Wind of change: Pension reform could increase liquidity and aid market development

While the Superintendency of Banking, Insurance and Pension Funds (Superintendencia de Banca, Seguros y Administradoras de Fondos de Pensiones [AFP], SBS) has spent the past year implementing reforms aimed at increasing competition in the sector, fund managers are eager to see the second stage focusing on investment regulation.

Regulators have announced plans to reduce the restrictions that limit pension funds’ use of certain investment instruments. In particular, pension funds hope that the reforms bring further increases in the limits on foreign investment. This possibility has led analysts from the banking and finance sectors to consider the potential impact of these reforms on the domestic capital markets.

As economic performance has improved, the market for private pensions has proven to have much potential. Renzo Ricci, general manager of private pension fund AFP Prima, told financial magazine World Finance in March 2013 that pension reform has not only expanded the market by including more workers, such as the self-employed, but has allowed competition to flourish. Furthermore, Ricci said recent reforms have afforded investment managers increased flexibility, which was a clear improvement.

Key Segment

AFPs are among the most prominent investors in the Peruvian debt and equity markets, and any change in AFP investment regulations could create a ripple effect across the economy. For instance, a recent reform requiring freelance workers to affiliate with either the public pension fund or a private one will add 700,000 participants to the system, which should significantly boost fund liquidity in the next few years. The reforms described below are intended to provide lower costs, increase profitability and give AFPs greater flexibility in investing. The new regulations are set be adopted gradually and to come into full force in mid-2014.

In July 2013 the SBS issued a pre-draft regulation on registration of tools that streamline investment, for instruments for which the AFP will not need prior SBS authorisation. This applies to tools such as stocks, bonds and simple hedging derivatives. In these cases, the AFPs will have to meet their risk assessments internally and the SBS will review their decisions. More structured and complex instruments will still need approval, but if some complex instruments become well-known investment tools for the AFPs, the authorisation may no longer be needed. This first regulation would enter into force by 2014.

A proposal allowing more efficient use of derivatives by covering all of the AFPs’ portfolio risk is expected. Currently, derivatives can be acquired but only through individual instruments. In 2014 there may also be a review of investment limits that are seen as somewhat restrictive, standardising some limits and making them more flexible in general. Also in 2014 the SBS will regulate the delegation mandate so that AFPs will have the option to outsource to specialists or expert groups for certain types of investments, which will generate higher returns.

Foreign Investment

In July 2011 Congress approved a new legal limit for AFP foreign investment of 50% of funds under management. However, the operational limit, which is set by the Central Reserve Bank of Peru (Banco Central de Reserva del Perú, BCRP), was held at 30% until recently.

In April 2013 the BCRP increased the operational limit to 36%, a decision driven primarily by appreciation of the local currency, which rose 5.7% against the dollar in 2012. The BCRP’s hope is that increasing the foreign investment limit for AFPs would allow them to send the large inflow of dollars into the domestic market back out of the country. In a best-case scenario, the BCRP reasoned that the outflow of foreign currency would help stabilise the sol.

In reality, the increase in the operational limit, which will allow AFPs to invest an additional $750m abroad, is relatively small in magnitude. It is not clear that it will be enough to slow the sol’s appreciation, but AFP leaders argue that it is a step in the right direction. After gaining official entry into the Peruvian market in December 2012, managers at Habitat, a Chilean AFP, were vocal in their belief that the foreign investment limit for AFPs should be raised.

An increase in foreign investment opportunities could allow some AFPs to set themselves apart and ultimately provide better returns for affiliates. However, there are concerns that the AFPs’ high level of investment in the Lima Stock Exchange (Bolsa de Valores de Lima, BVL) and limits on foreign investment may have led to an artificial appreciation of stock values on the bourse. “Some asset pricing is based on real market conditions, but some of it may be artificial, due to restrictions on AFP investments,” Jose Luis Sarrio, partner at audit and advisory firm GrantThornton, told OBG. If the pricing is artificial, and allowing AFPs to invest more abroad leads them to lower their positions in the Peruvian market, there would logically be a decline in the local stock index.

Christian Laub, the president of the BVL and CEO of Credicorp Capital, thinks such an outcome is unlikely, and does not believe the AFPs will reduce their positions on the BVL to the extent that asset pricing would be dramatically affected. Furthermore, there is also a counteracting flow of funds from abroad into the country that could serve to balance any outflows from AFPs. Sarrio said that there is a lot of new outside investment coming into the Peruvian market, particularly from family offices. These inflows are likely to counterbalance AFP outflows, meaning that asset prices could remain relatively stable. Increasing foreign investment limits could also be a good thing for the local stock exchange if it generated more liquidity. As institutional investors, AFPs buy large portions of equity on the BVL and hold their positions for extended periods. This dries up liquidity on the exchange, which could be deterring investors from participating. In this regard, a restructuring of AFP investments in the BVL could make room for new investors and boost trading volumes.

New Regulations

In addition to increasing foreign investment limits, the AFP reform has also led to the creation of a new fund asset class for alternative investments, including private equity, real estate, infrastructure and hedge funds. Under this arrangement, AFPs will be able to invest up to 15% of the moderately aggressive Fund 2 and 20% of the aggressive Fund 3 in alternative instruments.

Aldo Ferrini, the deputy general manager at Integra, one of Peru’s largest AFPs, told OBG that at present, as a result of previous investment restrictions, only 5% of Integra’s funds under management are invested in private equity and real estate in Peru. Ferrini believes that there will be opportunities under the new regulations to increase investment in these areas, especially in real estate, given the strong demand for housing. The new alternative asset class will also serve as a boon to Peru’s budding private equity market, which is in search of investors. The AFP reform includes new wording that will allow AFPs to use derivatives with greater frequency, where previously they could use them only to hedge risk. Receiving permission to do this was difficult and in most cases, by the time the AFP was able to make its case to the SBS, the market conditions had changed and the opportunity was lost.

Under the new regulations, AFPs can use derivatives for “efficient portfolio management” in addition to hedging. According to Ferrini, this will allow AFPs to use derivatives to control interest rate risk, credit risk and some market risk. He gave examples of where derivatives could be used to generate profit for affiliates, with the caveat that AFPs avoid speculation such as naked option positions.

While at present there is relatively limited trading in derivatives in Peru, reforms allowing AFPs to use these instruments more aggressively and more often could help this segment to grow and mature.

Next Up

The next reform most likely to impact the domestic capital market is an attempt to allow mutual funds access to a greater variety of investment options. In February 2013 the Superintendency of the Securities Market (Superintendencia del Mercado de Valores, SMV) published a mutual fund reform proposal, with plans to collect comments through early September before making any necessary changes and creating a final document.

Similar to AFPs, the current proposal for mutual fund reform includes plans to increase foreign investment limits. It also proposes changes that will allow mutual funds to grow their distribution networks to reach investors outside of Lima and from various socioeconomic classes. Mutual funds play an increasingly important role in the local capital markets, with the number of investors in the sector rising by 21% in 2012 and funds under management up to $7.2bn.

Expectations

Overall, analysts do not anticipate the reforms will have a major impact on the pricing of debt and equity traded on the BVL. Depending on how the AFPs and mutual funds respond to an increase in limits on foreign investments, changes in regulation could help generate greater liquidity on the exchange, making it more attractive for investment. Furthermore, a change in the AFP regulations that limit investment in alternative instruments and derivatives could allow for greater capital market development. This is particularly the case for derivatives and private equity, two segments in the market that are small but show great growth potential.

The BCRP seems likely to allow further increases in the foreign investment limit before 2014, with Ferrini predicting that the limit will rise by 5% in 2013. Alejandro Rabanal, the head of equity research for Peru at Credicorp Capital, said the SBS normally prefers AFPs to use funds generated from local affiliates to invest in local development. However, the sol’s appreciation, coupled with mounting pressure from AFPs to allow more flexible fund management, may push the BCRP and the SBS change tack.

New Turn

In September 2013 the country had its first pension insurance tender under the new joint risk management system and four firms – Peru’s Rimac, US insurance group Ohio National, and Chilean insurers Rigel and Vida Cámara – emerged as winners. The four companies now have the right to provide death, disability and funeral coverage to AFPs. Clients will be charged 1.23% of their monthly salaries, a 3.2% decrease from the current average, but still below the 15% reduction SBS expected.

Other Opportunities

In November 2013 local press reported that the country’s private pension funds were looking to invest in more infrastructure projects. Jose Antonio Roca, the chief investment officer of AFP Prima, said that the five pension funds currently operating in Peru – which together manage a fund of $34bn – are considering increasing a separate infrastructure fund of $82m managed by investment firm Sigma Capital to $300m.

Additionally, a $420m infrastructure fund established by the AFPs and managed by Brookfield Asset Management and AC Capitales may also be expanded. To date, the fund has invested $300m in bonds sold to fund the Huascacocha and La Taboada water treatment plants, as well as bonds being sold by Lima Municipality to finance the construction of the Vía Parque Rímac highway.

Between 2002 and October 2013, ProInversión, the government’s investment promotion agency, has tendered $4.8bn worth of transport concessions and $5.8bn worth of energy projects. The Lima Municipality is attempting to raise $750m for its Rutas de Lima highway project. Housing also provides an attractive option, and AFP Prima has already invested in a 600-apartment housing project in Lima’s Villa El Salvador district. While the lack of financial instruments is a concern, for the moment infrastructure projects appear to be filling in the gap as they are both profitable and have a positive social impact.