Toward Better Regulation of Private Pension Funds

This paper critically examines the typical model of investment regulation of private pension funds. The pension system reforms pioneered by Chile are being initiated or considered in many countries including Argentina, Colombia, Mexico, Peru, Bolivia, Costa Rica, Uruguay as well as China, Hungary, and elsewhere. These reforms greatly improve fiscal discipline, make social security burden and benefits equitable, and deepen financial markets. However, these reforms are also typically accompanied by very tight investment restrictions on pension fund portfolios, restriction of management of mandated retirement savings by newly created legal entities called pension administrators to the exclusion of all existing financial intermediaries such as banks and mutual funds, minimum return guarantees from the state and/or pension funds, and commissions based on salaries rather than assets managed. We show that while well-meaning, these restrictions are poorly justified by financial theory, distort incentives for competition based on product choice and efficiency, increase administrative costs, and seriously reduce appropriate risk-return choices and returns of the affiliates. The potential losses of retirement income are very large. These conclusions are illustrated with case studies of Chile and Peru. The paper recommends a significant departure from the Chilean-style private pension fund system model. It argues in favor of permitting diverse intermediaries -- including banks and mutual funds meeting appropriate prudential standards -- to manage retirement savings, greater choice of investment products, requirements of reporting returns on a net basis and charging commissions as a fraction of assets managed. The paper briefly describes implementation and transition issues for this alternative system.