Managing Public Pension Reserves

1. Managing Public Pension Reserves Robert Palacios World Bank Conference on Public Pension Fund Management Washington D.C. September 24, 2001

2. Structure of presentation • Managing public pension reserves – why is it important? • The failure of public management • Policy options for reform

3. Managing public pension reserves – why is it important?

4. Reserves exist in 60+ DCs

5. Socio-economic impact can be large • Social welfare and labor market policy • Sustainability of pension benefit promises • Need to raise taxes on labor • Fiscal policy • Short run – increase in public consumption • Long run – intertemporal constraint • Financial sector development • Positive vs distortionary impact or nil?

6. Social policy impact - pension levels

7. Fiscal policy impact – pension debt

8. Financial sector development impact

9. The failure of public management

10. Abundant indirect evidence • Deteriorating funding ratios – there are no fully funded public DB schemes • Low balances in provident fund accounts • Likely increase in government consumption due to captive credit • No evidence of positive capital market impact, some distortions likely • Stories of corruption and waste

11. Some direct evidence – returns

12. Some direct evidence – returns(vs bank deposit rates)

13. Some direct evidence – returns(vs income per capita growth)

14. What lies behind this failure? • Mandates and restrictions • Deficit financing by forced purchase government debt • social investments (e.g., housing) • development projects and ETIs • support for particular firms or whole market • prohibition on foreign investments • Governance • Tripartite boards have been ineffective • Political appointees have conflicting objectives • Lack of accountability and monopoly power • Lack of transparency

15. Result is poor asset allocation

16. Policy options for reform

17. Three key areas must be addressed • Institutional arrangement • Investment policy • Governance system • Country-specific conditions

18. Institutional arrangement - options • Centralized, public managers • Centralized with private managers chosen by independent authority • Centralized with private managers chosen by individual members • Decentralized with private managers chosen by individuals or employers

19. Institutional arrangement - options • Centralized, public management • Tripartite boards with executive control exerted through political appointments • Monopoly in-house public management • Bureaucrats with little incentive to take risks and no competition • This traditional approach has widely failed

20. Institutional arrangement - options • Centralized with private managers chosen by independent authority with private sector expertise • Relevant country examples include: • The CPP Investment Board • Irish Reserve Fund • Norwegian Petroleum Fund • Untested but promising under the right conditions

21. Institutional arrangement - options • Centralized with some individual choice of provider or portfolio or both • Choice of provider: • Bolivia’s AFP concession • India’s recent OASIS proposal • Choice of portfolio, not provider • Hong Kong’s industry funds • US Thrift Savings Plan

22. Institutional arrangement - options • Decentralized with private managers chosen by individuals or employers • The most popular structure for new funded pension schemes; minimizes political risk although not eliminated • Examples include: • Chile and other Latin America • Hungary, Poland, Sweden and the UK • Australia and Hong Kong • Singapore’s individual opt out

23. Investment policy • Clear statement of objective: invest for the best interest of the plan, explicitly prohibit other criteria • Some strategies to avoid conflicts of interest & discretion • Passive management • Don’t set minimum for government bonds • Prohibit illiquid investments • Allow significant foreign investment • Avoid active corporate governance

24. Investment policy • Transparent rules for evaluating performance of asset managers • Set clear monitoring targets for risk and returns • Benchmarks: Contracts with external managers can specify deviation allowed from indices

25. Governance • Trustees with clear competence in related fields, no public officials • Adequate remuneration • Minimize conflicts of interest • Transparent selection process with appropriate checks and balances • Appropriate assignment of liability • Clear mandates and limited discretion

26. Governance • Unless subject to scrutiny, this won’t have the desired effect • Reporting and disclosure of decisions made by Board and results needed • Ultimately, public awareness and understanding is the best discipline • If not, then governance problem may be too endemic to overcome

27. Country specific conditions • Size of fund relative to markets • Size of fund relative to other institutional investors • Absolute size and multiple fund case • Depth and quality of capital markets • Capacity to regulate, standards of accounting, trust law etc. • Human resources available • General governance quality

28. Summary • More than 60 low and middle income countries have significant public pension reserves with dozens more considering establishing them • Good management can have important impact on the social, fiscal and financial sector conditions • To date, traditional public management practices have produced poor results in each area • Improvement will depend on institutional design, investment policy, governance and how well these are adapted for country specific circumstances

29. End