How COVID-19, politics have impacted Latin America’s private pension fund industry

Assets under management held by Latin America’s private pension fund managers have trended higher, reaching US$659bn last year.

Growth, albeit slower than in previous years, was eked out in 2020 amid the COVID-19 economic fallout. Nevertheless, the number of contributors fell.

These managers – known in private pension fund trailblazer Chile as AFPs – are key drivers of economic development, typically investing in company stock, government debt and infrastructure bonds.

The project finance function has been weakened amid legislation allowing savers to make early pension drawdowns. In Chile, AFPs and insurers are the main buyers of bonds but, to increase liquidity, they have had to sell financial assets instead of purchasing them. 

Indeed, while the pension fund drawdown moves have helped families reduce debt, weather the crisis and build cash cushions, they have, indirectly, negatively impacted access to financing by the likes of the infrastructure sector, a key employer and investment generator, and sparked fears over a reduction in the size of future pensions and the fiscal implications.   

Against this backdrop and calls for better pensions, there are also proposals in Chile to scrap the system. Others in the country propose keeping the system but amending it. Key factors behind small pensions are contribution gaps and levels and the associated issue of labor informality.

To find out more about the state of play on the regional private pension front, BNamericas spoke to Manuel Tabilo, research manager at industry organization the International Federation of Pension Funds Administrators (FIAP).

BNamericas: In 2020, compared with the previous year, there was a drop in the number of pension system contributors. Meanwhile, coverage, measured as contributors as a proportion of the economically active population (EAP), fell 0.3 percentage points between 2019 and 2020. How significant are these drops?

Tabilo: Between 2019 and 2020, about 1.5mn workers stopped paying into their individually funded accounts in the Latin American countries analyzed [Bolivia, Chile, Colombia, Costa Rica, El Salvador, Mexico, Panama, Peru, Dominican Republic and Uruguay]. This significant drop in contributors, of the order of 3.5%, is the first observed in the past 10 years, and is mainly due to the negative effect of the COVID-19 pandemic on the loss of formal jobs. It should be noted that this reduction in the number of contributors is lower than the loss of jobs in other countries in the region, since formal employment suffers less than informal employment in periods of economic shock such as that observed during the pandemic.

If one considers the percentage of the EAP that contribute – that is, contributors as a proportion of the EAP – in 2019 that indicator was 32.9% and in 2020 that indicator fell slightly to 32.6%. This is explained by the generalized drop in contributors, by about 1.5mn workers, which more than compensates for the effect of a lower EAP. Due to the pandemic, the EAP has tended to fall in most countries, because many workers were forced to integrate into the inactive population or carry out unpaid family employment.

BNamericas: What is expected for this year in this regard?

Tabilo: Because of the advances in the vaccination process in various countries, one should expect that sanitary restrictions will be relaxed, and in that sense, that labor markets will be reactivated in terms of formal employment. This implies a recovery of the workers who pay into their individual accounts.

The evolution of the coverage of contributors, however, may be more uncertain. For example, if contributors in general increase, and if the EAP remains at similar or even lower levels compared to 2020, due to the existence of emergency subsidies that different governments have delivered to the population and that in some way discourage the active search for paid employment, the coverage of contributors would increase.

BNamericas: Is FIAP concerned about what is happening in Chile and Peru, namely, early withdrawals of pension funds and political proposals to dismantle the AFPs?

Tabilo: We are certainly very concerned. To improve pensions, it is necessary to increase accumulated savings, and what has been done with these populist policies of early withdrawal of funds in Chile and Peru is to go against what is considered essential to improve pensions. 

In the case of Chile, the three current withdrawals - for up to 10% of the funds – means the outflow of US$50bn, equivalent to 25% of the current funds. In addition, a total of 5mn people were left without funds in their accounts, and pension size could fall by almost 30%, which is equivalent to about six years of contributions.

In the case of Peru, the different approved withdrawal mechanisms meant the withdrawal of more than US$28bn in total – equivalent to 64% of current funds – and with this, almost 6mn members were left with zero balance in their individual account.

Thus, the current outlook implies that it will take many more years of contributions and/or a significant increase in the contribution rate to reach the level that was before the withdrawals.

With early withdrawals of funds, by leaving a high percentage of workers without sufficient savings to finance their pensions, the state will have to contribute to their financing, which would generate a pretext to demand that the new contributions, and their administration, go to the state together. Thus, the path of those who want to reestablish pay-as-you-go systems and eliminate private administration, despite the evidence of its failure in the world, is facilitated.

This is how bills have already appeared that discuss the possibility of withdrawing 100% of remaining funds, both in Chile and Peru. 

Although a policy of this type is irrational since it generates irreparable damage to the pensions of the next generations, it finds space and support in citizens who want to avoid the expropriation of their savings.

BNamericas: When looking at the weighted average participation of pension funds by economic sector for the years 2020 and 2019, increases in investment in the public sector and foreign assets has been observed, while we have seen decreases in the corporate and financial sector. What are the implications of this trend in terms of project financing, for example?

Tabilo: The pension fund managers in all the countries of the region have a strict regulatory framework for the management of workers' savings, which allows safeguarding and ensuring that they obtain the best investment profitability and security. In this context, the situation of financial stress caused by the pandemic has made Chilean and Peruvian pension fund managers seek greater liquidity, to be able to respond to the demand for funds produced by the approved early withdrawals of the pension funds.

Thus, the greater exposure that the fund managers had abroad in 2020 compared to 2019 can be explained by the liquidation of local assets – from the corporate and financial sector – due to early withdrawals of funds, but also by where they believe that the economic recovery will take place in 2021, and which regions will benefit the most.

If we concentrate on the countries where there have been early withdrawals of funds, fortunately, until now, their impact has been less for the population, in part, thanks to the actions of central banks. In Chile, for example, the central bank has helped cushion this impact, mainly in bond interest rates.

However, in the event of additional withdrawals or a 100% withdrawal, the AFPs would have to sell much more or all, and the central bank has already said that it does not have mechanisms to cushion all of such a large drop in prices. 

In this context, if new retirement initiatives prosper, there would be a significant rise in interest rates, which would hike the cost of financing for homes, due to higher mortgage loan rates, for companies, since banks would have to look for other forms of financing that would be more expensive, and for people, as there would probably be a shortening of loan maturities, which would mainly affect mortgage loans.

In addition to the impact on people and companies resulting from the withdrawals, there would be a fiscal impact. This occurs in the short term when rates rise as a result of the sale of assets, but also in the long term since the country risk could change, and with it, it could affect the investment grade of the countries and their rating. Being a riskier country, investors will lend money to the country, but at a higher cost.

 Percentage of private pension fund manager investments corresponding to corporate sector instruments in 2020. Source: FIAP. (R. Fija = fixed income instruments, R. Variable = variable income)

BNamericas: Finally, what kind of measures is FIAP proposing to improve individually funded pension systems in the region?

Tabilo: It is necessary to identify the true causes of the low replacement rates, avoiding measures of a demagogic nature that end up weakening the pension systems and do not solve the problem of workers' pensions. The solution to the problem of pensions does not involve returning to pay-as-you-go systems, since these systems are unviable because the aging of the population means that there will be fewer and fewer active workers for each old adult, a situation that is aggravated by labor informality.

There is no doubt that the individually funded system requires adjustments, both in the stages of savings accumulation and drawdown, but the need for such adjustments should not be a reason to question it structurally and, on the contrary, such adjustments should be urgently adopted for the ultimate good of workers and public finances.

Thus, the following measures should be included in the reforms carried out to improve the pension system:

Increase the contribution rate. In individually funded systems, the average contribution rate is around 10% of the worker's salary, while in OECD countries the average contribution is almost double that percentage. It is impossible to think of having better pensions with a low contribution rate.

Improve coverage. The level of coverage, measured as contributors to the working-age population, in the countries associated with FIAP averages 33%, a rather low figure.

Pension evasion is an important factor that reduces coverage, so it is essential to take measures to reduce its effect. It is necessary to strengthen the supervision of the payment of contributions by workers. Likewise, it is necessary to incorporate independent or self-employed workers into the mandatory pension system. Countries like Uruguay and Chile have made important steps in this regard.  

Experience shows that the most effective way to increase coverage is compulsory and as a second alternative to establish quasi-compulsory systems, such as those that exist in developed countries – automatic enrollment or automatic escalation of the contribution rate. However, in Latin American countries, where informality and labor costs are high, it is necessary to look for new mechanisms that are effective to implement the obligation and raise funds, such as the payment of contributions from withholding taxes, and also mechanisms that encourage participation in pension programs or at least do not discourage such participation, such as the existence of non-contributory benefits that are granted to informal sectors.

Finally, it seems convenient to explore a mechanism to universalize pension coverage, through the incorporation of a contribution collection scheme different from that based on the formal salary, such as the collection of contributions based on the consumption of all workers.

Adjust the retirement age according to the increase in life expectancy.

To decisively promote voluntary pension savings (APV) schemes. Voluntary savings are key in a scenario in which mandatory savings are insufficient. If a man begins to make voluntary pension savings of 5% at age 30, his total replacement rate would increase by 37 percentage points, while, in the case of a woman, her replacement rate would increase by 32 percentage points.   

There are a series of factors that will determine the effectiveness of public policies for voluntary savings: tax incentives for savings - benefits and subsidies - giving some degree of liquidity to people to make early withdrawals of their funds, strengthening competition between entities that offer APV products, encourage employer contributions, design simplified affiliation schemes and develop in-depth pension education.

Additionally, it is possible to incentivize APV with mechanisms based on behavioral economics, such as automatic enrollment in voluntary savings plans - with the option of disaffiliation – and automatic increases of the contribution rate over time.