowing more than one fund some time in the future.
In most OECD countries, in contrast, pension plans are offered by a variety of different
providers. In some, employers play an important role. In Ireland, the United Kingdom and the United States, employer schemes are a mix of defined benefit and defined contribution. Larger
schemes tend to be managed ‘in-house’, while smaller plans contract out fund management to
specialist financial institutions. The investment of defined-benefit schemes is, of course, of less
concern to members than defined-contribution. Other countries with predominantly defined-
benefit coverage include Belgium, Finland, France and Germany.
In the United States, around half of employer-provided pension coverage is now defined-
contribution. So-called 401(k) schemes (named after the relevant clause of the income tax
legislation) cover 37 million workers. They now account for 39 per cent of the total of pension
fund members, 29 per cent of assets and 53 per cent of new contributions.10 Typically, the
employer selects the range of investment options in 401(k)s, but they are generally broad,
including equity, bond and money-market funds.
In Denmark and the Netherlands, the pension system is based on industry-wide schemes.
There are 35 funds in Denmark, and the number of single-employer schemes has now declined to
around 100. There are 65 compulsory industry-wide funds in the Netherlands, of which 95 per
cent are defined-benefit. In contrast, pensions in Denmark are defined-contribution. Dutch
companies are free to opt out of these plans if they offer their own scheme with equivalent
benefits. There are around 1,000 of these single-employer plans.
Australia’s new superannuation system is based around compulsory employer-provided
defined-contribution schemes.11 Initially, the employer decided where contributions were
invested. However, the government is proposing that employers be required to offer a minimum
of five different funds. Already, 15 of the 24 largest funds offer a menu of investment strategies.
The market for individual pension accounts in OECD countries usually involves a wide
range of financial intermediaries. In the United Kingdom, for example, there are around 90
providers of personal pensions, including most life insurers and banks. They offer an average of
around 8 funds each, and individuals are free to divide their assets between different funds.12
10 VanDerhei (1999). 11 See Flanagan (1999) and Edey and Simon (1996). 12 Dilnot et al. (1994).
3.1 Rationale The restrictions in the Latin American and Eastern European regimes are designed to keep
the regulation and supervision of the industry simple, avoiding the complexity of multiple
instruments and funds. The poor performance of some existing financial intermediaries led to the
decision to establish a new industry. But this poor performance could only result either from poor
market or economic performance, or from inadequate regulation. In the first case, there is no a priori reason to expect the new pension funds to perform any better. The second case justifies
improvements in the existing regulatory framework, not necessarily the creation of another.
Moreover, if the previous regulatory failure resulted from some systematic, cultural failure of
governance, there is no reason to expect the new regime to be any better.
In addition to being simpler to regulate, restrictions on the structure of the pension market
makes the system easier for participants to understand. This is probably an advantage initially, as
the new régime offers people new choices. However, as people become accustomed to the new
system, this simplicity is less important.
Limiting managers to one fund avoids the moral-hazard risk generated by minimum
pension guarantees. If a manager were able to ‘stream’ low-income workers into one fund, they
could then take ‘wild bets’ in high risk/high return assets knowing that the government insures the
Excluding existing financial intermediaries, such as mutual funds and banking
conglomerates, from the new pensions industry is common in countries with weak banking systems
or poor past mutual-fund performance. The aim of the restrictions was to protect retirement
savings from deficiencies in existing financial institutions, often in the form of agency risks that
were not checked by the existing regulatory and supervisory system. In some countries, these
restrictions were also designed to reduce the market power of these intermediaries. The
mandatory nature of pension contributions in many countries increases the government’s
responsibility for the safety of pension assets.
Some OECD countries which also have mandatory private pension pillars also impose a
single instrument requirement. In France, Switzerland, Finland and Australia employers are obliged
to set-up pension plans for their employees. There is, however, more flexibility, because asset
management may be carried by a variety of financial institutions. In the reforming countries, only
licensed pension fund administrators are allowed to manage the funds.
3.2 Adverse effects of structural regulations The most important adverse effect of structural regulation is that it prevents
diversification. Workers are unable to spread retirement savings across different financial
intermediaries and different financial products. Hence, non-systematic market risk (the risk of
aberrant behaviour by a specific fund manager or investment instrument) is not pooled away. Such
risk could be easily diversified away if workers were able to invest in various funds at the same
time, though this may raise administrative costs significantly. Also, to the extent that governments
impose relative performance rules, and guarantee such performance, these constraints may not be
worrying. Some countries, however, do not have performance rules, and in some cases require
investors to remain with a specific fund for up to six months before they can transfer to a new one.
In these cases, governments will probably be forced to bear the responsibility for funds which
Another adverse effect arises because excluding existing financial intermediaries precludes
the use of existing infrastructure and the potential benefits of economies of scale, raising
administrative costs. Instead, investors have to finance the set-up costs of the new industry
through fees and commissions (Shah, 1997).
The restriction of one fund per administrator also has significant costs. Workers cannot
choose the optimal portfolio that best suits their age, career earnings path, and risk aversion. For
example, younger workers have few assets other than their human capital (i.e. their future
earnings). It is optimal for them to hold assets with a low correlation with their projected wages.13
It may also be better for younger workers to weight their portfolio towards equities, which have a
higher long-run return but also a higher short-term risk, whereas older workers prefer a less risky,
bond-weighted portfolio.14 Furthermore, workers of a given age will also vary in a range of
characteristics, such as occupation and industry and family type, which affect their attitudes to
risk. They will also differ in the types of other assets that they hold: housing, durable goods and
13 See Jagannathan and Kocherlakota (1996). This is a key attraction of defined-contribution plans over defined-benefit which also tie the worker’s pension to future earnings. See Disney and Whitehouse (1994, 1996) and Bodie, Marcus and
Merton (1988). 14 Constantinides, Donaldson and Mehra (1998) suggest that liquidity constraints prevent younger workers from investing as much as they should in equities. This behaviour in turn may help explain the ‘equity premium’ or the excess
risk-adjusted return observed on equities compared with short-term government bonds. A defined-contribution pension
could alleviate this problem, if workers have some control over their portfolio. See also Blanchard (1993), Jagannathan and
Kocherlakota. (1996) and Mehra and Prescott (1985).
liquid assets, such as equities, bonds or deposits. The ‘one-size-fits-all’ portfolio that results from
these restrictions means workers are unable to reap the benefits of diversification.
Finally, the structural constraints can behave as barriers to entry in the pension fund
industry, limiting competition, and raising administrative costs. This, however, is a very
controversial effect, since industry competition and administrative costs is affected by many factors, like the size of the industry, the stage of development of capital markets, and the ability of
3.3 Issues in member choice of investments The structural constraint that has received most attention is the limit of one fund per
administrator. In order to ensure an adequate degree of matching between investor preferences and
the portfolio chosen by the funds, the solution would be to liberalise the investment market to give
employees choice over how their pension fund is invested.
The main counter-argument is one of cost and complexity. Dividing individual pension
contributions between different funds (even when they are offered by the same manager) and
transferring investments between funds on members’ request adds significantly to the
administrative burden. Providing information on different investment options and educating
workers about investment choice would also be expensive.
There is also the risk that workers make the ‘wrong’ choices. Many studies of member-
directed investment in 401(k) plans in the United States have found evidence for ‘reckless
conservatism’, with people investing the majority of their fund in low-risk, low-return
Figure 1 (and Table A.1 in the Appendix) show the allocation of 401(k) investments from a
large survey covering 18 per cent of 401(k) members.16 Overall, nearly 70 per cent of funds are
invested in equities, with 15 per cent in bond or money-market funds and 15 per cent in
15 Regulations protect plans and sponsoring employers from fiduciary responsibilities if members are allowed a sufficiently broad choice of investments with different risk and return characteristics. The vast majority of plans intend to
comply with these regulations, allowing members to choose investments (94 per cent of schemes covering 92 per cent of
members according to survey data: KPMG Peat Marwick, 1998). 16 VanDerhei et al. (1999). Earlier studies used much smaller data sets. These include Yaboboski and VanDerhei (1996), who looked at 180,000 members with three large employers. Goodfellow and Schieber (1997) analysed 36,000 participants
in 24 schemes. Other papers have investigated investment choices in the Thrift Savings Plan (a defined-contribution scheme
for federal employees) — Hinz, McCarthy and Turner (1997) — and in TIAA-CREF (a plan for teachers and college
professors) — Ameriks, King and Warshawsky (1997).
guaranteed investment contracts. The pattern with age seems prudent. Older workers tend to
reduce the proportion in equities and increase the allocation to bond and money-market funds and guaranteed investment contracts. These contracts, provided by insurance companies, provide for a
‘holding period’ during which a fixed rate of return is paid, guaranteed for the life of the contract.
Withdrawals can be made at book value to provide benefits.
There are, however, some important divergences from prudent investment. First, the large
allocation to the stock of the employer: 28 per cent of the total invested in equities or 19 per cent
of the total fund. A more diverse portfolio would be more sensible. Indeed, given individuals’
future employment and wages are already dependent on the performance of their employer, any
investment in the employer’s stock seems imprudent.
There is also evidence that a substantial minority are very conservative. Fifteen per cent of
people have no equity investments at all, even though balanced funds or their own employer’s
stock. Although this may be a rational strategy for people in their 60s (25 per cent of whom have
no equity investments), it certainly is not for people in their 20s (of whom 15 per cent avoid equity investments).
Figure 1. Asset allocation in member-directed 401(k) pension plans
investment in balanced funds is allocated 60 per cent to equities and 40 per cent to bonds, in line
with the Investment Company Institute’s data for the average balanced mutual fund Source: VanDerhei et al. (1999)
In all, however, it is likely that workers would benefit from some degree of choice, like the
two funds of the Polish system, where one fund is invested in a ‘balanced’ manner, and the other is more conservative. The need for at least two portfolios becomes more apparent when one looks
into the future. As the new pension systems mature, older workers that are close to their
retirement have a high preference for a conservative portfolio.
3.4 Empirical evidence of concentration in fund management Figure 2 shows the degree of concentration in the pension fund industry in Latin America
and, for comparison, in the liberalised fund management market of the United Kingdom. The
curves show the cumulative percentage of funds under management moving downwards from the
largest fund. (Appendix Table A.2 gives detailed data.)
The pattern in Latin America is remarkably similar, particularly between Chile and
Argentina. The largest firm in Argentina, Chile and Mexico accounts for around 20-25 per cent of
total assets, with the top three holding over half of funds, and the top five, around three-quarters.
The situation is similar in Colombia, Peru and Uruguay (not shown in the Figure), where the
largest three firms cover 60-75 per cent of total members.17 Bolivia has licensed only two funds.
The situation is very similar in Hungary, although 45 funds were licensed initially. The
three-firm concentration ratio for mandatory funds is 57 per cent, and the five-firm ratio, 71 per
cent. The voluntary pension sector is a little less concentrated. The three-firm ratio is 46 per cent
and the five-firm ratio, 66 per cent. These ratios are exactly the same for voluntary funds in the
The fund management industry in the United Kingdom is significantly less concentrated
than in Latin America. Prudential takes just 8 per cent of the market, with under a quarter of
funds for the top three and a little over a third for the top five. Even the top 15 only accounts
only for around three-quarters of funds. These funds include both individual’s personal pensions
and externally managed accounts for employer-provided pension plans. The largest employer fund
managing its own assets — Hermes, which runs the pension schemes for the Post Office and
British Telecommunications — would rank 15-20th.
Other sectors of the pension market in the United Kingdom are more concentrated.
Employer-provided plans where funds are managed externally rely mainly on just five fund
managers. A recent Pensions and Investments survey in the United States found a five-firm
concentration ratio of 20 per cent and a 20-firm ratio of 40 per cent, significantly below even the
United Kingdom figures of 36 and 72 per cent respectively.
In both Chile and Argentina, there has been substantial recent consolidation in the pension
funds industry. In 1994, there were 26 funds in Argentina, falling to 18 at the beginning of 1998 and 15 after three recent mergers (see the notes to the Appendix Table). In Chile, there were 21
funds in 1994, 13 at the beginning of 1998 and 10 now. Mexico has also experienced substantial
consolidation, despite the relative infancy of its private pension fund industry. The number of fund
managers has fallen from 17 in 1997 to 13 at present and some more mergers are expected soon. In
other Latin American countries, reforms were more recent and there were fewer funds initially (e.g.,
nine in Colombia, five in Peru, six in Uruguay, and two in Bolivia). Hence, it is not surprising that
there has been little consolidation in these counties. Consolidation has already begun in Hungary,
where the majority of the 45 funds are very small. Hungária has already absorbed five of the
smallest funds. Poland expects to have 10-12 funds after two years, although regulators expect to
An important policy question is to whether the concentration in reforming countries is due
to entry restrictions and structural regulations or is a natural consequence of the size of the market, the efficiency of capital markets, and the ability of workers to switch between fund managers. In
addition, the impact of concentration on industry competition, administrative costs, quality of
service and capital markets should be explored.
Figure 2. Concentration curves for fund managers in Latin America and the United Kingdom Source: Pension fund regulators in Latin America, HSBC James Capel for United Kingdom
Regulating performance Some countries — Chile, Argentina, Peru, Uruguay, and Colombia — require pension
funds to achieve rates of return above a prescribed minimum, typically related to the industry
average (Table 4). Argentina and Chile define their profitability band in relative terms: the
minimum of 2 percentage points and 50 per cent (Chile) or 70 per cent (Argentina) above or below
the average annual return of the industry18. The supervisory agency monitors compliance with the
minimum on a monthly basis. All fund managers have to establish a reserve fund with their own
capital (invested in the same way as the pension fund). If the reserve is insufficient to top up the
fund’s return to the minimum, the government guarantees the minimum.
In Peru the minimum return is calculated in the same way as Argentina and Chile, but is
not guaranteed by the government. There is no maximum return: the ceiling was eliminated in
November 1996. There are also plans to move to a rate-of-return rule based on performance over
five years. In Uruguay, the guarantee is expressed in both absolute and relative terms. The state-managed fund guarantees a minimum real return of 2 per cent a year, while private pension
managers have to create a guarantee fund (similar to the reserve fundin Argentina and Chile).
This fund is drawn down if the return falls below the average of the industry by more than 2
percentage points. There is also a limit on the maximum return that funds can earn. Because the
state managed fund — República — dominates the market average (56 per cent of total assets in
May 1998), other pension funds are also forced to reach the 2 per cent real return. In Colombia,
the minimum return is calculated as the arithmetic average of the return of the pension fund
industry over three years and the return over three years of a market portfolio19. No ceiling is
placed on the returns. The regulator checks compliance with the stipulated minimum return on a
Table 4. Pension fund performance regulations and government guarantees in Latin America
18 Chile is considering changing the application of the rule to a 36-month rolling basis. 19 From 1 July 1995, the composition of the market portfolio is (percentage of total pension industry assets invested in shares x 90 per cent of the average rate of return of the three stock exchanges in the country) + (percentage of total industry assets not invested in shares x 95 per cent of rate of return of a fixed-income index). As of June 1998, only 5 per cent of
industry assets were invested in equities, so the market portfolio is mainly a fixed-income index.
Maximum removed in Peru in November 1996. Minimum legislated but regulations not yet issued
Poland will place a lower limit of 50 per cent of the pension funds’ average returns or four
percentage points below the average. There will not be an upper limit. Hungary regulates the
pension funds’ performance relative to benchmark indices.20
Unlike asset restrictions, performance regulation is rare outside the privatised Latin
American pension systems. In Brazil, non-occupational private pensions must deliver a minimum
real return of 6 per cent. In Singapore and Switzerland, minimum nominal returns of 4 and 2½ per
cent respectively are imposed. But these are all absolute not relative limits, and are likely to be more damaging, since they encourage fixed-income investments, particularly when the guarantee
4.1 Rationale Performance regulation is normally encountered in non-competitive industries, such as
utilities. Asset management, in contrast, is a competitive business and barriers to entry are fairly
low. Investors are typically able to diversify away fund manager risk by investing in various funds.
In the pension systems of Latin America, however, affiliates may only invest in a single fund
managed by a specific fund manager. Since investment in pension funds is mandatory, individuals
can neither avoid nor diversify away fund manager risk. In some countries, workers may not even
transfer between funds within a specified period, which can be as long as six months. Performance
rules ensure that the worker does not suffer from the exposure to this diversifiable, non-systematic
20 Chlon, Gora and Rutkowski (1998) and Palacios and Rocha (1998).
4.2 Adverse effects of performance regulation The main adverse effect of performance regulation is to exacerbate ‘herding’ behaviour
(Vittas, 1998b and Queisser, 1998a). Smaller fund managers behave like Stackelberg followers
(Tirole, 1988), choosing portfolios similar to the larger funds, which have a greater weight in the
industry average return. Free from intense rate-of-return competition, the larger funds have an
incentive to opt for lower risk-return assets, such as deposits and bonds.
Return ceilings (as in Argentina, Chile, El Salvador and Uruguay) generate moral hazard in
fund managers. At a given level of risk, there is no incentive to achieve a return above the ceiling
and so the optimal point in the portfolio efficiency frontier might not be reached. Since returns no
longer serve as a benchmark for comparing schemes, funds compete through advertising and
marketing campaigns. The costs are passed on to consumers in the form of higher commissions.
Portfolio homogeneity can be explained by other factors. First, the limit of one fund per
manager forces them all to have a similarly balanced portfolio. Secondly, illiquidity of markets
also encourages concentration of asset choice, as funds cannot easily take advantage of buying or selling opportunities. Thirdly, ‘yardstick’ competition, where managers measure their performance
relative to their competitors, is entrenched even in countries with liberal regimes. Fourthly, an
institution’s trading decisions have informational content, which can be observed by its
competitors and inferences drawn. Fifthly, fund managers tend to react in the same way to market
news (e.g., the issue of macroeconomic data). Finally, the prudent-person legislation seems to be
worded in a way that encourages herding. The United States rules say managers must invest “with
the care, skill, prudence and diligence under the circumstances then prevailing that a prudent
person, acting in a like capacity and familiar with such mattes would use in the conduct of an
enterprise of a like character and with like aims”. The Employee Retirement Income Security Act
of 1974 goes further than common law. It is not sufficient to be a careful amateur: managers must
act as a prudent professional, experienced and educated in financial matters.
Trustees of employer-provided pension plans surveyed in the United Kingdom reported
that they took four main factors into account when determining investment policy: historic returns
of different assets, the financial position of the scheme (the relationship between assets and
defined-benefit liabilities), the scheme’s maturity. Finally, and most important for our purposes,
trustees said they took into account the asset allocation of other schemes. Indeed, the majority
said they remained close to the average portfolios measured by WM (World Markets) or Combined
Actuarial Performance Services (CAPS).21
However, compared with countries with prudent-person regulations, the degree of
similarity in Latin American portfolios is much greater. Workers end up with practically identical
portfolios, whichever their choice of manager.
4.3 Empirical evidence of herding Herding has become almost a defining characteristic of the pension fund industry in Latin
America. Table 5 shows the mean and standard deviations of portfolio weightings of different
assets in Chile. In equities, for example, the mean share of the portfolio is 29.4 per cent and the
Table 5. The herding effect in Chile
The principal effect of herding is to generate very similar returns between different funds.
Table 6 summarises the correlation in returns across pension funds in Argentina, Chile and Peru
from the inception of their systems until May 1998. The average correlation between pairs of
funds is exceptionally high: 0.98 in Chile, 0.93 in Peru and 0.87 in Argentina. Since these
countries have the most flexible regimes, the figures for the other countries are unlikely to be very
21 Pratten and Satchell (1998). See also Bunt, Winterbotham and Williams (1998).
Table 6. Correlation of pension fund returns
Based on annualised monthly returns. Includes only
companies operating throughout the period Source: Authors’ calculations based on data from Superintendencias de Administradoras de Fondos de Pensiones.
Studies of other countries include Lakonishok et al. (1991) on the United States and Blake,
Lehman and Timmerman (1997) on the United Kingdom. Pension funds in the United States
invest mainly in the equities of large companies: they own 25 per cent of the stockmarket as a
whole, but 55 per cent of the largest 100 companies.22
4.4 Performance regulation and herding The link between performance regulation and herding is controversial. Ramirez Tomic
(1997) found that herding by Chilean pension funds had (perversely) decreased slightly after the
fluctuation band around the minimum rate of return was narrowed. Valdés-Prieto and Ramirez
(1999) revised Ramirez Tomic’s figures, showing that the width of the band caused a statistically
significant but very small increase in the degree of herding among Chilean pension funds.
To investigate the impact of return ceiling on herding, we take a closer look at the case of
Peru, which eliminated its upper band in November 1996. Until then, the constraint on the return
was 50 per cent above or below the industry average. The removal of the upper limit might be
expected to lead to greater dispersion of investment across asset classes, as a wider range of risks
can now be taken. However, Table 7 shows that the opposite occurred. After the regulation
changed, the squared deviations from the industry averages for the largest asset classes, such as
equities and government bonds, fell. This suggests that removing upper limits on performance
does not provide adequate incentive for taking greater risks than the industry average. A more
definitive analysis will be possible when data from countries without portfolio limits, such as
Table 7. Peru: Average pension fund portfolio and standard deviation, 1995-8
Data are squared deviation from quarterly industry average,
averaged over the periods (March 1995-March 1996) and March 1997-March 1998) and square-rooted. Source: Authors’ calculations based on data from Superintendencia de Administrados de Fondos de Pensiones
It is possible that other regulations (such as the limit of one fund per manager) and the
structure of capital markets (for example, the supply of liquid investments) are more important
than performance regulation in explaining herding and the lack of portfolio diversity. What is
certain is that performance regulations have reduced — and indeed almost eliminated — the risk
of below industry-average performance by specific fund managers to the point where all workers
obtain a similar return, irrespective of their choice of pension fund. The result is that there is no
real choice between different asset managers, and no performance reason for transferring between
Despite this, transfers in many reforming countries have been running at very high rates. In
Chile, for example, 29 per cent of members transferred in 1997. In Argentina, regulations designed
to reduce transfers have been introduced, which cut the annualised transfer rate from 18 per cent
in December 1997 to 5 per cent in January 1998. Since then, however, the rate has increased
again, but only to 7½ per cent. Chile is currently looking at reducing transfers by allowing funds to
cut charges for long stayers. Poland has adopted such a policy as a way of limiting transfers. With
little difference in portfolios between funds, this transfer process is, at least in part, wasteful. And
the marketing costs of wooing and keeping new members, including, in Chile, now-banned
practices such as gifts and promotions, an indication of the degree of waste. Sweden is to adopt a
‘clearing-house’ system to try and limit direct marketing. Contributions will be collected centrally
and allocated to chosen fund managers, but the managers will not know the identity of their
members. This will not, however, preclude indirect marketing and promotional expenditure.
Regulating asset allocation Pension fund investments in all countries in Latin America are tightly controlled. Almost
all countries’ regulations include five types of limits
• by asset class (a ceiling on the proportion of specific assets classes in a fund’s portfolio);
• by concentration of ownership (a ceiling on the proportion of the issue of a company that a
• by issuer (a ceiling on the proportion of assets in a fund’s portfolio issued by the same
• by security (a ceiling on the proportion of individual securities in a fund’s portfolio);
• by risk (a minimum acceptable risk rating of securities).
The last four types of controls are a form of prudential regulation, similar to those of other
institutional investors, like mutual funds. All countries impose restrictions on concentration by
ownership, by issuer and by security.23 In addition, most reforming countries have restricted the
securities eligible for investment to those that have been risk rated. In Chile, the minimum
acceptable risk category for fixed-income securities is BBB or equivalent. The law requires all
investments — not just fixed-income securities — to be rated. This rating system for stocks has
meant that only 30, mainly blue chip companies, out of a total of approximately 300 listed were
eligible for pension fund investment until 1997. The new capital market reform bill, approved in
1997, extended coverage to more than 200 companies with smaller capitalisation and to other
financial instruments, such as project financing, securitised bonds and venture capital.
Concentration of ownership is limited in Chile through ceilings on the proportion of a
firm’s bond or share issue that any fund can hold, currently 20 and 7 per cent respectively.
Minimum diversification requirements are also imposed, limiting funds to 7 per cent of fixed-
income securities and 5 per cent of shares from the same issuer. To avoid conflicts of interest, the
limits are set lower for issuers that have financial interests in the pension fund managing
companies. There are similar prudential rules elsewhere.
23 Exceptions include the large balances invested by 401(k) participants in the United States in their employer’s stock (see Table 2 above). Reserve funding systems, such as those in Germany, Japan and Luxembourg are equivalent to investing all
of the fund in the sponsoring employer’s equity.
In addition to these prudential rules, some countries also impose direct constraints on asset
allocation. Countries tend to take two approaches to regulation of asset allocation, which Vittas (1996) describes as ‘Draconian’ and ‘relaxed’. The latter refers to countries that apply the
‘prudent-person’ principle as described in section 4.2. (Countries with few or no restrictions on
investments are listed at the top of Appendix Table A.3.)24
Secondly, countries which impose limits, usually either a minimum investment in public
bonds (between 15 and 50 per cent of total assets) or a maximum in equities (between 20 and 30
per cent of total assets), including Denmark, France, Germany, Japan, Norway, Portugal and
Other countries have quantitative limits on investments in particular assets or asset
classes. (These are listed countries in the lower panel of Appendix Table A.3.) For example,
around half of OECD countries have limits on foreign investments, averaging around 16 per cent
of total funds (Figure 3). Belgium, Denmark, Portugal and France impose a minimum investment
in bonds (Figure 4). Six countries limit equity holdings (Figure 4, again) and eight, investment in property.
Figure 3. Limits on foreign investments in OECD countries Source: Laboul (1992), Davis (1998), EFRP (1996), Watson Wyatt (1997), Chlon, Gora and Rutkowski (1998)
24 See Blommenstein (1998), Davis (1995) and OECD (1998), chapter V.
Figure 4. Limits on domestic investments in OECD countries Source: Laboul (1992), Davis (1998), EFRP (1996), Watson Wyatt (1997)
The portfolio restrictions imposed by regulators in May 1998 in seven Latin American
countries are summarised in Figure 5 and shown in detail in Appendix Table A.4. In some countries, although legislation allows a more liberal investment regime, regulators have imposed
tighter restrictions. In Chile and Bolivia, the law establishes a band for the ceiling by asset class.
The regulator must then fix the ceiling within the value of the band. In Argentina, the law only
sets out portfolio maxima. For example, the ceiling on equities is 50 per cent by law, but the
regulator permits only 35 per cent of the fund to be invested in this asset class.
All countries have tight portfolio limits, but the most flexible systems currently are Chile,
Argentina, Colombia, and Peru (probably in that order). They are the only countries that permit
equity and foreign investment (the highest limit on shares is Peru’s of 40 per cent, and on foreign
assets, Chile’s of 12 per cent). In Bolivia, although the legislated limits on shares and foreign
assets have been set at relatively high levels (50-90 and 10-50 per cent, respectively), funds have
to invest a minimum amount in government bonds. In the first few months of the system, this was
set at $180m per annum, only just below the actual flow of funds into the funds. In general, the
limits encourage government debt holdings at the expense of equity and foreign assets.
Figure 5. Pension fund portfolio limits, 1998
Uruguay and Mexico have the most restrictive regimes, although, as in Bolivia, they are
supposed to be only temporary. In Uruguay, pension funds are subject to both minimum and
maximum limits on investments in government securities. The band is expressed as a percentage of
the portfolio, and there is a phased program in which the band is to fall from 80-100 per cent in
1996 to 40-60 per cent in 2000. The laws allow the amount above the band to be invested in any
security, but only time deposits have so far been approved. In Mexico, the regulator has so far only
approved fixed-income instruments (largely government securities).25
Investment guidelines for pension funds have tended to become more liberal over time,
permitting and extending investments in equities, foreign assets and less liquid assets, such as real
estate and venture capital. The development of the regime in Chile, which has the longest
experience, is shown in Figure 6. (Details are in Appendix Table A.5.)
In general, the domestic investment regime currently in place in Chile, Argentina, Peru,
Colombia and the new regime to be implemented in Poland is more liberal than in most of the
OECD countries with statutory portfolio limits. On the other hand, these same OECD countries
allow a higher share of the portfolio to be invested in foreign securities, and some also permit
direct investment in property and lending to affiliates (at least employer pension plans).
25 The Mexican pensions law also requires that funds must invest in securities that encourage national productive activity,
create infrastructure, generate employment, housing investment, and regional development (article 43).
Figure 6. Evolution of portfolio limits in Chile, 1982-1998 limit, per cent of portfolio Source: Superintendencia de Administradoras de Fondos de Pensiones
5.1 Rationale of asset allocation regulations Two common arguments for controls on international investment26 are first, that they limit
volatile capital flows and hence achieve monetary sovereignty and macro-economic stability
(Fontaine, 1997) and secondly, that they reduce capital flight and deepen domestic financial
markets (Reisen, 1997). These are problems that are particularly relevant for developing countries,
which would explain why in general the ceiling on investment in foreign securities is lower in these
Five main arguments have been used to justify domestic portfolio limits
• lack of experience in fund management and, in particular, the absence of adequate risk
assessment models mean pension funds take ‘excessive’ risks
• capital markets lack liquidity and transparency
• fragile financial markets might jeopardise the sustainability of the pension reform
• limiting the fund’s overall risk can alleviate the moral-hazard problem caused by government
• the transition cost to a funded pension system may be prohibitively high for countries with
large explicit debt burdens and so can be eased by requiring investment in government bonds
As with restrictions on industry structure, asset-allocation limits are a way of isolating
pension assets from agency and systemic risks in capital markets. The prudent-person rule may
not be viable where capital-market infrastructure is underdeveloped and prudential controls are not properly in place.
Theoretical models, such as that of Corsetti and Schmidt-Hebbel (1996), support the
government-debt argument to an extent. But they provide a case for floors on investment in
government securities, not for ceilings. If the new pension funds were unwilling to hold the
explicit debt burden created by the transition from pay-as-you-go to funded financing of pensions,
interest rates would rise. This would, in turn, worsen government finances and crowd out private
All of these arguments apply only temporarily. Over time, the efficiency and effectiveness
of fund managers should improve with experience and as prudential standards are adopted and the
costs of the transition amortised. Regimes should therefore be relaxed over time and, eventually,
5.2 Adverse effects of asset allocation regulations Limits on asset classes have three main adverse effects:
• constraints on portfolio diversification create systematic market risk, meaning that higher
returns can only be achieved at higher relative risk
• pension funds are more likely to control large shares of the markets in which they can invest,
• capital market development might be hindered
Modern portfolio theory provides the most critical perspective on portfolio limits. Shah
(1997) uses a capital-asset-pricing model to show that asset restrictions hamper the ability of fund
managers to earn the highest possible risk-adjusted return. Returns as high those in an
unconstrained system can only be reached with greater risk. Or, for a given degree of risk, retirement income will be lower. This argument is particularly relevant for developing countries,
because the range of investment products is typically very limited when the new pension system
was set-up. Further restricting portfolios can therefore have adverse consequence on the degree of risk diversification that can be achieved.
Market power (the second adverse effect) has become more of a problem as systems
develop. Figure 7 shows the percentage of the stockmarket owned by pension funds in a selection of OECD and Latin American countries. Chile comes top among Latin American countries, with
11 per cent of equities owned by pension funds. Pension funds account for a third of stocks in the
United Kingdom, and a quarter in the United States. In the Netherlands, although pension funds
are very large, only a quarter is invested in shares (compared with over three-quarters in the United
Kingdom, for example). In contrast, Belgian funds’ portfolio is the most heavily weighted in
equities after Ireland and the United Kingdom, but the pension funds overall assets are relatively
small. In other countries, both the funds’ assets and their equity proportions are small.
The concentration of equity ownership in pension funds’ hands raises a number of issues.
First, liquidity problems. Coupled with the herding effect of performance regulation (see above), when shifts in asset allocation involve the majority of pension funds buying or selling at the same
time, market prices can shift strongly (in an adverse direction). When the Chilean investment
regime was partially liberalised in 1985, pension funds found it difficult to close their fixed-income
positions without adversely affecting prices. Pension funds moved only gradually from fixed-
income instruments into stocks.28 As a result, asset allocations become ossified, and changed only
slowly in response to liberalisation of the investment regime. Walker (1993a, 1993b) looks at
differences in risk-adjusted returns between Chilean funds and finds that smaller funds’ variable
income portfolios perform better than those of larger ones. He attributes this to the 7-per-cent
limit of each company’s shares that funds can hold. In fixed-income portfolios, he finds no
A second important issue arising from the concentration of ownership is corporate
governance: whether pension funds make effective owners of stocks. This has been hotly debated
in the United Kingdom and the United States, where strong movements for ‘shareholder activism’;
27 See also Holzmann (1998b) on the issue of debt financing of the transition to a funded system. 28 The jump in the share of the proportion allocated to equities between 1990 and 1991 (from 11 to 24 per cent) is largely
due to an extraordinary stock market real return of nearly 90 per cent that year.
Figure 7. Pension funds’ equity holdings as a percentage of total stockmarket capitalisation, 1997 pension fund holdings, per cent of stockmarket Source: De Ryck (1998); pension fund regulators
5.3 Empirical evidence of portfolio limits and asset allocations
Asset allocation varies widely across countries. Appendix Table A.6 compares the
portfolios of five Latin American countries with a range of OECD countries and two from Asia.
Figure 8 focuses on the proportion invested in equities. With the exception of Mexico and
Uruguay, the Latin American countries all invest above the average (24 per cent) proportion in
equities. The highest proportion of funds are invested in equities in the English-speaking
countries. In Australia, Ireland, the United Kingdom and the United States, the average equity
holding is 60 per cent of the fund. At the other end of the scale are Mexico and Uruguay, which
have only recently reformed their systems, Singapore, where the provident fund invests mainly in
bonds, and a number of continental European countries. The first contributions have only just
begun to flow into Hungarian pension funds, so most of the assets are currently invested in short-
Figure 8. Equity investments as a percentage of total pension-fund portfolios equities, per cent of total portfolio Source: De Ryck (1998), Mariscal (1998a,b,c,d), Asher (1998)
5.3.1. Latin American countries
Table 13 shows the structure of portfolios in Argentina, Chile and Peru in June 1997 along
with the legal maxima by type of instrument. For some instruments, restrictions have been
binding.29 Table 14 shows how the relaxation of portfolio restrictions in Chile over time has led to
29 Information refers to aggregate portfolios. Restrictions do not necessarily require the aggregated amount to coincide with
the legal upper limit. Also, individual funds usually establish lower-than-legal upper limits of their own, to avoid incurring
the costs of asset liquidation when changes in the portfolio are required. Another reason for lower-than-legal limits in
Argentina is that the supervisor values the funds, and, in exceptional cases, this may result in differences between official
prices and those assumed by the pension-fund managers.
changes in portfolio composition. Pension funds have taken advantage of the elimination of the
ban on investment in equities. By 1997, they had invested nearly one quarter of their portfolio in stocks. The lowering of the limit on mortgage investments (from 70 per cent of the portfolio in
1981 to 50 per cent in 1990) had the opposite effect. However, the dramatic reduction in their
portfolio share (from 51 per cent in 1983 to 17 per cent in 1997) is largely a consequence of a
supply constraint. In 1997, pension funds owned over one half of all mortgages.
The Table does not indicate the full extent of the impact of regulations on portfolio
allocation. Other regulatory controls, such as limits on the concentration of ownership, can create
a discrepancy between the effective limit to which the funds are subject and the one stipulated in
legislation. In Chile, for example, the 7-per-cent limit of a company’s shares that a pension fund
can own becomes binding for larger funds long before the overall equities limit of 37 per cent
(Walker, 1993b). Iglesias (1990) calculated that, because of the 7-per-cent constraint, the
effective limit on equities for the largest Chilean funds was around 14.8 per cent, compared with
the overall maximum of 30 per cent at that time.
Pension funds in Latin America have so far only dipped their toes in the water of
international markets. Foreign investment has been permitted in Chile since 1992, but only 1 per
cent of the portfolio is now invested overseas, mainly via mutual funds.
Table 13. Pension-fund portfolios and limits in Argentina, Chile and Peru
Table 14. Asset allocation of funds in Chile, 1981-97 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997Source: Superintendencia de Administrados de Fondos de Pensiones 5.3.2. OECD countries
Table 15 shows portfolios relative to limits for eight OECD countries with quantitative
investment restrictions (Table 8 above). In most cases, the limits again do not seem to be binding,
with the exception of the (soon to be abolished) equity limit in Japan and the (informal) equity
limit in the Netherlands. In effect, fund managers in, for example, Germany and Switzerland have
been far more conservative than the regulations would allow.
This is also the case in international investment. Even countries with no restrictions invest
very few assets abroad. In Belgium, Ireland and the United Kingdom this proportion exceeds 30
per cent. In the United States, the proportion is just 10 per cent. This effect is termed home bias,
and there are a number of likely explanations.30
First, overseas investments imply additional exchange-rate, settlement and liquidity risks.
While it is possible to hedge such risks, this can be costly and, as recent experience has shown, can
be difficult in periods of extreme volatility, lack of liquidity or where historic relationships between
markets break down. Secondly, pension funds’ liabilities are almost wholly domestic, so it seems
prudent to match them mainly with domestic assets. Thirdly, the type of benchmark or yardstick
orientation of fund managers outlined in section 5.1 may play a role. Fourthly, the world market
portfolio, as suggested for pension-fund investment by Kotlikoff (1994), may not be optimal if
markets are inefficient.31 Moreover, there is also evidence that adverse, downward movements in
world markets are more correlated than upward.32 Finally, some have argued that increased
30 See Adler and Jorion (1992), French and Poterba (1991), Solnik (1991), Nowakowskic and Ralli (1987) and Candia (1998). 31 Beltratti (1998) and Huel and Cozzini (1990). 32 Solnik, Boucle and Le Fur (1996).
integration of global capital markets mean that the benefits of diversification are decreasing.33 The
correlation of returns between a broad United States equity index (the Standard and Poors 500) and returns in emerging markets was 0.41 in the period 1990-95, compared with 0.27 in 1975-95.34
A similar effect can be observed between the United States and Latin American markets: the
correlations were 0.38 in 1990-95 and 0.24 in 1975-95. Investment returns among the major
industrial economies are stronger: between Germany, the United Kingdom and the United States,
the correlations are between 0.54 and 0.62. One exception is Japan: the correlation with return s
in the United Kingdom and the United States is around 0.05.35
Table 15. Portfolios relative to regulations in eight OECD countries
5.4 Empirical evidence of pension fund returns
In section 4.2 above we established that individual pension funds in Latin America perform
very close to the industry average. We now assess performance of pension funds relative to
Funded pension systems of the type introduced in Latin America impose considerable
fiduciary duties on governments. First, because government mandates contributions. Secondly,
because governments set investment allocation limits, and empirical evidence suggests that 90 per
cent of individual funds’ returns in Latin America can be explained by the investment regime, with
only 10 per cent attributable to investment managers’ performance.
In this section, we compare pension fund investment performance with various market
benchmark indices. While market benchmark comparison is common in the pension fund industry
33 Kessler (1996), Blommenstien (1998) and OECD (1998). 34 Source: ICFA. 35 Holzmann (1998a), Table A.2.
in developed countries (especially in defined-benefit schemes), they are as yet rare in Latin
America. Absolute returns are often quoted to demonstrate the ‘success’ of the new systems but returns can only be judged against alternatives. The Colombian supervisory agency has established
its own market index that makes up half of the stipulated pension fund return. In Bolivia, the
contract between the government and the pension funds requires a benchmark to be established,
and permits funds would to raise commissions by 10 per cent if they reach the benchmark. But the
government has not so far decided what the benchmark should be.
Table 16 evaluates performance in Chile, Argentina, and Peru against domestic market
indices (to May 1998). The IFC index of equity returns comprises 60 per cent of the balanced
portfolio, with 40 per cent from an index of bond returns. The Table gives the average annual real
returns before fees and the standard deviation of returns, a simple measure of volatility.
Pension funds only appear to have performed better than the benchmark in Argentina.
However, it is important to note that around 25 per cent of the assets of Argentine pension funds
are in an ‘investment account’. This account, created after the Mexican peso devaluation in 1994,
allows funds to avoid marking to market fixed income securities that lost significant value during
the crisis. Hence, ‘return’ figures for the Argentine pension fund industry should be interpreted
with caution, since they are likely to be significantly overstated.
Pension fund returns in Peru were only half the return of the balanced portfolio and three-
quarters in Chile. However, the volatility of pension fund returns was much less than the variance
in the balanced portfolio in all three countries. It must be remembered, however, that these three
are the countries with the most liberal investment regimes. In countries with more stringent
regimes pension funds can be expected to have performed relatively worse36.
36 An adequate evaluation of performance in countries like Bolivia, Uruguay, and Mexico cannot be carried out, however, because the time period is too short.
Table 16. Returns on pension funds and balanced portfolios: Latin America
Balanced domestic portfolio is 40 per cent bonds, 60 per cent equities. Standard
deviation in parentheses Source: Pension Fund Regulators, National Securities Commission, Central Banks, IFC
5.4.2 OECD countries: cross-national comparisons
Earlier in this section, we showed that OECD countries’ policies can broadly be divided
between those with prudent-person rules and those with asset limits. Comparing pension fund
performance between the two groups of countries can provide some useful evidence on the effect
Figure 9 gives data for ten countries. Four — Australia, Ireland, the Netherlands, the
United Kingdom and the United States — have systems best described as prudent person. The other six have some form of portfolio regulation (although the degree, of course, varies). The bars
show actual returns for pension funds, the lines, the returns on a balanced portfolio (50 per cent
bonds, 50 per cent equities). Table A.7 in the Appendix gives more details, and some data for
On the surface, the prudent-person countries perform significantly better, earning 9½ per
cent a year, compared with 6½-7 per cent a year in the countries with asset limits. But this
analysis is rather superficial for a number of reasons. First, it ignores risk. Funds in prudent-
person countries have larger equity portfolios. Davis (1998) constructs a synthetic rate of return
for pension funds over the period 1967-90. He couples data on the portfolio structure of funds in
different countries with aggregate indices of the return on different asset classes to estimate
pension funds returns. (Actual returns of pension funds will differ from this synthetic return.)
Over this period, the standard deviation of returns in prudent-person countries was 11.1,
compared with 8.1 in asset-limits countries. Thus, some of the higher return is bought at the price
of higher volatility. Secondly, there may be many other correlated factors that explain the
difference in returns between the two groups of countries, including other types of regulations,
macroeconomic policies, taxation, structural factors etc. But the lines on the Figure, however,
show that market returns on a balanced portfolio were somewhat lower in prudent-person
countries. Thus, it was pension-fund rather than market performance that differs between the two
Figure 9. Returns on pension funds and balanced portfolios: OECD countries Prudent person balanced portfolio Asset limits Source: OECD (1998), Tables V.2 and V.3, based on EFRP (1996), Pragma Consulting, Davis (1998)
5.4.3 United Kingdom and United States
Section 5.3.1 showed the rate of return to pension funds in Latin America relative to
market returns. A comparable analysis for the United Kingdom and the United States, both of
which have prudent-person rules rather than asset limits, is instructive. Lakonishok, Shleifer and
Vishny (1992) investigated the performance of defined-benefit pension funds relative to the
Standard & Poors 500 over the period 1983-89. Weighting each funds return equally, the average
return fell 1.3 percentage points below the index return of 19 per cent. Weighting funds by value,
the under-performance was 2.6 percentage points. Over the same period, other institutional
investors, such as mutual funds, outperformed the market. Since there are no asset limits, this
under-performance should arise from some other structural factors such as market failure.
A similar analysis for the United Kingdom shows marginal underperformance of pension
funds’ investments in domestic equities of around 0.3 percentage points over the period 1981-91.37
37 Dilnot et al. (1994), section 5.4 and Figure 5.4, based on data from Combined Actuarial Performance Services (1993).
Government bond investments also performed at about the market average. The only significant
underperformance was in investments in overseas equities, which were three percentage points below market indices, reflecting a conservative strategy with foreign investments.
The lesson of these analyses is that it is too simplistic to attribute the whole of
underperformance to investment regulations. Even in countries with prudent-person rules, there is some evidence that pension funds do not achieve market levels of returns.
Conclusions and policy implications Along with housing, pensions will be the largest asset most workers (at least in developing
economies) own. Governments that have mandated pension contributions have a fiduciary
responsibility and a financial interest (through implicit and explicit guarantees) in ensuring that this
important component of workers’ savings provides the best possible returns. Governments have
used this responsibility to justify Draconian regulations of pension funds’ structure, performance,
The result of these regulations is that pension funds’ portfolios are very similar and their
returns practically indistinguishable. Such regulations provide little incentive for improved
efficiencies in investment management. They also fail to offer workers significant portfolio choice.
Although workers have their individual accounts, they have no real choice over how their
contributions are invested. They have little real responsibility for determining their own financial
future. A policy implication of the evidence presented in the paper is that investment regimes
should be liberalised to allow diversification. Funds should be able to compete in offering
different risk-return strategies, to allow workers with different degrees of risk aversion and at
different points in their lifecycle to choose different portfolios.
Restrictions when a reform is first introduced are probably necessary to bolster confidence
in the system. Much of the risk at this point comes not from market volatility, but from systemic
risk that could lead to the collapse of one or more of the private funds, or indeed, of the whole
system. If new financial intermediaries and the restriction of a single fund manager per investor
are deemed desirable, then performance regulations may also be required to ensure that investors
in mandatory systems are not exposed to fund manager risk that they cannot diversify away. The
key policy question then becomes how quickly should the system be liberalised? In Chile, which
pioneered this type of reform, the answer was probably fairly slowly. In countries that have
reformed more recently, the success of other countries’ models should allow for far more rapid
relaxation of investment restrictions. A medium-term goal should be to allow managers to offer
different types of funds. The long-term goal should be to move towards a ‘prudent-person’ rule. This kind of regulation also has its faults, but is still preferable to a long-term policy of
Governments have a responsibility to ensure that mandatory pension funds are managed
well. It is therefore not unnatural that developing countries with a history of poor performance of
financial institutions err on the side of caution. Draconian regulations are designed to protect
pension funds from fragile and underdeveloped financial systems, both in Latin America and in the
transition economies of Eastern Europe and Central Asia. These regulations are not cost free,
however, and it is critical that governments evaluate carefully the impact of the regulations they
impose, since they can undermine many of the objectives of pension reform.
Appendix. Detailed data tables
Table A.1. Asset allocation in member-directed 401(k) pension plans 28
investment in balanced funds is allocated 60 per cent to equities and 40 per cent to bonds, in line
with the Investment Company Institute’s data for the average balanced mutual fund Source: VanDerhei et al. (1999)
Table A.2. Concentration of fund managers in Latin America and the United Kingdom
Bancrecer/Dresdner 95.1 Prorenta/San Jose 96.1
Columns show the cumulative percentage of total funds under management. Figures for Argentina
includes three recently announced mergers (Consolidar/Fecunda, Origines/Claridad, Prorenta/San Jose), as does Chile (Provida/Union, Summa/Bansander, Magister/Qualitas) Source: Pension fund regulators in Latin America, HSBC James Capel for United Kingdom
Table A.3. Pension asset regulations in OECD countries Prudent person
no foreign investments by public-sector funds (e.g. civil servants and fishermen)
no limits (informal 30% limit on equities)
Asset limits
20% limit in other EU states (lower limit on property, higher on government bonds)
(AGIRC/ARRCO) minimum 34% in public bonds, 40% limit on property and 15% Treasury deposits (insured funds)
guidelines: 30% limit on EU equities, 25%
limit on non-EU equities, 6% on non-EU bonds
20% limit on domestically based mutual funds, which can invest abroad
limited to public bonds, deposits, property,
mortgages, investment funds (insured funds)
guidelines (being phased out): 30% limit on
30% limit on foreign assets; 10% limit in
equities, 20% property; minimum 50% bonds
20% limit on equities, 30% on private bonds
minimum 30% in public bonds, 50% limit on
20% limit on bank deposits or securities,
40% in listed equities, 15% in open-ended investment funds, 5% in closed-end funds, 15% in publicly traded municipal bonds, 5% in untraded bonds; property, commodity and derivatives investments prohibited
majority of investments in listed bonds and
30% total limit, 30% in foreign bonds, 25% in foreign equities, property 5%
Source: Laboul (1992), Davis (1998), EFRP (1996), Watson Wyatt (1997), Chlon, Gora and Rutkowski (1998) Note:
Table A.4. Pension fund portfolio limits, 1998 Argentina: The Nacion pension fund must invest between 20 and 50 per cent (or $300m) in
provincial and municipal bonds to finance regional projects. Colombia: a limit of 15 per cent is imposed on investment securitised instruments backed by non-admitted assets, real estate and infrastructure Source: Pension fund regulators
Table A.5. Evolution of portfolio limits in Chile, 1981-1998 Source: Superintendencia de Administradoras de Fondos de Pensiones
Table A.6. Pension fund portfolios, selected countries Source: De Ryck (1998), Mariscal (1998a,b,c,d), Asher (1998)
Table A.7. Returns on pension funds and balanced portfolios: OECD countries Prudent person Asset limits
Balanced domestic portfolio is 50 per cent bonds, 50 per cent
equities. Source: OECD (1998), Tables V.2 and V.3, based on EFRP (1996), Pragma Consulting, Davis (1998)
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