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  1. 1. Pension Funds and Capital Markets in Macedonia Klaus Schmidt-Hebbel MAPAS Workshop on Pension Funds and Capital Markets Skopje (Macedonia), June 19, 2008
  2. 2. Outline <ul><li>Comparative International Experience on Private Pension Funds </li></ul><ul><li>Macroeconomic Conditions and Prospects </li></ul><ul><li>Financial and Capital Market Development </li></ul><ul><li>Pension Reform Features and Outcomes </li></ul><ul><li>Pension Reform and Capital Market Development: Future Challenges </li></ul>
  3. 3. 1. Comparative International Experience on Private Pension Funds
  4. 4. <ul><li>27-year world experience in mandatory fully-funded pension funds managed by private management companies </li></ul><ul><ul><li>Comprehensive introduction of a mandatory second pillar based on fully-funded privately-managed pension funds that invest in capital markets defined contributions accumulated in individual accounts: Chile in 1981 </li></ul></ul><ul><ul><li>Major structural reforms in industrial countries toward DC, funding, and private management (Switzerland, Australia, Netherlands, Sweden, etc.) </li></ul></ul><ul><ul><li>Large number of structural reforms that replaced PAYG systems by two-pillar systems in circa 20 developing and transition economies </li></ul></ul><ul><li>Reforms generally successful, subject to conditions: </li></ul><ul><li>a) Macroeconomic stability and/or lack of political interference in fund management (i.e., Chile versus Argentina) </li></ul><ul><li>b) Strong legal, regulatory, and supervisory set-up </li></ul><ul><li>c) Existence of competitive and liquid financial markets for at least: </li></ul><ul><li>- Government securities </li></ul><ul><li>- Domestic bank securities (at least deposits) </li></ul><ul><li>d) Access to international financial markets for foreign investment of pension funds </li></ul>International Experience on Pension Reform
  5. 5. <ul><li>The latter conditions are met by Macedonia, which started successfully its two-pillar pension system in 2006, after several years of careful preparation </li></ul><ul><li>International experience sows that initial composition of private pension fund investment portfolio is often biased toward government debt and bank deposits </li></ul><ul><li>But over time, portfolios are gradually diversified into domestic equity and corporate debt, domestic mortgages, and foreign investment </li></ul><ul><li>As time passes, larger portfolio diversification is attained as new asset classes are supplied in response to the funds’ demands -> virtuous cycle between private pension funds and capital market development </li></ul>International Experience on Pension Reform
  6. 6. <ul><li>We now review international evidence on the evolution and performance of many reformed pension systems, emphasizing Macedonia’s pension reform design and experience. </li></ul>International Experience on Pension Reform
  7. 7. Contributions to First and Second Pillars in Reformed Pension Systems
  8. 8. Contribution Rates, Contributions Ceilings, and Retirement Ages
  9. 9. System Coverage Rates, Informal Sector Size, and Relations between Contributors and Affiliates, Selected Countries, mid-2007 (a) Relationship between Size of Informal Sector and Coverage of New Systems (b) Coverage and Relationship Between Affiliates and Contributors
  10. 10. Size of Reformed Pension Systems
  11. 11. Demographics and Size of Reformed Pension Systems (a) Pension Expenditure and Age Dependency Rate (b) Total Assets and Contribution Rate of Second Pillar, and Years after the Reform in Latin American Countries
  12. 12. Pension Expenditure and Replacement Ratios in PAYG Systems, mid-1990s
  13. 13. Implicit Pension Debt before Reforms, Age Dependency Rate, and Role of Contribution-based First Pillar (PAYG) in Reformed Systems
  14. 14. Second-Pillar Affiliation Options for Workers by Age
  15. 15. Dynamics of Shares of Second-Pillar Contributions in Selected Latin American Pension Reforms
  16. 16. Number of Pension Fund Management Companies and Share of Total Pension Assets Managed by Two Largest Companies
  17. 17. Regulation of Second-Pillar Fees
  18. 18. Regulation of Fees in Second-Pillar Systems
  19. 19. Fee Revenues, Contributors, and Total Pension Assets in Latin America, December 2007
  20. 20. Sales Costs of Pension Fund Management Companies in Latin America, December 2007 (% of Total Costs)
  21. 21. Regulations of Pension Benefit Options in Second Pillars
  22. 22. Government Guarantees on Second-Pillar Returns and Benefits
  23. 23. Minimum Pension Guarantees
  24. 24. Pension Fund Investment Limits by Securities
  25. 25. Investment Limits on Government Assets and Other Assets
  26. 26. Portfolio Composition of Pension Funds, as of June 2007 Chile Peru Colombia Argentina Uruguay Mexico Bolivia El Salvador Costa Rica
  27. 27. Dominican Republic Kazakhstan Bulgaria Poland Macedonia Portfolio Composition of Pension Funds, as of June 2007
  28. 28. 2. Macedonia: Macroeconomic Conditions and Prospects
  29. 29. <ul><li>Macedonia has attained massive progress in macroeconomic and financial stabilization </li></ul><ul><li>At the same time, much success has been achieved in adopting deep structural reforms, including pension reform </li></ul><ul><li>In the following, we review progress to date, as well as medium-term macroeconomic projections (largely based on published IMF documents), and future risks to policies and reforms </li></ul>Macroeconomic Conditions and Prospects
  30. 30. NBRM Policies geared at Exchange-Rate Stability and Sustainable Money and Credit Growth: Denar/Euro Exchange Rate, Short-term Nominal Rate on 3-m Deposits, and M3 Growth
  31. 31. Sustainable Fiscal Policy: Central Government Expenditure/GDP and Budget Balance/GDP, 2004-2012
  32. 32. Sustained Growth and Low Inflation (GDP Growth and Average CPI Inflation, 2004-2012)
  33. 33. A Sustainable Foreign Position: Current Account/GDP and Foreign Debt/GDP, 2004-2012
  34. 34. Moderate but sustained Real Wage Growth, consistent with gradually declining Official Unemployment: Real Wage Growth and Unemployment Rate
  35. 35. <ul><li>Adverse effects of international credit crunch (less and more expensive access to foreign financing) </li></ul><ul><li>Domestic impact of large international negative supply shock (higher oil and food prices, weak international economy): low growth, high inflation </li></ul><ul><li>Continuing uncertainties on NATO membership and EU accession (talks): lower growth prospects and lower foreign capital inflows </li></ul><ul><li>Lack of structural reforms, particularly in labor markets and production / employment informality </li></ul><ul><li>Policy and reform reversals (e.g., second-pillar pension reform) </li></ul>Macroeconomic and Structural Policy Risks
  36. 36. 3. Financial and Capital Market Development
  37. 37. <ul><li>Macedonia’s financial and capital markets are still small and relatively shallow but experiencing significant deepening and broadening since 2003 </li></ul><ul><li>Development is supported by: </li></ul><ul><ul><li>Bank privatization </li></ul></ul><ul><ul><li>Free entry of foreign investors </li></ul></ul><ul><ul><li>New laws and regulations that satisfy international standards </li></ul></ul><ul><ul><li>More effective supervision of financial institutions and new specialized supervisory bodies (SEC, MAPAS; future insurance supervision) </li></ul></ul><ul><li>Next we review progress and challenges in individual markets </li></ul>Financial and Capital Market Development
  38. 38. <ul><li>Structural government bonds </li></ul><ul><ul><li>Significant outstanding stock </li></ul></ul><ul><ul><li>Active trading in MSE </li></ul></ul><ul><li>Government securities </li></ul><ul><ul><li>Short-term T-bills and medium-term government bond market started in 2005 </li></ul></ul><ul><ul><li>Active primary issues, less active secondary trading </li></ul></ul><ul><ul><li>Growing outstanding stock </li></ul></ul><ul><ul><li>Pension fund investment </li></ul></ul><ul><li>NBRM short-term bills </li></ul><ul><ul><li>Used for monetary operations </li></ul></ul><ul><li>Interest rates </li></ul><ul><ul><li>Significant reduction since 2002, due to lower inflation, lower country-risk premium, better foreign arbitrage </li></ul></ul>Government and NBRM Securities
  39. 39. <ul><li>Significant banking growth and increase in bank profits in recent years </li></ul><ul><li>New 2007 banking law requires modernization of banking and banking regulation, according to Basle II standards </li></ul><ul><li>Consolidation of banks due to economies of scale, foreign investment, and stronger regulation </li></ul><ul><li>Major improvements in financial stability: </li></ul><ul><ul><li>Lower exposure to specific risks </li></ul></ul><ul><ul><li>Major improvements in bad loans and overall health </li></ul></ul><ul><ul><li>Strengthened role of NBRM banking supervision </li></ul></ul><ul><li>But: large heterogeneity in bank profitability and financial health </li></ul>Banks
  40. 40. Number and Size of Deposit Institutions, 2001-2007
  41. 41. Bank’s Financial Soundness Indicators, 2005-2007
  42. 42. <ul><li>Challenges for future strengthening of banking growth and stability: </li></ul><ul><li>Up-grade performance of weak banks </li></ul><ul><li>Continue banking sector consolidation </li></ul><ul><li>Reduce bad-loan portfolio </li></ul><ul><li>Modernize deposit insurance (premiums based on bank performance and risk-based financial management practice) </li></ul>Banks
  43. 43. <ul><li>Legal framework for development of primary issues and secondary trading of equities at the MSE is in place: modern laws on companies, securities, takeovers, and investment funds </li></ul><ul><li>Effective regulation and supervision by the Macedonian Securities and Exchange Commission </li></ul><ul><li>MSE operates as a two-tier market: listed shares are still few, turnover is not high, primary issues are very few </li></ul><ul><li>Yet large growth in SME trading and prices were observed until the second half of 2007, when a significant downward correction started, in tandem with world stock market price adjustment after the U.S. sub-prime crisis and international credit crunch </li></ul>Stock Market
  44. 44. Macedonian Stock Exchange Indicators, 2002-2007
  45. 45. <ul><li>Stock market development challenges: </li></ul><ul><li>Encourage companies to engage in primary issues (IPOs) and discourage private placements / block trading </li></ul><ul><li>Raise corporate governance and transparency requirements on companies listed at the SME </li></ul>Stock Market
  46. 46. <ul><li>No legal or regulatory limitations to issues and trading of corporate bonds </li></ul><ul><li>Incipient start in Dec. 2007 with issue of € 5 m. 3-year ProKredit Bank bond issued in late 2007, sold to Tutunska Banka and re-sold on MSE </li></ul><ul><li>Further bond issues expected, although initially at small scale (e.g. Alkaloid bond) </li></ul><ul><li>High commissions? Cheaper bond issues in Athens or London </li></ul><ul><li>Good investment instrument for pension funds </li></ul><ul><li>Requires also development of domestic securities rating </li></ul>Corporate Bonds
  47. 47. <ul><li>Incipient insurance industry </li></ul><ul><li>Legislation in place </li></ul><ul><li>Life insurance (extremely small) and non-life (small: premiums equivalent to ca. 2% of GDP) </li></ul><ul><li>Insurance demand is highly income-elastic: only with high economic growth, insurance grows significantly </li></ul><ul><li>Moreover: future development of annuities markets for pensioners requires significant long-term development of life insurance </li></ul><ul><li>Challenges: </li></ul><ul><li>(1) establishment of insurance supervision </li></ul><ul><li>(2) future development of secondary regulation of pension benefits, including annuities. </li></ul>Insurance
  48. 48. <ul><li>Mortgage and housing loans by banks and saving houses are growing significantly </li></ul><ul><li>But there are no mortgage bonds yet </li></ul><ul><li>Mortgage bonds or mortgage-backed securities are a potentially important instrument for pension fund investment: long-term, low-risk, and liquid securities </li></ul><ul><li>Effective securitization of mortgages requires: tax pass-through, strong property law and lien registration and transfer, effective foreclosure procedures, and bankruptcy remoteness </li></ul>Missing: Mortgage Bonds
  49. 49. 4. Pension Reform Features and Outcomes
  50. 50. <ul><li>Macedonia started its two-pillar pension system in January 2006 </li></ul><ul><li>In comparison to prior expectations and other international experiences, the reform has been very successful to date, as reflected by: </li></ul><ul><li>Large number of participants, including many voluntary contributors </li></ul><ul><li>Smooth institutional implementation, from collection of contributions to operation of pension fund management companies and investment of pension funds </li></ul><ul><li>Increasing portfolio diversification </li></ul><ul><li>Active, effective regulation and supervision of pension funds </li></ul><ul><li>Low actual and projected reform transition deficits, consistent with long-term sustainability of fiscal policy </li></ul>Pension Reform Outcomes
  51. 51. Contributors to First and Second Pillars and Pensioners, 1991-2007
  52. 52. Pension Fund Net Assets, 2006-2007
  53. 53. Composition of Pension Fund Portfolios (%), 2006-2008
  54. 54. Assumptions for PDIF Projections, 2008-2020
  55. 55. Second Pillar and Reform-Transition Projections, 2008-2015
  56. 56. 5. Pension Reform and Capital Market Development: Future Challenges
  57. 57. <ul><li>Continue improvements in banking supervision and stability strengthening (NBRM) </li></ul><ul><li>Encourage development of corporate bonds </li></ul><ul><li>Encourage development of mortgage bonds </li></ul><ul><li>Promote establishment of domestic subsidiaries of international rating agencies </li></ul>Capital-Market Development Challenges
  58. 58. <ul><li>Note: all changes and improvements in the pension system have to be driven by the aim of benefiting current contributors and future pensioners. </li></ul><ul><li>MAINTAIN THE SECOND PILLAR: IT IS THE PILLAR FOR FUTURE ACTUARIALLY-FAIR PENSIONS AND INCREASED LABOR FORMALITY </li></ul><ul><li>WITHOUT A SECODN PILLAR – OR WITH A DOWNGRADED SECOND PILLAR – THE FIRST PILLAR WILL NOT BE ABLE TO PAY OUT PROMISED PENSION BENEFITS </li></ul>Short-Term Pension System Challenges (1)
  59. 59. <ul><li>Strengthen independence of MAPAS, required for effective and independent pension fund supervision </li></ul><ul><li>Develop voluntary (third-pillar) pension savings and industry, with secondary regulation on pension fund establishment and investments </li></ul><ul><li>Continue efforts to raise efficiency and reduce fees charged to contributors by key players: pension fund management companies, SME, custodians </li></ul><ul><li>Transfer custodian services from NBRM to private providers </li></ul><ul><li>Fine-tune investment regulation of mandatory second-pillar pensions ….. </li></ul>Short-Term Pension System Challenges (2)
  60. 60. <ul><li>Pension law defines investment ceilings by securities that already are relatively high -> good for portfolio diversification </li></ul><ul><li>Current secondary regulation is relatively restrictive for investment in: </li></ul><ul><ul><li>Securities must be traded competitively in open and contested markets </li></ul></ul><ul><ul><li>Minimum size of issues of securities </li></ul></ul><ul><ul><li>Minimum ratings of securities </li></ul></ul><ul><ul><li>Foreign investment in highly-rated countries, securities, and investment funds </li></ul></ul><ul><li>There may be elusion or avoidance of regulation on ratings through investment in mutual funds or investment funds, which hold portfolios of lower rated securities and/or countries </li></ul><ul><li>Hence a revision of secondary regulation is called for – something which all countries engage in all the time </li></ul>Pension Fund Investment Regulations
  61. 61. <ul><li>Evaluate multi-fund choice by contributors for possible future adoption (not recommended now) </li></ul><ul><ul><li>Benefits: more choice for participants, tailored to their risk-return preferences (with more age, reduce exposure to investment risk, allowing shift toward portfolios with larger share of fixed-income securities); encourages active choice by participants </li></ul></ul><ul><ul><li>Costs: increase with exercise of consumer choice (portfolio shifts), management, and investment of more fund portfolios </li></ul></ul><ul><ul><li>International experience (Chile, Mexico, Australia): very positive. </li></ul></ul>Long-Term Pension System Challenges
  62. 62. <ul><li>Evaluate Risk-based Approach to Supervision of Pension Funds for possible future Adoption (not recommended now) </li></ul><ul><ul><li>Current predominant supervision model adopted in most countries (including Macedonia): based on strict compliance with quantitative controls and specific rules on management of pension fund companies and investment of pension funds </li></ul></ul><ul><ul><li>Disadvantages: rigidity, sub-optimal investment (below available risk-return frontier) </li></ul></ul><ul><ul><li>Alternative risk-based supervision model: based on identification and management of relevant operational and investment risks </li></ul></ul><ul><ul><li>Increasing international experience of risk-based supervision of banks and insurance companies </li></ul></ul><ul><ul><li>Based on three elements: capital requirements, supervisory review of company risk-management models, and market discipline </li></ul></ul><ul><ul><li>Partial / gradual shift to risk-based supervision of pension funds has taken place successfully in Australia, Denmark, Netherlands, Mexico </li></ul></ul><ul><ul><li>Risk-based Supervision requires high specialization of pension fund managers and supervisors </li></ul></ul>Long-Term Pension System Challenges
  63. 63. Pension Funds and Capital Markets in Macedonia Klaus Schmidt-Hebbel MAPAS Workshop on Pension Funds and Capital Markets Skopje (Macedonia), June 19, 2008