Lessons from Multifunds: Insights from the President of FIAP

1. Multifunds: Lessons from experience GUILLERMO ARTHUR PRESIDENT INTERNATIONAL FEDERATION OF PENSION FUND ADMINISTRATORS (FIAP) 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.

2. Index • Why multifunds? • Conditions for their development • Alternative designs • Results • Lessons from experience

3. 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.

4. 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.

5. III. Alternative designs A. Types of Funds and Limits on Investment in Variable Income • Twocountries in LatinAmericaoffer 5 funds (Chile and Mexico), and onlyoneoffers 3 funds (Peru), whereas in Central and Eastern Europe 4 countriesoffer 3 funds (Slovakia, Estonia, Hungary and Latvia), and only 1 offers 4 funds (Lithuania). • In allcountriesMultifunds are differentiatedaccordingtotheirdegree of exposureto variable incomeinstruments. • Themaximuminvestmentlimits in variable income are heterogeneousacrosscountries: • - Themaximum variable incomelimitforthemostconservativefundranges from 0% (e.g.Mexico) to 10% (e.g.Hungary). • - Themaximum variable incomelimitfortheriskiestfundranges from 30% (e.g.Latvia) to 80% (e.g. Chile).

6. Maximum Investment Limits in Variable Income per Fund Type and Country • Source: FIAP. • Notes: • 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.

7. 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).

8. Restrictions on choice and default criteria in Latin America Source: FIAP.VI: Variable Income.

9. Restrictions on choice and default criteria in Central and Eastern Europe Source: FIAP. VI: Variable Income.

10. 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.

11. 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: Source: FIAP.

12. A. Distribution of members according to fund type IV. Results Distribution of members according to fund type and country (as a % of total members) December 2008 Source: FIAP. • 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).

13. B. Distribution of members by age group • Itisnoteworthythat a considerable number of membersbelongtothefundcorrespondingtothemby default (the case of Chile). • E.g.: 73% of men and womenbelow 35 contributetotheriskyfund.

14. 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.

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

16. E. Return by fund type Real Accumulated Return (annual average) December, 2008 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).

17. CHILE Value of the assets of the pension funds, Dec. 2008 – Aug. 2009 (MUSD) Source: Superintendency of Pensions, Chile. Pension fund assets according to type of multifund, Dec. 2008 – Aug. 2009 (MUSD) Source: Superintendency of Pensions, Chile.

18. V. Lessons from experience Chile: Real Returns of the Multifunds per Year • 1. The Multifunds system successfullyresisted the financial crisis test. Source: Chilean Pension Fund Administrators’ Association. • 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.

19. 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. 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.

20. Therecentdevelopment of theLifeCycleTheorygives conceptual sustenancetothe idea of Multifundswith default optionsdependingonthemember’sage. • TheMultifundssystemenablescloserinteraction of memberswiththepensionsystem and helpstodevelopdemand/supplyforpensioninformation and financialeducation. • TheMultifundshaveincreasedthepoliticalviability of theindividuallyfundedprograms, sincetheyenableofferinginvestmentalternativeswithstableresultsover time.

21. 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

22. Tocreateadequatemechanismsforovercomingmembers’ inertia. • Informthemember so he can leavethe default fund. Ifthe individual doesnotconfirm, he returnstothe default fund. • Establish a pathbasedonthelifecycleforthosememberswhoactivelychoosebymeans of voluntarymembers’ mandates forimprovingmultifundsassignment in futureagebrackets.

23. 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.

24. Multifunds: Lessons from experience GUILLERMO ARTHUR PRESIDENT INTERNATIONAL FEDERATION OF PENSION FUND ADMINISTRATORS (FIAP) 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.

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