National Commission for the Retirement Savings System consar.gob.mx

1. National Commission for the Retirement Savings System www.consar.gob.mx The Mexican Pension System for Private Sector Workers Adapting India’s Financial Sector to a Globalizing World November 2002

2. Content • Overview of the Pension System for Private Sector workers • Desirable Characteristics of an Individual Capitalization Account System • Conclusions

3. In 1997, Mexico reformed the Private Sector Workers’ Pension System • Previous regime was a defined benefits PAYG system. • The PAYG system was severely underfunded. • The new scheme is an Individual Capitalization Account (ICA). • Contributions are made by the worker, the employer and the Federal Government.

4. By September 2002, the System has affiliated 28.5 million workers As of September 2002, 8.5 million accounts of workers who had not chosen a Fund Manager (Afore) were distributed 28.5 30 26.5 • Active contributors: 43.6% • Averagemonthly income: 500 USD 25 20 17.8 15.6 Millions of Affiliates 13.8 15 10 5 0 1998 1999 2000 2001 September 2002 Figures as of December of each year.

5. 10.2 10.0 10.0 9.7 9.8 9.6 Percentage 9.4 9.2 9.0 9.0 8.8 8.6 8.4 Jul-02 Jan-02 Oct-01 Apr-02 Jun-02 Feb-02 Dec-01 Mar-02 Sep-02 Nov-01 Aug-02 May-02 The system has been able to offer high real returns As of today, annual average compound real return is 9.3% Real Annual Compound Return (Last 12 months)

6. Five years after the inception of the System, total assets sum up 59 US billion dollars, or 10% of GDP Retirement Savings as % of GDP 12.0 10.1 % SAR 92 (Old Regime) 2.1% 8.9 % 10.0 8.0 7.1 % 6.1 % Percentage of GDP 6.0 Housing 3.0% 4.0 Retirement Funds invested by Pension Funds 5.0% 2.0 - September 2002 1999 2000 2001 SAR 92 Retirement Housing Siefores are expected to receive US$4.0 billion dollars of mandatory contributions in 2002 Figures as of December of each year

7. Assets under management will reach 50% of GDP Pension Funds’ Assets Under Management Estimations 70 60 50 40 Percentage of GDP 30 20 10 0 2002 2005 2008 2011 2014 2017 2020 2023 2026 2029 2032 2035 2038 2041 2044 2047 2050 2053 2056 2059 2062 2065 2068 2071 2074 *Assumptions: 3.5% GDP real annual growth rate, 4.25% real annual return rate and CONAPO’s population growth rates Source: CONSAR

8. Content • Overview of the Pension System for Private Sector workers • Desirable Characteristics of an Individual Capitalization Account System • Conclusions

9. The ultimate goal of a pension system is to provide adequate replacement rates to the greatest number of workers To achieve that goal the system should have the following desirable characteristics: • Effective checks and balances • Sufficient contributions • High risk-adjusted returns • Low costs • Competitive fees • Broad coverage or a National Pension System

10. Content • Overview of the Pension System for Private Sector workers • Desirable Characteristics of an Individual Capitalization Account System • Effective checks and balances • Sufficient contributions • High risk-adjusted returns • Low costs • Competitive fees • Broad coverage or a National Pension System • Conclusions

11. Effective checks and balances are a must since any pension system is sensitive to social, political and economic issues... In Mexico, checks and balances take place at the Regulatory Agency and at the Fund Manager level: • Regulatory Agency • Board composition: • Workers and employers representatives in addition to government officials from the social and the financial sector participate in the governing bodies. • Investment and fees regulations are subject to the favorable opinion of the above mentioned representatives. • Core activities: • A daily automated surveillance of the system’s operational process and compliance with the investment regime is performed. • In-site inspections at fund managers’ premises take place on regular basis.

12. Effective checks and balances are a must since any pension system is sensitive to social, political and economic issues (Cont) In Mexico, checks and balances take place at the Regulatory Agency and at the Fund Manager level: • Fund Manager • Independent board member: avoids conflicts of interest in key decisions. • Compliance officer: verifies Consar’s and own regulation compliance. It develops self regulation schemes and designs corrective programs. • Risk committee: establishes a risk profile of the fund and authorizes limits, models and guidelines. • Investments committee: determines the investment strategy and designates the authorized portfolio manager.

13. Content • Overview of the Pension System for Private Sector workers • Desirable Characteristics of an Individual Capitalization Account System • Effective checks and balances • Sufficient contributions • High risk-adjusted returns • Low costs • Competitive fees • Broad coverage or a National Pension System • Conclusions

14. Sufficient contributions are the cornerstone of adequate replacement rates... • Target replacement rates should be primarily a function of contributions • Reliance on high expected returns is not advisable • In Mexico, the Government participates in the new system in two ways: • Contributing periodically to each worker’s account. A fixed amount has redistributive effects. • Guaranteeing a minimum pension.

15. Sufficient contributions are the cornerstone of adequate replacement rates (Cont) • A special voluntary savings account with favorable tax treatment is highly desirable: • In October, Mexican Congress reformed the Law governing our system. One of the new features was the creation of a Retirement Complementary Contributions account. • Last December, Congress approved some changes to the tax code that will allow workers to deduct voluntary contributions to a pension plan. • These two reforms are key building blocks to create a US-type 401-K scheme.

16. Pensions in developed countries depend heavily on voluntary savings Replacement Rates in Developed Countries 80 70 68 68 70 60 60 Voluntary System 25 28 13 35 50 Replacement Rate (%) 40 Mandatory System 30 40 47 43 20 35 10 0 Japan United States UK Canada Source: OCDE, The Macroeconomics of Ageing, Pensions and Savings (Khol y O’Brien 1998)

17. Content • Overview of the Pension System for Private Sector workers • Desirable Characteristics of an Individual Capitalization Account System • Effective checks and balances • Sufficient contributions • High risk-adjusted returns • Low costs • Competitive fees • Broad coverage or a National Pension System • Conclusions

18. An investment regime is necessary given the characteristics of the system • Mandatory contributions • Sole financial asset for most participants • Socially and politically sensitive scheme • Governmental minimum pension guarantee Need to avoid excessive risk

19. The investment regime should allow the greatest diversification in order to maximize returns at each risk level However, according to our vision, a comprehensive risk limit is granted given the system’s characteristics Return Risk maximum level

20. The risk limit can be expanded as asset managers build up the necessary skills Mexico’s skills-build-up path Return • Independent Risk Committee that establishes internal limits, methodologies and policies • Risk Management Unit that carries on a daily basis the Risk Committee’s guidelines • ISO-9000 for the investment strategy process • Compliance with international “best practices” for operational risks • 1 • 0 Risk

21. Given fund managers’ increasingly comprehensive set of skills, Consar’s Board recently approved two important changes to the investment regime • Operations with derivatives of underlying securities permitted in the investment regime will be allowed. Fund Managers will have to comply first with strict regulations of risk management prudential rules and operative requirements. • A VaR limit that will substitute actual duration-type parameter will come into effect by December 2002.

22. Content • Overview of the Pension System for Private Sector workers • Desirable Characteristics of an Individual Capitalization Account System • Effective checks and balances • Sufficient contributions • High risk-adjusted returns • Low costs • Competitive fees • Broad coverage or a National Pension System • Conclusions

23. A cost effective ICA industry should capture available economies of scale To accomplish it, some core processes can be centralized: • Contributions’ collection • Workers database (Name, Social Security Number, Fund Manager) • Contributions and returns’ recordkeeping In Mexico, Fund Managers take care of the third process

24. A key feature of the Mexican Pension system is the design of its mandatory contributions collection process The Social Security Institution and the National Data Base play a key role in this process Social Security Institute 1 a. Sends a bill of due contributions 1 b. Audits companies’ correct and prompt payments 4. Sends information on received payments National Data Base Fund Manager 3 a. Sends information on received payments Collector Bank 6. Delivers contributions Employer 3 b. Sends contributions Clearance Bank 2. Pays contributions Central Bank 5. Sends contributions

25. Content • Overview of the Pension System for Private Sector workers • Desirable Characteristics of an Individual Capitalization Account System • Effective checks and balances • Sufficient contributions • High risk-adjusted returns • Low costs • Competitive fees • Broad coverage or a National Pension System • Conclusions

26. Competitive fees are the result of the interaction of three key elements • Simple products: • Few and homogeneous options. • A fee structure that is easy to understand and to compare. • Adequate incentives: • Key decisions for the worker’s pension should be made by the most financial-literate and price sensitive person. • Costs of those decisions should be born by the decision maker in order to align interests. • Relevant and readily available information: • Specially, one that highlights the impact of fees and returns differences in the worker’s pension. • Easy to access through different channels.

27. + 35.9% 60,000 50,000 40,000 US Dollars 30,000 20,000 10,000 0 XXI ING Allianz Inbursa Banorte Tepeyac Principal Banamex Profuturo Bancomer Santander Relevant and readily available information... Fees differentials might have a significant impact on pensions Final Balance of the Retirement Savings Source: Consar. Estimates with an affiliate who earns three minimum wages (constant salary), initial balance of $20,973.26 Pesos, a term of 40 years, and the current fee structure. Balance invested at a real annual rate of 5% for every Afore.

28. Relevant and readily available information (Cont) An example is our internet-based pension’s calculator INPUT DATA • Actual Fund Manager (Afore) • Nominal monthly salary • Last pension fund balance • Number of expected additional working years • Expected annual wage increase • Expected rate of return

29. Content • Overview of the Pension System for Private Sector workers • Desirable Characteristics of an Individual Capitalization Account System • Effective checks and balances • Sufficient contributions • High risk-adjusted returns • Low costs • Competitive fees • Broad coverage or a National Pension System • Conclusions

30. The system should aim to achieve the broadest possible coverage A broad coverage: • Reduces the number of non-contributing workers that can become a dead weight cost to the system and thus an obstacle for decreases in fees. • Diminishes the fragmentation of rights when workers change of employment.

31. Unfortunately, in Mexico 60% of the Employed Labour Force does not have a formal pension plan The other 40% has a pension plan but within unrelated systems 45 40.7 12.5 40 35 2.4 30 1.0 0.6 24.2 Millions of inhabitants 25 20 15 10 5 0 ELF1 IMSS 2 ISSSTE 3 STATE INSTITUTIONS 4 OTHERS 5 NOT COVERED 1. Employed Labour Force. 2. IMSS (private sector employees). July 2002 3. ISSSTE (Federal Government employees). May 2002 4. Ham Chande, Roberto; “The Future of the Pensions”. UNAM 5. Includes: ISSFAM, PEMEX, CFE, LFC, Universities (80). Sources: INEGI 2000 Census, Social Security Institutions and First Governmental Address to the Nation

32. To increase Pension Coverage, the System will be opened to the rest of the population on a voluntary basis Individual accounts will be available to: • State workers who want to transfer their complementary pension savings to an Afore. • Independent workers who want to make voluntary savings for retirement. • Private, State, Municipal and Public Agency's workers who want to make retirement complementary contributions in the Afore who manages their employer’s Pension Plan based on individual accounts.

33. The coexistence of different pension schemes calls for the creation of a National Pension System (NPS) Pension System for Private Sector Workers The main goal of a NPS is the preservation of pension rights among different employers regardless of the full completion of pension prerequisites Pension System for State Service Workers Pension Plans for Public Entities, Municipalities, and States Universities Pension Plans Occupational Pension Plans

34. The financial feasibility and the portability are key elements in the construction of a National Pension System Element Implication Importance • Financial feasibility • Portability Matches the benefits, contributions, and requirements Recognition, preservation and transfer of rights when the worker switches pension plan Gives certainty to the worker and avoids fiscal contingencies for an actuarial imbalance Does not allow the loss of rights because of being affiliated to different plans through worklife

35. Content • Overview of the Pension System for Private Sector workers • Desirable Characteristics of an Individual Capitalization Account System • Conclusions

36. Conclusions • ICA are, in our opinion, the best option to reform a pension system • The outcome depends on the specific design of some key elements • Desirable characteristics include: • Effective checks and balances • Sufficient contributions • High risk-adjusted returns • Low costs • Competitive fees • Broad coverage or a National Pension System

37. National Commission for the Retirement Savings System www.consar.gob.mx The Mexican Pension System for Private Sector Workers Adapting India’s Financial Sector to a Globalizing World November 2002