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T h e P e r u v i a n M o d e l

T h e P e r u v i a n M o d e l. MULTIFUNDS:. FIAP International Seminar Melvin Escudero Villavicencio Intendente de AFP Supervision Department of Pension Fund Portfolio Management Santiago de Chile, May, 2006. SUPERVISION AND REGULATION BASED ON VALUE CREATION. Pension Fund (AFP).

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T h e P e r u v i a n M o d e l

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  1. T h e P e r u v i a n M o d e l MULTIFUNDS: FIAP International Seminar Melvin Escudero Villavicencio Intendente de AFP Supervision Department of Pension Fund Portfolio Management Santiago de Chile, May, 2006

  2. SUPERVISION AND REGULATION BASED ON VALUE CREATION. Pension Fund (AFP) Pension (Insurance Co) Salary (Employer) Maximize the Affiliates’ Pension Value Creation Chain in the Private Pension Fund System Investment Management: Fiduciary Obligations: • Prudent Investor Rule • Fiduciary governance of Pension Funds • Best Practices in investment and risk management. • Access to a wide range of instruments • Disciplined investment policy • Benchmarking • Performance Attribution. Portfolios Optimized for Risk-Adjusted Returns Supervision based on Investment and Risk Management: Investment Risk Management: • Monitoring of decision-making and investment policies. • Auditing of investment management capabilities at the Front-, Middle-, and Back-Office levels • On-Line access to Fund investments • Market watch: Vigilance of marketplace transactions. • Market Risk • Credit Risk • Operational Risk • Liquidity Risk • Risk exposure limits Value Circle

  3. Portfolio Managers Intermediaries Mutual Funds Investment Funds Investment Advisors Benchmarks Houses. Investment banks Broker dealers Law Firms Rating Agencies Research Companies Foreign Issuers Regulators Local Foreign Sovereigns Corporates Mutual Funds Trusts, SPV Markets Local Issuers Stock Exchanges Settlement/Clearing Depositories OTC Markets AFP Sovereign Corporates Inka Bond Investment Policy Front office Middle office Back office Fiduciary Obligations SUPERVISION AND REGULATION BASED ON VALUE CREATION. Factors which create value: VALUE FOR THE AFFILIATE International standards of regulation and supervision Best investment and risk practices Promotion and development of new investments and markets Highly trained and experienced staff SBS Supervision and Regulation Based on Value Creation Knowledge of and experience in local and foreign markets. Exemplarily ethical and professional standards Continually building credibility and a reputation for trustworthiness. On-line access to risk and investment information. Interaction with major market players Contact with a global network of investment specialists.

  4. INVESTMENT MANAGEMENT 1 Objective: Maximize Risk Adjusted Returns for Each Portfolio Return The major challenge is to find the optimal portfolio given each funds’ objective. Fund Risk Risk Earlier System Investment Alternatives 2 Ample Investment Flexibility: Efficient Frontier: Multifund System Return Efficient Frontier: Previous System 3 Multifunds: Three clearly differentiated risk profiles. Fund Risk Multifund System Global Systemic Risk

  5. INVESTMENT MANAGEMENT Eligible Instruments in Multifund System >60 years >45 and <60 years >20 and <45 years

  6. INVESTMENT MANAGEMENT 4 Disciplined Investment Policies: 5 Benchmarking and Performance Attribution Analysis: Activity Best Practices 1. Define Fund Objectives • Risk-Adjusted Return Profile. • Profile of targeted investor • Risk profile Benchmarking allows the managers performance and measurement ofrisk-adjusted return on a comparative basis. Each asset class has its own benchmark Each AFP chooses their own benchmark Benchmarks can be different between funds, even when they are compared to the same or similar asset classes. Benchmarks allow for Performance Analysis 2. Strategic Investment Allocation • Eligible asset classes • Long term investment objectives • Target long-term diversification • Benchmark for each asset class 3. Tactical Asset allocation • Describe strategic criteria for varying from long-term asset allocation • Explain the criteria for deciding between active or passive management • Monitoring procedures and methodologies • Describe investment styles • Define internal limits and maximum variation allowed. 4. Investment policy for each type of instrument. • Define criteria for selecting between internal and external management • Investment objective for each instrument type • Allowable instruments. • Applicable restrictions and limits. • Define risk parameters 5. Construction of optimized portfolio • Portfolio construction criteria • Characteristics of trading policy • Optimization models Performance information will initially be restricted to the SBS and the AFP. Later, the information will be made public. 6. Fund monitoring and portfolio rebalancing. • Analysis of risk-adjusted return performance • Rebalancing policy based on asset class and investment type.

  7. PERFORMANCE ATTRIBUTION ANALYSIS

  8. INVESTMENT RISK MANAGEMENT 1 Best Practices in Management Company Structure and Reduction of Conflicts of Interest: 2 Professional Risk Management: Responsibility: The AFPs must identify, measure, analyze, monitor, control, and disclose the investment risk of the funds under management, whether or not those risks are quantifiable. Market Risk: • Models and systems sufficient to monitor and evaluate all positions. • Calculate VaR, including sensitivity analysis to key factors, using historical information and stress testing of key risk factors. • Contingency planning. Credit Risk: • Credit analysis procedures • Calculate default probability for each instrument and issuer (transition matrix) • Analyze expected losses. Liquidity risk Estimate withdrawals. Estimate losses from sales of illiquid assets Plans for mitigating illiquidity. The AFPs provide mandatory risk limits with the above mentioned criteria. Operational risk: • Propose and monitor the implementation of internal controls • Define processes, identify points of failures, and contingency planning. • Balance Score Card. Minimum returns are established based on Relative VaR.

  9. MANAGEMENT COMPANY STRUCTURE Board of Directors Independent Outside Auditor Internal Audit CEO Investment Committee Risk Committee Custody Records and Accounting Investment Unit Risk Unit Daily Investment Report. Fund Accounting. Design and implement the investment policy for each fund Optimize the portfolio. Manage the portfolio. Investment Analysis Evaluate investment alternatives. Identify, measure, analyze and monitor: Market Risk. Credit Risk. Operational Risk. Liquidity Risk. Establish investment and risk limits Clearing and settlement Monitoring of physical movements and registers Centralized record keeping.

  10. INVESTMENT RISK MANAGEMENT 3 New Pricing System provided by the SBS: Recently Adopted Improvements: Best Practices in Valuation. Improved transparency in the valuation of illiquid assets Experienced Outside Auditor (international price vendor) Price Vector Committee, with outside independent members. AFPs can object to specific, individual prices. Published zero-coupon sovereign curves. Price estimation of illiquid corporate bonds via a credit spread over the sovereign curve makes visible the portfolios volatility. The greater visibility of volatility requires the development of an appropriate risk management system. Incentives for the development of a derivatives market for interest rate hedging (FRAs and swaps) Arbitrage possibilities between local and external bond markets.

  11. Price vector Committee: • 5 Representatives from the SBS • 2 Independent professionals named by the SBS • 1 Representative of the AFPs Functions:Approve and validate the policies, criteria, methodologies and manuals regarding valuation and review objections to pricing. Meets periodically, at minimum, monthly.. Establishes Policies, Criteria, and Methodologies. Reports compliance with the policies, criteria and methodologies and objections received. End Users of Price Vector (AFP) • Represented on the Price Vector Committee • Can present objections on a daily basis. Can Object to Preliminary Price Vector (5:00–5:30 pm) Valuation Committee: • 4 Representatives of the SBS Functions:Approves the final version of the price vector on a daily basis, verifies compliance with the pricing manual, evaluates pricing objections and reports to the Price Vector Committee. Transmits Preliminary Price Vector (5:00 pm) Send Final Price Vector (6:00 pm) Department of Investment Valuation. • Technical Team. Functions:Produce and distribute the preliminary price vector ( ) and, if there are objections accepted by the Valuation Committee, produce and distribute an updated final price vector ( ). Directs the modification of the preliminary price vector, in the case of a sustained objection (5:00 pm – 6:00 pm) PRICE VECTOR GENERATION

  12. SOVEREIGN CERO CUPON CURVE

  13. 2 Prudent Investor Rule: FIDUCIARY OBLIGATIONS 1 Pension FundsFiduciary Governance : Investment and decision making based in processes with an adequate basis. Mitigate conflicts of interest and agency problems. Prudent Fiduciary Obligation with the Fund Specialists professionals in investment and risk management. Investor Aligns interests with those of the affiliates In the process of investing Fund resources, the AFPs must act : • With the objective of providing benefits to each Fund’s affiliates; • With the diligence and competency required of an investment expert; • With impartiality, care, reserve, discretion, prudence and honesty; • Maintaining a risk-return balance appropriate with each Fund’s objectives; • Diversifying the investments in such a way that the portfolio maintains a level of risk reasonable for the Fund’s objectives; and • Respecting and complying the applicable rules and laws. Responsibilities defined at governing, managerial and operational levels.

  14. AFP Board of Directors Pension Fund Fiduciary Governance Corporate Governance Investments (Front Office) Risks (Middle Office) Custody, Record Keeping, and Accounting(Back Office)

  15. 3 Best Practices: FIDUCIARY OBLIGATIONS Code of Ethics: Based on international standards and applicable to all personnel involved in the investment process, it includes Personal Investment Policy, Conflict of Interests, Proper Use of Information, etc. Professional Capacity: The AFP define the minimum requirements for training and experience for investment and risk management personnel to guarantee a sufficiently high level of technical competence. The AFP have indicated a preference for requiring that covered employees pass the CFA Level I exam. Conflicts of Interest: The AFP cannot redistribute gains or losses between funds, within funds, to the management company, or to related third parties. Prohibited Trading Practices: The AFP have drawn up a detailed list of trading practices which will not be used. Some of these practices are Front Running, Cherry Picking, Insider Trading, etc. Marketwatch: Both the AFP and the SBS have marketwatch systems to detect possible trading violations. Evaluation of Trading Costs: The AFP should take an inclusive approach to evaluating investments, including all relevant trading and execution costs, to ensure that they acquire the most competitively priced instruments.

  16. 2 Daily access to detailed risk and investment information: 1 Requirements for the authorization of new asset classes and instruments: 3 Monitoring the diligence of investment management: SUPERVISION OF INVESTMENT AND RISK MANAGEMENT Front Office: Expertise (Specialists) Middle Office: Appropriate Risk Evaluation Back Office: Adequate settlement and clearing, record keeping, and accounting capacity. Daily Investment Report including details of all transactions. Direct access to depository and custodian accounts Validation, checks, and daily audit of the investments and NAV of each fund Register of instruments and counterparties. 4 Modern and flexible regulation and supervision based on best practices: Market Watch Prudent Investor Rule Best Practices Investment Policies Performance Analysis Risk Limits Appropriate Personnel and Resources Prevent adverse situations for the affiliate. Focus on the supervision of processes and the management of investments and risk. Specialists with the required know-how to adequately audit investment and risk management. Adjust regulation based on market evolution and promote more efficient investment options.

  17. EVOLUTION OF THE MULTIFUND SYSTEM TO DATE • Start Date: December 9, 2005 • Initial low levels of inter-fund movement due to: Fund 1: Mandatory transfer for persons over 60. Fund 2: Perceived as neutral and well-known Fund 3: Perceived as risky. Competition caused by the entrance of a new AFP interfered with new system’s publicity campaign Electoral uncertainty. Wait-and-see attitude. Expected higher levels of inter-fund transfers based on return differential between funds. Structural limitations on the supply of investment opportunities drives the development of new domestic investment alternatives (private placements, structured products, project finance, etc.) and an evaluation of the external investment limits. Pension funds in the last 6 years have grown at a 27% annual rate.

  18. BENEFITS OF THE MULTIFUND SYSTEM Higher expected pension benefits due to compounding effect (1% increase in returns during 30 years implies around 20% higher expected pension benefit) The improved decision-making process and the alignment of the affiliate’s and AFP’s interests towards more efficient investment management, guarantees a transparent process which will generate value for everyone. Greater efficiency in the savings-investment cycle of the economy improves the virtuous circle of development and growth, improving the permanent income of affiliates.

  19. THE MULTIFUND SYSTEM’S ENVIRONMENT

  20. IMPACT AND ADDED VALUE OF THE MULTIFUND SYSTEM

  21. IMPACTO Y VALOR AGREGADO DE LOS MULTIFONDOS

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