Contractual Savings and

Financial MarketsAlberto R. Musalem,Thierry Tressel, and Gregorio Impavido

2

Definition and Importance of Contractual Savings

Funded benefit plans: Retirement savings and Annuities Life insurance Funded unemployment benefits, gratuity, end of

service indemnity, severance payments Funded contingencies: down payment for a house,

education, weddings, funerals Importance: supply long term savings

3

Financial assets of contractual savings, (% of GDP)

Countries 1970 1980 1990 2000Switzerland 51 70 88.51 162.74

life 32.29 60.74pension 56.22 102

United Kingdom 43 38.81 86.91 176.57life 17.77 36.87 91.57pension 21.04 50.04 85

The Netherlands 45 66.9 108.11 182.82life 21.13 36.06 67.62pension 45.77 72.05 115.2

United States 40 43.31 69.2 99.79life 17.72 25.85 29.89pension 25.59 43.35 69.9

Chile 1.1 29.94 67.49life 5.59 16.58pension 1.1 24.35 50.91

South Africa 40 39.27 78.13 134.92life 17.2 43.94 79.63pension 22.07 34.19 55.29

Malaysia* 18 20.12 44.29 64.18life 3.07 5.97 11.14pension 17.05 38.32 53.04

Singapore* 17 41.15 117.86 78.11life 2.81 6.16 11.17 21.64pension 14.19 34.99 106.69 56.47

Singapore: Employees Provident Fund; and Monetary Authority of Singapore, 2002.

Source :1970 data from Davis (1995).OECD:Institutional Inv. Statistical YB, 2001; & Insurance Statistics YB, 2002.

Notes :* Prior to 1990, data do not include funds invested by w orkers in housing and other approved assets.

South Africa Reserve Bank, 2002. Malaysia Employees Provident Fund; & Life and General Insurance Funds, 2002.

Chile:Superintendencias de Administradoras de Fondos de Pensiones; Superintendencias de Valores y Seguros. 2002.

4

Shares of contractual savings and M2 in financial assets (%, 1996)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

m2%

ctr%

5

Economic Impact of Contractual Savings

Potential positive effects on national saving Requires fiscal adjustment to finance transitional costs of

pension reforms that increase funding More likely with mandatory funded systems due to credit

constraints faced by low wage earners Less likely with voluntary plans

Allocation effects due to higher share of long term funds Securities market development Improvement in financial risks management

Growth effects Due to allocation and potential saving effects

6

Impact of Contractual Savings Institutions on Securities Market (I)

An increase in CS relative to domestic financial assets promotes depth of stock and bond markets (MK/GDP)

The impact on stock market depth and liquidity (VT/GDP) is stronger in countries with more transparent corporate information

The impact on the stock markets is stronger in countries where:

1. The financial system is more market based

2. Contributions to pension funds are mandatory

3. Portfolio transactions in the capital account of the balance of payments are lower

7

Impact of Contractual Savings Institutions on Securities Market (II)

The impact on the bond market is stronger in countries with a bank based financial system

The impact of contractual savings institutions on securities market is not the consequence of a joint determination of both contractual savings institutions and financial markets by other slow-moving characteristics of economies (level of development, education, demographic structures, legal environment)

Accordingly, policies shaping the institutionalization of savings do matter

8

Social and Financial Risk Mitigation Effects

Beneficiaries improve management of longevity, death and other risks

Reduce debtors refinancing risks, including governments, by lengthening the maturity of debts

Reduce pressure on banks to engage in excessive term transformation risks

Reduce enterprise vulnerability to interest rate and demand shocks due to improved financial structure (higher equity/debt ratio)

9

Government long-term to total debt ratio and contractual savings assets, 1996 (% GDP)

Financial Assets of CS over GDP.003 1.482

.32

.97

TUR

HUN

GRC

AUT

DEU

KOR

NZL

NOR

FRA

JPN

SWE

FIN

DNK

AUSISL

CAN

SGP

USA

ZAF

CHE

GBRNLD

10

Banks’ Short Term to Total Loans vs Contractual Savings: Conditional Correlation Regression Line: STL = -6.03 (4.58) * Log(Csfa,%GDP)+37.5 ( R2=0.18)

LogCSfa,%GDP(-1)

STL Fitted values

-7.48757 .517491

.00062

96.0695

11

Banks’ Net Interest Margin (NIM) and Contractual Savings: Conditional Correlation

Regression Line: NIM = -0.60 (-10.78) * Log(Csfa,%GDP)+1.47 (R2=0.35)

LogCSfa,%GDP(-1)

NIM Fitted values

-7.48757 .517491

.565787

11.8842

12

Banks’ Credit Risk (Loan Loss Provisions to Total Assets) and Contractual Savings: Conditional Correlation Regression Line: LLTA = -2.8 E-3 (-3.23) * Csfa,%GDP + 0.6 ( R2 = 0.043)

CSfa,%GDP(-1)

LLTA Fitted values

.056 167.781

.025104

4.17727

13

Firms’ Leverage (TDTE) vs Contractual Savings: Conditional Correlation - Market-based Financial

Structure Residual = -1.16 * (CS Fin. Assets, % Sec. Market) (t-stat = -2.47) Pooled reg., 82 obs .

Un

exp

lain

ed

Re

sid

ua

l ( T

DT

E )

CS Financial Assets, % Sec. Mark.122694 1.14333

-2.30492

6.70387

14

Firms’ Leverage (TDTE) vs Contractual Savings: Conditional Correlation - Bank-based Financial Structure

Residual = 4.0 * (CS Fin. Assets, % Sec. Market) (t-stat = 2.37) Pooled regression, 74 obs.

Unexpla

ined R

esid

ual (

TD

TE

)

CS Financial Assets, % Sec. Mark.029634 .608034

-1.6972

5.48049

15

Firms’ Debt Maturity vs Contractual Savings: Conditional Correlation - Market-based Financial Structure

Residual = -0.09 * (CS Fin. Assets, % Sec Mkt) (t-stat = -3.84) Pooled regression, 82 obs.

Unexpla

ined R

esid

ual (

LT

DT

D )

CS Financial Assets, % Sec. Mark.122694 1.14333

-.18621

.11524

16

Firms’ Debt Maturity vs Contractual Savings: Conditional Correlation - Bank-based Financial Structure

Residual = 0.28 * (CS Fin. Assets, % Sec Mkt) (t-stat = 5.28) Pooled Regression, 74 obs.

Un

exp

lain

ed

Re

sid

ua

l (L

TD

TD

)

CS Financial Assets, % Sec. Mark.029634 .608034

-.156052

.180361

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Main Issues with Contractual Savings in Latin America (I)

Except Brazil and Costa Rica, over-reliance on mandatory long term saving schemes

High administrative costs, high transaction costs (for members and fund managers due to interaction between pillars on collections and benefits), high industry concentration and lack of market contestability

High political risk due to dependency of pension fund regulators from governments

Over-regulated investment policies: High exposure to governments Restrictions to diversify investments internationally in an

environment where the best companies migrate abroad increases pension funds portfolio risks

18

Charge ratio in funded pension schemes

0 5 10 15 20 25 30 35

Bolivia

Australia

Kazakhstan

Colombia

Sweden

Uruguay

El Salvador

Chile

Poland

Peru

UK: stakeholder

UK: personal

Argentina

Mexico

Source: Whitehouse (2000)

charged, per cent of contributions / accumulation

maximum

minimum

maximumpermitted

master trust

19

Main Issues with Contractual Savings in Latin America (II)

Inadequate opportunities for members to manage market risks

Limited choices regarding portfolio composition (although some countries are expanding choices)

Conversion of accumulated balances into annuities at a given point in time only

Although supervision is gradually shifting towards a risk based approach, it is still focused on compliance

20

Recommendations to promote Contractual Savings in Latin

America (I) Review regulations and tax treatment to encourage

voluntary long term savings Review systems design:

Encourage market contestability by allowing opting out to employer sponsored plans (Australia, Brazil, Hong Kong)

Consider clearing house models (Sweden, Thrift Saving Plan for federal employees in the USA, Bolivia)

Adopt independent benefit payments between pillars (Argentina), and restrict switching across pillars (Colombia, Peru)

21

Recommendations to promote Contractual Savings in Latin

America (II) Consider adopting regulators which are independent from

governments and accountable to congresses (central bank model)

Adopt more flexible investment regulations based on the prudent person investment rule in tandem with risk based supervision, and allow gradual opening of investments in foreign securities

Improve members’ ability to manage market risks: Increase portfolio options Allow for multiple and partial conversions of members’

accumulated balances into annuities