Multifunds:Lessons from experience

Presentation prepared for the International Conference on “Multifunds – Implementation and Prospects in the Pension System of the Central and Eastern European Countries” , Sofia, Bulgaria, 17-18 September 2009.

GUILLERMO ARTHUR

PRESIDENT

INTERNATIONAL FEDERATION OF PENSION FUND ADMINISTRATORS (FIAP)

IndexI. Why multifunds?

II. Conditions for their development

III. Alternative designs

IV. Results

V. Lessons from experience

I. Why Multifunds? 1. They enable offering portfolios adjusted to members’

preferences and risk profiles: The composition of the optimal portfolio for each member changes throughout

the life cycle (more variable income at the outset, since there is time to compensate for poor results, and additionally, the proportion of human capital in the total wealth is higher).

The composition of the optimal portfolio for members of the same age is different (since there are income and wealth differences that have a bearing on risk preferences).

2. They reduce future pension risk.

3. They mitigate the “herd effect” on capital markets.

II. Conditions for their development

Investment regulation enabling investment in a variety of financial assets with varying characteristics.

If local markets are not well developed, authorization for foreign investment.

Establish automatic assignment criteria for those who do not actively choose and gradual adjustments over time in accordance with age.

Incorporate supporting mechanisms for identifying members’ risk profiles and creating pension culture.

III. Alternative designs

A. Types of Funds and Limits on Investment in Variable Income

Two countries in Latin America offer 5 funds (Chile and Mexico), and only one offers 3 funds (Peru), whereas in Central and Eastern Europe 4 countries offer 3 funds (Slovakia, Estonia, Hungary and Latvia), and only 1 offers 4 funds (Lithuania).

In all countries Multifunds are differentiated according to their degree of exposure to variable income instruments.

The maximum investment limits in variable income are heterogeneous across countries:

- The maximum variable income limit for the most conservative fund ranges from 0% (e.g. Mexico) to 10% (e.g. Hungary).- The maximum variable income limit for the riskiest fund ranges from 30% (e.g. Latvia) to 80% (e.g. Chile).

Maximum Investment Limits in Variable Income per Fund Type and Country

Source: FIAP.Notes: (1)Latvia has 3 types of investmnent strategy (each pension fund administrator can offer more than one fund in each strategy).n.a.: Not applicable (since this type of fund does not exist).For the sake of simplicity, the names of each type of fund in each country have been omitted.

Fund Type

Latin America Central and Eastern Europe

Chile Mexico Peru Slovakia Estonia Hungary Latvia(1) Lithuania

Most conservative 5% 0% 10% 0% 0% 10% 0% 0%Conservative 20% 15% n.a. n.a. n.a. n.a. n.a. n.a.Intermediate 40% 20% 45% 50% 25% 40% 15% 30%Risky 60% 25% n.a. n.a. n.a. n.a. n.a. 70%

Riskiest 80% 30% 80% 80% 50% >40% (no limits) 30%

>70%

(no limits)

No. Of funds 5 5 3 3 3 3 3 4

B. Freedom of choice and the default option

1. The general rule in all countries is that members choose a fund according to their risk profile. However, there are some restrictions.

In the majority of countries with Multifunds, older members cannot choose relatively riskier funds. The exceptions are: Estonia, Latvia and Lithuania where there are no restrictions whatsoever.

2. As a general rule, those who do not actively choose are assigned to a default fund by law.

In Latin America the default assignment criterion is based on members’ age.

In Central and Eastern Europe, only Hungary has a default assignment criterion based on members’ age.

In Estonia, Latvia and Lithuania, the default assignment criterion is not linked to age. The default funds are conservative.

In Slovakia there is no default assignment (the member is obligated to choose a fund in order to join the system).

Restrictions on choice and default criteria in Latin America

Chile Mexico Peru

Restrictions on fund choice

Retired members (men over 65 and women over 60): only allowed to choose between the three funds of least relative risk (C, D and E)

Choosing a more agressive fund than such assigned by default is not allowed.

Members > 60: cannot invest in fund type 3 (up to 80% in VI).

Male members > 55 and women > 50 : only allowed to choose between the four least risky funds (B,C, D and E).

Members are automatically switched to more conservative funds as they get older, although changing to a fund that is more conservative than the one assigned by default is allowed

Default assignment

criteriaMembers’ age Members’ age Members’ age

Age Group Default fund Age Group Default fund Age Group Default fund

Men and women <=35 Risky (up to 60% VI)

Members < 27 Riskiest (up to 30% VI)

Men and women <= 60

Intermediate (up to 45% in VI)

Men between 36 and 55

Intermediate (up to 40% VI)

Members between 27 and 36

Risky (up to 25% VI) Men and women > 60

Most conservative (up to 10% in VI)

Women between 36 and 55

Members between 37 and 45

Intermediate (up to 20% VI)

Men >= 56 Conservative (up

to 20% VI)Members between 46 and 55

Conservative (up to 15% VI)

Women >= 51 Members > 55 Most conservative

(0% VI) Source: FIAP.VI: Variable Income.

Slovakia Estonia Hungary Latvia Lithuania

Restrictions on fund choice

Members > 47: opting for riskiest fund (up to 80% in VI) prohibited

None

Members > 57 : can only opt for the most conservative fund (up to 10% en VI) and the intermediate fund (up to 40% in VI).

None NoneMembers> 55 : cannot opt for the intermediate fund (up to 50% en VI).

Default assignment

criteria

Does not exist. The member is obliged to choose a pension fund in order to join the system.

Does not depend on age. Default fund: conservative

Members’ age

Does not depend on age. Default fund: Conservative Strategy

Does not depend on age. Default fund: Conservative Strategy

Age group Default fund

Members< 47Riskiest (> 40% in VI)

Members between 47 and 57

Intermediate (up to 40% in VI)

Members > 57

Most conservative (up to 10% in VI)

Source: FIAP.VI: Variable Income.

Restrictions on choice and default criteria in Central and Eastern Europe

C. Division of balances of mandatory contributions among funds

Among the countries that have implemented Multifunds, only Chile allows members to assign the resources from mandatory contributions in a sole individual account to up to two types of funds.

In the rest of the countries, the resources of an individual account can only be kept in one fund.

D. Possibilty of transfering among funds within the same fund manager

In all countries members can freely transfer the balances of their mandatory contributions among different funds.

In Chile members can transfer future balances among fund types subject to contract.

In some countries there are restrictions on the number of transfers within a set time period:

Chile Peru Slovakia Estonia Hungary Latvia

Restrictions on the

transfer of balances between

funds

Cost free up to twice per calendar year

Cost free every 3 months

Cost free not more than once per calendar year

Cost free not more than once per calendar year

Cost free every 6 months

Cost free not more than twice per calendar yearMore than twice per

calendar year: an exit comission is charged to the member’s expense (no AFP currently does so).

More than once a year: the member is charged a commission of 16 EUR(Approx. US$ 23)

Source: FIAP.

IV. ResultsA. Distribution of members according to fund type

Distribution of members according to fund type and country (as a % of total members) December 2008

Source: FIAP.

Fund Type

Latin America Central and Eastern Europe

Chile Peru Slovakia Hungary (1) Latvia Lithuania

Most conservative 2% 3% 5% 1% 20% 12%

Conservative 8% n.a. n.a. n.a. n.a. n.a.

Intermediate 37% 90% 26% 13% 8% 27%

Risky 40% n.a. n.a. n.a. n.a. 56%

Riskiest 14% 7% 70% 86% 72% 6%

(1) Hungary: Takes into account the number of members who as of December 2008 belonged to a fund manager that had implemented the Multifunds system (61% of the total number of members of the system, in other words, approximately 3 million members). Note that on that date the implementationof Multifunds was still voluntary (it only became mandatory in January 2009)

n.a.: Not Applicable (since this type of fund does not exist).The names of the different types of funds in each country have been omitted for the sake of simplicity.

In Latin America (Chile and Peru) the majority of members are concentrated in realtively risky funds, as in Lithuania. In Central and Eastern Europe the majority of members are concentrated in very risky funds (Slovakia, Hungary and Latvia). If the percentages of members and assets in each multifund are compared, it can be seen that older people with the most accumulated funds are in the most conservative funds (the case of Chile, Peru and Lithuania).

B. Distribution of members by age group

CHILE: Distribution of members by age group and gender (as a % of total members) December 2008

1- age group 2- age group 3- age group

Tipo de Fondo Men up to 35

Women up to 35

Men between 36

and 55

Women between 36

and 50

Men older than 55

Women older than 50

Riskiest 23 22 11 8 2 2Risky 73 73 20 24 6 7Intermediate 3 4 65 66 36 36Conservative 0 0 1 1 53 53Most conservative 1 1 2 2 3 3

Source: Superintendency of Pensions, Chile.

It is noteworthy that a considerable number of members belong to the fund corresponding to them by default (the case of Chile). E.g.: 73% of men and women below 35 contribute to the risky fund.

Chile: Distribution of members by income level and gender (as a % of total members) December 2008

< 450 US$ 450 – 900 US$ 900 – 1,350 US$ > 1,350 US$

Type of Fund Men Women Men Women Men Women Men Women

Riskiest 12 13 16 20 24 29 37 33risky 44 44 42 42 34 34 24 29Intermediate 37 35 36 29 34 25 26 24Conservative 5 7 4 5 4 6 4 7

Most conservative 1 1 2 3 4 5 8 7

Source: Superintendency of Pensions, Chile.

C. Distribution of members by income level

Lower income contributors mainly choose funds with intermediate risk.

E.g..: 77% of men with incomes < US$ 450 chose risky and intermediate funds.The preference for more aggressive funds increases with higher

income. E.g..: 61% of men with incomes > 1,350 US$ chose the riskiest funds.

D. Distribution of assets per fund type

Type of FundLatin America Central and Eastern Europe

Chile Mexico Peru Slovakia Estonia Hungary (1) Latvia LithuaniaMost conservative 8% 11% 9% 4% 8% 1% 15% 17%Conservative 13% 23% n.a. n.a. n.a. n.a. n.a. n.a.Intermediate 44% 29% 74% 29% 17% 23% 6%

81%Risky 19% 30% n.a. n.a. n.a. n.a. n.a.Most risky 16% 7% 17% 67% 74% 76% 79% 2%Total PF Assets (MUSD) 74.313 73.109 16.170 3.109 1.034 9.857 930 5.321Total PF Assets (% of GDP) 41% 6% 14% 3% 4% 6% 3% 13%

Source: FIAP.n.a.: Not Applicable.Note: (1) In the case of Hungary, asset distribution only takes into account the assets of the pension funds that had implemented the multifunds system to this date.

Distribution of assets per fund type and country (as a % of the total amount of managed assets) December, 2008

In Latin America (Chile, Mexico, Peru) assets are mostly concentrated in relatively risky funds, as in Lithuania. In Central and Eastern Europe, assets are mostly concentrated in the riskiest funds (Slovakia, Estonia, Hungary and Latvia), with the exception of Lithuania. In Chile, even though 40% of members are in the risky fund, only 19% of assets are concentrated in this type of fund, which can be attributed to the fact that they are young people with low accumulated balances .

E. Return by fund type

Tipo de Fondo

Latin America Central and Eastern Europe

Chile Mexico Peru Slovakia Estonia Hungary Latvia Lithuania

Most conservative 2.74% 6.46% -1.91% 0.43% -3.11% -7% -9.28% -4.08%

Conservative 3.43% 6.19% n.a. n.a. n.a. n.a. n.a. n.a.

Intermediate 3.42% 6.07% 7.55% -3.78% -3.08% -16.8% -12.5% -6.07%

Risky 3.33% 5.94% n.a. n.a. n.a. n.a. n.a. -7.12%

Most risky 4.21% 5.77% -1.87% -4.93% -1.72% -28.4% -16.78% -8.93%Source: FIAP.Notes:In the case of Chile, Mexico and Peru, the real (annual average ) profitabilities since the start of the multifunds system are given. In the case of Slovakia, the real (annual average) profitability since 2007 is given; only 2008 is considered in the case of Hungary (the system began in 2007); only figures since 2007 are considered in the case of Latvia; figures since 2005 in the case of Lithuania; figures since the beginning of the multifunds in Estonia (2003).

Real Accumulated Return (annual average) December, 2008

CHILE

Pension fund assets according to type of multifund, Dec. 2008 – Aug. 2009 (MUSD)

Value of the assets of the pension funds, Dec. 2008 – Aug. 2009 (MUSD)

Source: Superintendency of Pensions, Chile.

Source: Superintendency of Pensions, Chile.

V. Lessons from experience1. The Multifunds system successfully resisted the financial crisis test.

YearType of Fund

Riskiest Risky Intermediate Conservative Most conservative2003 26.9 16.0 10.5 8.9 3.32004 12.9 10.3 8.9 6.8 5.42005 10.7 7.3 4.6 2.8 0.92006 22.3 18.8 15.8 11.5 7.42007 10.1 7.5 5.0 3.3 1.92008 -40.3 -30.1 -18.9 -9.9 -0.9

Ago.09 32.7 25.4 17.7 12.4 7.5Accumulated 71.9 54.0 45.3 38.8 27.2

Annual Average 8.1 6.4 5.5 4.8 3.5

In the midst of the 2008 crisis, contributors in the riskiest funds suffered a 40% loss in value.

However, if those contributors are young, there are good possibilities for the to recover the value of their fund. In just 8 months, the balance of a contributor in the riskier fund has already recovered 33% of its value.

In the long term (annual average return since the beginning) the riskier funds still have higher returns than conservatives ones.

Chile: Real Returns of the Multifunds per Year

Source: Chilean Pension Fund Administrators’ Association.

Type of Fund

Real average annual profitability Sept. 02

- Aug. 09

Real average long term annual profitability

Expected annual return range

No. of negative years

Riskiest 8.10% 6.40%From -23,3% to

36,1% 1 in 3

Risky 6.40% 5.80%From -17,1% to

28,7% 1 in 3

Intermediate 5.50% 5.20%From -10,5% to

20,9% 1 in 4

Conservative 4.80% 4.60%From -6,2% to

15,4% 1 in 5

Most conservative 3.50% 4.20% From -3,8% to 12,1% 1 in 7

Chile: Expected Long Term Profitability

Note: Calculations performed on the basis of historical results and financial literature, assuming maximum investment at the variable income limit for each Multifund. The profitability range is drawn up with the historical volatility and a confidence interval of 95%.Source: AFP Cuprum.

Expected long term return shows that a young contributor in the riskiest fund earns 6.4% annual yield in the long run, despite short term negative fluctuations.

2. The recent development of the Life Cycle Theory gives conceptual sustenance to the idea of Multifunds with default options depending on the member’s age.

3. The Multifunds system enables closer interaction of members with the pension system and helps to develop demand/supply for pension information and financial education.

4. The Multifunds have increased the political viability of the individually funded programs, since they enable offering investment alternatives with stable results over time.

5. The financial crisis shows that members must have a clear notion of the concept of risk in the Multifunds system. For that reason it is essential for us as an industry to take measures that contribute to the creation of a “financial culture.”

Fund managers must provide advice for identifying each member’s risk profile.

6. Current Multifunds systems can be improved. When regulations allow only a few fund types, it makes sense to allow splitting the balance

of mandatory contributions among different types of funds. The variable income range limits of each fund should not be too broad. Avoiding the

overlapping of such limits between Multifunds improves the expected yield and risk information.

Chile: riskiest fund - 40% to 80% in variable income Peru: riskiest fund - 30% to 80% in variable income Hungary: riskiest fund - 40% to 100% in variable income

To create adequate mechanisms for overcoming members’ inertia.

Inform the member so he can leave the default fund. If the individual does not confirm, he returns to the default fund.

Establish a path based on the life cycle for those members who actively choose by means of voluntary members’ mandates for improving multifunds assignment in future age brackets.

7. Countries with “sole fund” individually funded systems must evolve towards “multiple fund” systems, critically studying the options. Upcoming implementations of the Multifunds system (Colombia 2001); Bulgaria (2009, in the third pillar); Romania (2010), prove that these systems are an unstoppable trend.

Presentation prepared for the International Conference on “Multifunds – Implementation and Prospects in the Pension System of the Central and Eastern European Countries” , Sofia, Bulgaria, 17-18 September 2009.

GUILLERMO ARTHUR

PRESIDENT

INTERNATIONAL FEDERATION OF PENSION FUND ADMINISTRATORS (FIAP)

Multifunds:Lessons from experience

THANK YOU VERY MUCH