Creating competition: Pension funds are set to undergo several changes to improve quality and efficiency

Pension fund reform has become a hot topic among leading fund administrators and lawmakers. As of May 2012, two government commissions, consisting of a technical team appointed by the executive branch and an economic commission that was formed by the Congress, were hard at work to develop a proposal for the restructuring of the pension fund system. The commissions are expected to present their proposals for debate in Congress by the end of July 2012.

PUBLIC & PRIVATE OPTIONS: In Peru, there are two separate pension fund systems – one public and one private. Private pension funds are a fairly young industry. Known locally by their Spanish acronym, AFPs were created in 1992. At present, there are four private funds. Prima AFP, which is affiliated with Banco de Cré dito del Perú, holds 30% of the market. AFP Integra, which was part of ING’s Latin American operations purchased by the Colombia-based GrupoSura in 2011, holds an additional 30% of the funds. The remaining market share is divided between BBVA’s Horizonte AFP (22%) and Scotiabank’s Profuturo AFP (15%).

Clients of the private system are provided with individual retirement accounts and given the option of investing in one of three funds – conservative, moderate or aggressive. Upon retirement, participants can expect to receive payouts in line with their contributions and fund performance. The public system consists of a single fund, known locally as the ONP. The ONP is a defined benefit system, similar to social security in the US and schemes in many other countries. Participants contribute to a general fund rather than to individual accounts and this fund is used for the pension payments of current retirees in what is known as a “pay-as-you-go” system. The payout received upon retirement is determined in accordance with contributions to the fund, years of work and age.

Every Peruvian engaged in formal employment has the right to choose between the public and private systems. Those who do not actively select a fund are automatically enrolled in the ONP. While the ONP has suffered from a long history of mismanagement and inefficiencies, which are also to be addressed as part of the reform movement, the bulk of reform proposals are directed at the private sector.

PRIVATE PENSION REFORMS: There are two main objectives of the private pension fund reform initiative. The first aim is to increase competition in what is presently a concentrated industry. The second is to increase coverage by bringing more Peruvians into the system. Lawmakers’ primary solution for extending coverage is to create more affordable plans by lowering the commission fees charged by AFPs.

As of January 2012, the average commission fee for AFPs was 1.92% on contributions, which are linked to participants’ salary. This figure has fallen over the years, down from 2.4% in the early 2000s. Still, lawmakers argue that it is not low enough and that by charging on the contribution flow, AFPs are discouraging clients from making regular contributions. One suggestion for modifying the system is for AFPs to charge commission based on the balance of an individual account as opposed to an individual’s contributions.

CHANGING CHARGES: To understand the rationale behind this solution, it is necessary to re-examine the origins of the AFPs. When they first began operating, AFPs charged commission on contributions as there was no money in the accounts upon which to apply charges, and the AFPs needed cash flow to support administrative costs. Lawmakers argue that now with more than $33.5bn in the system and 5m customers, the AFPs have overcome this hurdle and can now afford to charge commissions based on account balances.

In practice, there are two ways to implement this change. AFPs could charge commission on either the total account balance or on the investment returns accrued to an account. In either case, the benefit of such a system is that it aligns the interests of both the AFP and its customers. The AFP wants to make more money on commissions and customers want to grow their accounts. In this system, the AFP needs to use sound and profitable investment techniques to grow customers’ accounts and ultimately increase the firm’s bottom line. The downside with this system is that AFPs would earn very little in commissions from new clients with non-existent or low account balances.

BOOSTING COMPETITION: Lawmakers are also investigate opportunities for attracting new entrants as part of the reforms to increase competition. Sector leaders agree that this will be a difficult – if not impossible – task. Any firm entering the sector would need substantial funding to cover the start-up costs associated with building a business that essentially relies on scale. As any new AFP would start with zero account balances, the commission system proposed as part of the reform would necessarily imply years of heavy losses.

Finally, some members of the reform commissions have proposed creating a centralised sales point for AFPs, managed by a single non-profit organisation. Currently, each AFP operates its own commercial and sales department. The argument behind this initiative is that it would force AFPs to compete head-to-head, while freeing up time and energy for the firms to concentrate exclusively on improving fund performance.

PUBLIC PENSION REFORMS: Peru’s ONP suffers from a deficit similar in nature to pension systems in Europe or the US, though perhaps for different reasons. In the 1980s, the public pension fund system was essentially bankrupted by poor management. The deficit grew even deeper following the growth of the private pension system in the early 1990s, as the poor reputation of the ONP meant that many workers, particularly the highest-earning individuals, chose the AFPs.

Presently, there is simply not enough money in the public fund to provide decent retirement packages. Luis Galarretta, the president of the congressional economic commission working on the reform, and leaders from across the industry believe that in an ideal world, the ONP would be eliminated, forcing everyone to join an AFP, and thereby leaving the government to subsidise those individuals that receive insufficient payouts.

Despite the ONP’s inefficiencies, it is not likely to be eliminated, as doing so would amount to little more than political suicide for the lawmakers taking part in such a reform. The only country in Latin America that has managed to implement a reform of this nature was Chile, under the dictatorship of Augusto Pinochet. For now the ONP will continue with the status quo, as lawmakers around the world, not only in Peru, tackle the very same challenge of maintaining a defined benefit, pay-as-you-go public pension fund.

WIDENING COVERAGE: Many argue that increasing coverage is an issue upon which the ONP and AFPs must cooperate, particularly in relation to bringing more independent workers into the system. Some argue that it should be mandatory for self-employed workers to contribute to one of the systems. Melvin Escudero, the CEO of El Dorado Investment Funds, told the local press, “We need to look for adequate mechanisms to accomplish this, as there is a large number of self-employed that is totally unprotected.”

On a similar note, the prevalence of informal workers creates a challenge for the pension fund system as a whole. Aldo Ferrini, the chief investment officer of AFP Integra, told OBG, “The coverage issue will eventually need to touch on labour reform. In the end, people contributing to either the public or private systems must have formal employment. We need to make the formalisation process easier in a country where over 50% of workers operate in the informal sector.” Currently, the only government programme that exists to protect informal and low-income workers in their old age is Pensión 65, which was implemented in early 2012. Established by the Ministry of Development and Social Inclusion, the programme is essentially aimed at the poorest segments of the population and provides monthly payments of $47 to eligible adults over 65.

The pension fund reform debates scheduled to begin in July 2012 are likely to extend for some time. Peru, like many developed countries, will continue in search for solutions that will provide all members of society with a dignified level of care well into their old age.