PENSION REFORM

1. …Fundamentals of Presentation to the Pencom Conference Elias Masilela PENSION REFORM

2. Theme of conference • Investment…? • Basic fundamentals remain important • Retirement system can never be over-mature • It cannot be implemented in isolation of other reforms • Investment is an intermediate step, yet an important one • It assumes that money has been saved and available for investing • Savings are inadequate in SA… • Savings performance has been a global concern in the past

3. Aim of presentation • Highlight the importance of a sound retirement design • Identify the importance of sound regulation • Interrelationship between retirement saving, investment and growth

4. Road map • Why retirement funding • Social objective function (SOF) • Hurdles to SOF – value chain • Why reforms • Other social considerations • Role of sound investing • Role of regulation in investment environment • Balancing financial and social returns • Conclusions

5. Why retirement funding?

6. Role of retirement savings (1) • Consumption smoothing • Deal with household vulnerability • Poverty alleviation amongst the elderly • Income redistribution • Manage long term fiscal risk • Adequacy of savings • At macroeconomic level, improve saving/investment balance • Deal with a rising passivity ratio

7. Role of retirement savings (2) • Source of long term savings • Financial market deepening • Enhanced intermediation • Catalyst for efficient trading and settlement system • Influence corporate governance • Particularly under mandatory regime • PIC in SA

8. Conditions for success • Investment policies are critical • Buy and hold has minimal impact on liquidity • Dynamic trading related to short-term speculative positions • Geographical limitations • Exchange control restrictions

9. Implications of poor saving • Higher cost of capital • Low investment thresholds • Increased fiscal costs and reduction in social and economic delivery • Poor growth • More difficult to deal with poverty • Household vulnerability

10. Saving decisions Source: Eighty20, 2007, The Savings Market for the Poor

11. Short term savings leading Source: Finscope South Africa 2006

12. Social objective function

13. Multi-pronged objectives • Saving for retirement cannot be the only objective • Policy should deal with all other societal objectives • Income distribution is major challenge • Inadequate incomes to save • Lack of information and education • Rampant poverty • Social security becomes an imperative

14. Time value of consumption? Transition to retirement End state (Retirement) Current state • What level of welfare should society enjoy? • Ability to manage immediate risks (death, disability, unemployment)? • How meaningful is retirement funding, therefore? • What is the aim of the retirement design? • Retirement and/or social security? • How many people can afford to save for retirement • What retirement amount is adequate? Replacement ratio • What form of retirement is appropriate? • How many people will reach retirement? • Preserving income growth • For low income earners, risk and current welfare is more important • For high income earners, retirement is more important

15. Social Security defn. “… an institutional arrangement, driven by the state to secure the welfare of members of society through securing a certain amount of minimum income, during their productive years and in retirement. It is a system that prevents destitution in the case of members of society faced with incapacity and unemployment. It is a highly distributive institution that relies on the principle of solidarity amongst the income capable and the less income capable…” The design of such system varies from society to society depending on the underlying philosophies and circumstances.

16. Hurdles to social objective function

17. Value chain Retirement savings = (Replacement ratio) + Contributions: ƒ(Ŷ, Cons. behaviour…) + Returns: ƒ(ř, Ρ˙, choice of manager…) + Period to retirement: ƒ(Ŷ stability, Ē/Ū…) - Leakages: ƒ(Т, Ρ˙, erratic Ē, Intermediate costs, ancillary benefits…)

18. Conditions • Sound macroeconomic policies • Effective regulation • Robust accounting and legal standards • Information symmetries/transparency

19. Consequence • If objective function is sub-optimal or society fails to realise optimality • …Need for reform • …Any resistance often is imposed on the state

20. Why reforms

21. Concerns of most economies • Cost of provision • Poor efficiency • Lack of competition • Poor coverage • Future fiscal risk • Lack of trust of government and politicians • Design flaws • Inability of state to administer • Poor fund management • Inequitable benefits • Regressivity in income distribution

22. Globally: Reactionary considerations… Short term budgetary constraints Demographic pressures, ageing and dependency ratios Inefficient public systems Untrustworthy governments South Africa: Proactive considerations… Long term fiscal abilities Acute social imbalances and dependency ratios Inadequate private system Fragmented public sector system Triggers for reform

23. Backdrop to Chilean reform • Considered it as a macro rather than a sectoral reform • Unsustainable PAYG system • Demographic pressure • Abuse • Premature retirements • Reform had to be based on honest promises to deliver • Guarantee promise way into the future • RDP and GEAR nostalgia…? • Key macroeconomic pre-requisites • Structural fiscal surplus targetting (1%) • Inflation targetting (3%) • Floating exchange rate regime • Labour market flexibility

24. Economic impact of reform • Labour market impact • Flexibility • Productivity • Shifting and sharing of risk • Government vs individuals • Poverty impact • Industry impact • Employment • Firm efficiency • Fiscal impact

25. South African reforms

26. Why reform? • Increasing access • Increasing welfare • Reduce dependency on the state • Adequacy of retirement savings • Deal with household vulnerability • Increase overall savings • Increase shareholder activism • Empowerment of individual saver • Efficiency, sustainability and equitability

27. Feature of SA economy • Poor domestic savings (15%) • Long history of government dissaving • Low inflation environment (6%) • High unemployment (35%) • Loe literacy levels • Skewed income distribution • High dependency ratios • High poverty levels • Rising marginal propensities to consume • Greater social transfers • Financial liberalisation • Higher credit-financed consumer spending • Low income levels

28. Implications • Cannot plan for retirement only • Social security is equally…, if not more, important • South Africa does not have a comprehensive social security net • Huge gap between haves and have nots

29. Key proposed reforms • Compulsory state retirement fund • Compulsory social security • Risk benefits and annuities • Individual savings accounts • Critical contribution thresholds • Wage subsidy • Administration of national fund by state? • SOAP means test made non-binding • Double dipping • Consolidation and pooling of funds • Preservation • Changes in tax treatment • Common legislation • Post retirement medical aid

30. Social security model Funded DB, from productively employed “A” is similar to “C” save only for funding Unfunded DB, from fiscus C A B Social Security (DB) Basic social security and welfare - Universe Individual accounts (DC) 50-60% Death, disability, Annuities, Unemployment 40-50% • SOAG • CSG Retirement (DB) (Income based) Opt-out option Guaranteed rates of return? Cross-subsidisation - solidarity Accreditation (Factors) Inflation linked bonds

31. Macroeconomic consequence • Increased retirement provision • Provide without risking job creation • Poverty reduction • Increased aggregate savings • More competition on service provision • Short term loss of business to private sector • Consolidation has positive impact on umbrella business • Expansion of markets • Shift from supply to demand led market… • Reduced need for large marketing budgets • What is the net impact…?

32. Industry challenges identified • Likely shrinkage of private sector participation due to mandatory nature of scheme • Admin business • Risk business • Annuities business • Asset management business • Benefit and other consulting business?

33. Role of sound investing

34. Case for sound investment • Preserve purchasing power of savings • Mitigate for • Low contributions • Leakage • Build confidence towards the system • Deal with short and long term expectations

35. Sequencing • Internationally, retirement saving leads financial markets development • In South Africa we started with financial deepening to the detriment of the poor • Poor coverage • Complex systems that excludes the average person • Large conglomerates and high concentration

36. Role of deep capital markets • Essential economic assets in their own rights • Need to be treasured • Encourage better portfolio returns and risk management • Efficient diversification of investment • Essential growth vehicles

37. Assets

38. Coverage

39. Why sound investing is critical • Conversions from DB to DC • Shifting risk to beneficiaries • Managing past and future conversions • Effective member representation on boards • Better skilled cadre of trustees (Numbers??) • Deciding on the amount of investment risk that is appropriate for the members • Growing market volatility • Corrosion on savings

40. Investment (1) • In the age of DC funds individual bears the investment risk • Trasparency in management • Competitive returns • Beat inflation at all times • Preserve purchasing power • Take account of life cycle • Costs remain an essential element of realising good returns • Socially useful investment • Sound regulation

41. Why regulate investment • Pension and insurance reserves are biggest component of household wealth • Protect savers • Establish more certainty in the industry • Ensure healthy returns over time • Avoid over-speculation and risk taking • Exposure limits in particular to currency risk • Ensure asset/liability matching • Compensate for absence of strong and transparent markets

42. Advantages Retains domestic savings Capital market deepening Forces creative intermediation Encourages investment in real economy Growth Disadvantages Capital outflows and possible flight Failure to reap benefits of domestic savings Disallows divesification Arguments re country limits

43. Global rule of thumb • Thresholds for phasing out limits • Assets/GDP ≤5%  Bonds • Assets/GDP >5%, ≤ 20%  Bonds and equities • Assets/GDP > 20%  Bonds, equities and alternative investments

44. Global rule of thumb • Depends on • Risk appetite • Sophistication of market and society • Economic openness • Macro stability • Regulatory effectiveness

45. Risk of regulation • Over-regulation • Breeds bottlenecks and inefficiencies • Potential abuse of resources by government • Asset prescription • Inappropriate financing of government deficits • Poor returns to beneficiaries

46. Regulation in SA context • Shifting focus from financial stability… • Emphasise increased access • Poor • Previously disadvantaged • People in outlying areas • Diversification • Relaxing limits • Prudent-expert rules • Sound investment policy statement • Performance and transparency • Member choice? • Phasing out exchange controls

47. Investment decision challenge • Short versus long term views • Socially responsible investment decisions • Political or economic imperative? • Are returns comparable? • Is it compulsory? • How conscious are owners of assets?

48. Investment decision challenge (Long-term) Economic returns Risk of not doing this? Financial returns Social returns (Short-term) (Long-term)

49. Summing up - Key themes • End state • Optimal replacement ratio • DB vs DC • Funded vs unfunded • Benefit structure and design • Savings vs risk • Annuity, Housing, medical • Compulsion vs voluntary savings • Incentives and impact • Preservation • Appropriate regulatory structure

50. Conclusion • Investment focus on its own, will be inadequate to deal with our challenges • Macroeconomic environment is important • Income levels should allow for adequate savings first • Sound retirement regime is essential • However, sound investment is essential for the realisation of comfortable retirement for our societies