Process of reform: Regulatory changes are reshaping the pension fund industry

Arguably one of the most important regulatory reforms to take place recently, the privately managed pension fund system reform was passed by Congress in May 2012. The reform can be divided into two stages with different objectives. The first stage, which was implemented in 2012, focused on increasing competition among private fund administrators (Administradoras de Fondos de Pensiones, AFP), lowering administration fees for affiliates. The second stage concentrates on expanding AFP investment opportunities with the goal of increasing pension funds’ returns (see Economy chapter). With the first stage of the reform finished, the results are already becoming visible.

Major Players

Traditionally, the AFP system has been highly concentrated in the hands of two companies – Prima and Integra. As of August 2013, Prima and Integra accounted for more than 60% of funds under management, divided equally between the two firms. Spanish banking group BBVA’s Horizonte, Canadian bank Scotiabank’s Profuturo and, following therefrom, AFP Habitat of Chile, accounted for the remaining market share. As of August 2013, the acquisition of BBVA’s Horizonte by Profuturo and Integra was complete.

The first step towards increasing competition and lowering commission fees charged to affiliates came in September 2012, when the Superintendence of Banking, Insurance and Pension Funds (Superintendencia de Banca, Seguros y AFP, SBS) conducted a bidding process in which the AFP that offered the lowest administration fee became entitled to the business of all new affiliates entering the private pension fund system from late September 2012 to the end of the year. Only active pension funds at the time were allowed to participate. Prima AFP won the bid by offering a commission of 1.6%, lower than the 1.74% offered by Integra and the rates offered by the other two smaller AFPs. The AFPs that did not win were obligated to apply the fees they bid thereafter to their respective affiliate accounts.

In December 2012 SBS conducted its first open auction of all new affiliates aimed at attracting a new AFP. Six AFPs participated in the auction, including two new competitors – AFP Habitat and Interactiva, a subsidiary of Intercorp, a Peruvian financial services firm.

AFP Habitat won the bid, offering a commission of 0.47% on affiliates’ remunerations (account flows) and 1.25% on affiliates’ account balances, with an average commission of 0.548%. The other AFPs in the system are not required to implement the fees that they bid in the auction, as was the case in the first round of bidding in September 2012.

Effects

AFP Habitat’s win entitles the firm to all new affiliates entering the private pension fund system from its scheduled commencement of operations in June 2013 until December 2014. A report by local business publication Gestión estimates that Habitat should receive 700,000 affiliates over the next two years.

The pressure is now on AFP Habitat to perform. Michel Canta, deputy superintendent of private pension funds and insurance companies at SBS, told OBG that new AFP Habitat affiliates would have the option of switching to another AFP after six months if AFP Habitat’s net returns turn out to be lower than those of any other AFP within the system.

Meanwhile, Aldo Ferrini, the deputy general manager at AFP Integra, told OBG that the four original AFP players would rely only on organic growth. “The growth of our revenues will be defined by the salary of our current clients and some improvements in formal employment,” Ferrini said. “Integra has approximately 1.2m affiliates, only half of whom make contributions to their accounts. If there are more formal jobs, probably more of these affiliates will start to make contributions, but this will only create marginal growth. The main source of growth for the pension fund system is new affiliates,” Ferrini added. Given that the goals of this first stage of the reform were to lower commissions and increase competition, it seems that the regulators’ mission was largely accomplished. “There is one new competitor in the sector, so we can say that the objectives of the reform were achieved in this regard,” said Ferrini.

Commission Structure

In addition to lowering the commissions charged by AFPs, the first stage of the reform also focused on changing the commission structure. Previously, commissions were charged exclusively on account contributions, which were determined by an affiliate’s salary. Regulators wanted to change this system so that commissions would be charged on account balances. “An AFP that charges commissions based on account contributions is guaranteed a relatively stable flow of revenue every year regardless of market performance because their revenues are based on salaries not the returns they earn for investors,” Canta told OBG. “If we change the system so that AFPs charge a commission on affiliate account balances we align the incentives of the AFP with those of the affiliate. The AFP must earn better returns for clients in order to increase the size of their accounts and ultimately generate a stronger bottom line for the company.”

Reactions

At first, the proposal for a change in commission structure was met with criticism in several quarters, arguing it was illegal under the Peruvian law to use the funds deposited in AFPs for anything other than investments made on behalf of affiliates. In the end, this argument was not deemed valid to reverse the reform efforts. Ferrini stated that while the argument against charging funds on account balances is logical in the most literal sense, from “a spirit [of the law] point of view and what I believe should be common sense, I do not see anything wrong with charging commission on funds under management.”

AFP affiliates who formed part of the system prior to the bidding processes described above had until November 30, 2013 to decide whether they want to stay under the previous system, which charges a commission for account contributions, or convert to paying a commission for account balances.

At the time of writing, the AFP and the SBS had put a pop-up box on their homepages explaining how the two commission systems worked and how visitors should submit their selection. Any affiliates that do not specify which commission they prefer will automatically be converted to commission on account balance. As time progresses, this commission is set to be phased out as current affiliates reach retirement age.

Pension Reform & Insurance

In addition to the reforms outlined above, one element of the AFP reform will have a direct impact on insurance companies offering insurance to pension fund subscribers. In August 2013 SBS issued a resolution establishing a collective insurance policy to manage the risks of disability, survivors and funeral expenses of AFP members, and regulate the participation of insurance companies in the bidding process. Until September 2013, pension funds conducted annual bidding processes for insurers, selecting a winner that will provide survivor and permanent disability insurance to its respective AFP affiliates. Each AFP receives coverage for its entire portfolio of affiliates from one insurance company. Canta told OBG that the problem with this process is that on many occasions the insurance company that wins the bidding process for any given AFP is its sister company. These links between AFPs and insurance companies can distort prices for pension insurance and result in higher charges for AFP affiliates.

In effect as of October 1, 2013, the new collective insurance policy’s legal framework establishes a new model of pension insurance management to handle disability, survival and funeral expenses by insurance companies that win the tender. Concessions will be assigned to the bidder with the lowest price.

The framework also seeks to promote greater transparency, efficiency and competition through a bidding process whereby all the AFP members will be charged the same premium payment, which is to be determined in the auction by the average of the prices offered by the insurance companies winning the tender.

The first round of bidding took place in mid-September 2013 and was for about $250m in premiums per year. The winning insurance companies were local firm Rimac Internacional, Ohio National of the US, and Vida Cámara and Riegel of Chile, with an average charge of 1.23% for all members of the AFP. Additional tendering will take place over the period from October 2014 to December 2014. In addition to the four companies that have traditionally managed pension insurance, to date at least eight more firms have expressed interest in participating in the bidding process.

This shows firms’ interest in the pension insurance market, as well as new product design and structure. Ultimately, this system could encourage greater competition with a larger number of players and ensure that affiliates pay a fair market price for pension insurance.

Expectations

In addition to the changes in the pension fund segment described above, the second stage of the AFP reform aimed at expanding investment options will begin to be implemented in early 2014 (see Economy chapter). So far SBS’ actions have helped reduce commissions by an average of around 8% and have boosted the level of competition. Costs for affiliates are likely to see further reductions going forward with the pension insurance reform described above.