Santiago Montenegro and çlvaro Pedraza give an overview of the Colombian pension system
The pension fund system in Colombia, as it stands today, dates back from the expedition of Law 100 in 1993. The system is still young, not only because of the age composition of its participants, but also because it requires additional modifications to optimise its efficiency.
History of the system
At the beginning of the 1990s, it became clear the Colombian defined benefit (DB) system was not sustainable from a fiscal point of view. The financial reserves of the Institute of Social Security (ISS), in charge of private sector pensions, were being depleted at an accelerated rate.
Besides the ISS, other special regimes for different groups of public employees existed. In all cases, contributions were very low and benefits high, with replacement rates extremely generous. These were calculated on the basis of the average salary for the last two years before retirement.
This asymmetry benefited only high earning workers at the end of their labour life, usually those with higher levels of education. Considering approximately 60% of the working force had - and still has - a rather flat wage path, or an expectation of low future income, this method for calculating the pension was biased against the most vulnerable.
After a tough political debate, Congress adopted a Chilean-like pension system with the following characteristics: (i) The country would adopt a dual pension system. An individual savings regime (RAI) was created in addition to the DB system. Even new workers could opt for either of the two systems. For affiliates with prior history in the DB system, and who decided to move to the new system, bonds would be recognised and issued by the government. (ii) The RAI had two main features. It was defined to be a capitalisation system with solidarity. In fact, all affiliates were to assign 1.5% of their salary for a minimum pension fund which was also created. These resources would be used to guarantee a pension equivalent to the official minimum wage when affiliates who had reached the age for retirement (62 for men and 57 for women) had not accumulated enough capital to obtain a standard pension. Additionally, a pension solidarity fund was created to offer grants for the population in extreme poverty or indigence. (iii) A "transition regime" was defined, meaning that for the following 20 years, people so wishing could get their pension in the DB system, according to the original rules. In practical terms, the approved new parametric reform was to be applied 20 years later.
Due to the persistence of the DB system and the duration of the transition regime, the government budget will be exposed to severe pressures over the next 50 years. After a 2005 Constitutional Reform that eliminated special pension regimes and reduced certain privileges, the public pension debt amounted to 150% of GDP.
The new savings regime was to be managed by the AFPs (Administradoras de Fondos de Pensiones y Cesant'as). In the first two years, ten AFPs offered their services to new workers and old affiliates of the DB system. Seven AFPs were domestic companies, while the other three were foreign. Today, there are six AFPs, two local (Protecci-n and Porvenir) and four foreign-owned (Skandia, BBvaHorizonte, ING, which recently aquired Santander, and Citicolfondos).
The young Colombian working population has chosen this option and the AFPs have become the most important managers of savings in Colombia. In addition, the AFPs also manage severance payment funds and voluntary savings.
The value of the capitalisation system, including the severance payments and voluntary savings, amounted to US$30bn dollars at the end of 2007, which was equivalent to 17.1% of GDP. Monthly contributions reached $250m. Affiliates to the funds are young: out of 7.8 million affiliates, 73.43% are less than 40 years old.
Since the beginning, the investment regime for the capitalisation system has been rather flexible. The only limit established by law, was a maximum of 50% of the total portfolio in government securities. The Superintendecia Financiera de Colombia, responsible for pension supervision, has made the necessary adjustments to the industry's investment regime, according to the evolution of the capital markets.
The funds' yearly real returns have reached the impressive figure of more than 10% through the history of the capitalisation system. As of 31 December 2007, 40% of the total managed assets correspond to previous returns, while the other 60% are contributions. To a large extent, these profits were achieved by the valuation of fixed income securities as inflation came down from a two digit level in the 1990s to 4.48% in 2006.
Considering that further reductions of the inflation rate are still possible, it will certainly be no lower than zero. For that reason, it is safe to say that the "golden years" of fixed income securities have come to an end.
This is why institutional investors, including AFPs, have the great challenge of searching, finding, creating or facilitating the creation and development of new investment instruments that respond to the needs of long term savers. Furthermore, given that the country needs to respond to the challenges of globalisation, the savings regime is willing to invest in infrastructure projects or in areas with high potential, clear competitive advantages and high demand in world markets.
Another concern is the recent volatility in local and foreign capital markets. This volatility is particularly critical for the savings accumulated by older workers closer to retirement.
At this age, an affiliate cannot replace adverse financial results with future work. On the other hand, a young affiliate may be willing to face higher risks in exchange for higher yields, knowing that he or she may count on his or her human capital and future labor.
Such differences of returns and risks cannot be reconciled in a single fund system. In this direction, the government is about to submit to Congress a financial reform project to introduce a multifund system following the experience of Chile, Mexico, Perœ and other countries.
Meanwhile, both the government and the industry are reviewing other regulatory aspects of the system. More specifically, the requirement for a minimum return guarantee is being considered.
When an AFP fails to obtain a return for its managed fund above the minimum threshold, it must respond with its own capital for the difference. As it has been argued, this scheme has two main defects: (i) it encourages conservative investments and (ii) it induces the well known 'herd' behaviour.
This requirement separates the interests of the affiliates and those of the AFP. Ideally, the minimum return guarantee should not exist, allowing free competition between AFPs for higher yields.
Unfortunately, politically, this may not be an option. Another possibility is to generate an additional incentive with a commission on performance. This commission would incentivise the AFP to outperform the benchmark, while limiting the risk of failing to provide the minimum return.
In summary, this industry has been beneficial for millions of Colombian workers, for the Colombian State and for society as a whole. Although a lot has been accomplished, there is a long road ahead.
The introduction of the multifund system, along with a more flexible investment regime, will be an important move towards ensuring Colombian workers enjoy a more pleasant retirement.
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