By Katie Llanos-Small
A decade ago, administering a pension fund in Mexico was a relative cinch. The recipe was straightforward: throw 85% of your assets into government bonds, and go for lunch. It was an easy decision for the fund managers. With investments in equities, real estate funds, commodities and international debt all banned, they had little choice.
Back then, the funds were already growing quickly. Indeed, they had nearly tripled in size in three years. But at around 350 billion pesos in May 2003, the pension pot was not raising any concerns.
Today, however, the stakes are higher. Mexico’s pension funds have experienced a giddying rise in their asset pools. Assets of the Afores, as Mexico’s pension fund administrators are known, hit 2 trillion pesos ($164 billion) in March this year, twice the cash they looked after just four years ago. The momentum shows no sign of slowing. Mexico’s pension regulator, Consar, estimates the country’s retirement funds will be looking after close to 5 trillion pesos by 2019.
This exponential expansion has led to heady excitement. But it also poses challenges for pension fund managers and their regulator as they try to keep a handle on the ballooning assets under management.
It is a phenomenon being repeated across Latin America. As the region’s middle class booms, the benefits are reaching many industries. Pension funds are one area seeing particularly positive effects.
Youthful populations mean more people are starting work than are hitting retirement age, pushing up the numbers of potential pension fund contributors. And as a greater proportion enters formal employment, potential contributors are becoming real ones.
In the Andean region alone, assets under management more than doubled between 2008 and 2012. Pension funds in Chile, Colombia and Peru had $271 billion equivalent of assets at the end of 2012, according to data from Strategic Insight, a consultancy. That was $116 billion in 2008.
In sharp contrast to the mature pension funds in the developed world, Latin America’s funds face unique difficulties. The young populations are driving growth so rapidly that the funds threaten to become unwieldy. In Peru and Colombia, for example, pension fund assets equaled 17% of GDP at the end of 2011, according to OECD figures. In Brazil they were close to 14%, and in Chile, a whopping 58.5%.
With the pension systems in the region still a fairly new phenomenon – Chile in 1981 pioneered the structure now in place across most of the larger economies – worries are emerging over how the mushrooming pools of assets should best be managed and invested.
“The most pressing issue is related to guaranteeing this growth of the system, the savings,” says Carlos Ramírez, head of Mexico’s pension regulator, Consar. “We have to guarantee that this growth is followed by better asset managers on the side of the Afores. They are managing almost 13% of GDP every single day. We need to guarantee that the quality of the corporate governance of the Afores improves.”
Across Latin America’s biggest economies, regulators are dealing with similar concerns. Part of the solution, to varying degrees, is being found in giving the pension funds greater freedom over where they can invest, and allowing them to hand some control to third party managers.
Brazil’s pension funds, no longer able to rely on the local market for the inflation beating returns they target, are poised to contract international managers to look offshore for better yields. Five Mexican funds are in the final stages of signing off third party mandates with their regulator.
Peru’s regulator raised the cap on international investment for the third time this year in April, allowing funds to allocate as much as 36% of their portfolio offshore. The two-point increase gave Peruvian pensions around $775 million to send abroad – and increased the opportunities for third party managers.
From August, the pension fund administrators – AFPs – will also be able to invest in alternative strategies, including infrastructure, private equity and hedge funds.
As they loosen the rules, regulators are keeping a close eye on the results, aware that they are entering, for them, uncharted territory.
“The art is to find a way to manage a fund well, and also with caution,” says Daniel Schydlowsky, head of SBS, Peru’s banking, insurance and private pension fund regulator.
“We face a big challenge, to define benchmarks for long term investment in a growing economy where the retirement funds are big players and therefore affect the market and the economy´s rate of growth. No-one knows how to do this perfectly. We’re on the frontier, looking at new areas, and we have to proceed with caution.”
Boasting the region’s most mature private pension fund system, Chile offers a model for managers and regulators in other jurisdictions.
One basic lesson has already been taken on board almost everywhere: that a defined contribution, rather than defined benefit, system eases the pressure on managers to hit lofty return targets. Under defined contribution schemes, retirees’ savings are the sum of what they put in and the returns generated by the manager. Defined benefit schemes guarantee a pension amount, such as a percentage of the employee’s final salary.
Three of the largest markets – Colombia, Mexico and Peru – have switched to the defined contribution model. There, returns are encouraged through competitive systems that take into account yields and management fees.
An outlier is Brazil, where some funds remain defined benefit systems, guaranteeing savers a certain level of income once they stop working. That creates a headache for the pension administrators, who are forced to chase chunky returns above Brazil’s already infamously high inflation levels.
Compared globally, the country spends a lot on pensions – especially since its workforce is young. The IMF warned last year that Brazil’s pension system faces a funding gap of as much as 25% of GDP on a net present value basis over the next 20 years, as the population begins aging.
Brazil is working on the problem: the largest defined benefit schemes are closed to new participants, and the country changed pension rules in 2003 and again in 2012. The regulator has capped the yields pension funds can use in their forecasting, and is winching it down.
But, moving from inflation plus 6% in 2012, to inflation plus 4.5% in 2018, those yield targets are still tough. Latin America’s largest fund, Previ’s Plano 1, which had 163.5 billion reais ($81.5 billion) of assets at the end of 2012, is the most prominent fund exposed to the difficulty.
Plano I’s investments yielded 12.63% last year, more than a point above its inflation-plus-5% target. This year, it plans to shift its allocation further away from fixed income instruments, capping those securities at a third of the portfolio. Still, meeting this year’s target in the local market will not be easy.
“The interest rates in Brazil have declined very fast,” says Renê Sanda, CIO of Previ. “In 2013, for the first time, if we invest in Brazilian bonds, we are not going to receive interest that is enough to cover our actuarial rate. This is the first year that has happened.”
Among the countries with defined contribution systems, Chile has led the way in another structural aspect.
“Chile opened the multifondos system, offering a series of funds with different risk contexts,” says Peter Wall, of Wall’s Street Advisor Services. “The type A funds have the largest allocation to equities and to foreign assets. The most conservative funds, the E funds, have reduced limits on exposure to risky assets.”
That is reflected in the returns. Type A funds have posted real returns of 6.9% a year on average between September 2002 and March 2013, according to Chile’s pension regulator. Type Es returned 3.87% on average over the same period.
Peruvian funds see a similar trend. The most conservative funds, known as Type 1s, averaged real returns of 5.86% over the past seven years. The riskier Type 3s, meanwhile, have average annual returns of 13.09%.
Other regulators are following Chile’s lead in another area, too: allowing increasingly large investments offshore. Chilean funds can allocate as much as 80% of their cash outside of the country.
Regulators across the continent are giving pension administrators greater freedom to invest internationally.
The idea is to diversify risk. But it is also a somewhat counterintuitive move in today’s global economic circumstances.
Latin America’s growth has outstripped that of developed markets. Global asset managers are rushing into the region, taking advantage of yields that are difficult to find elsewhere in the world. So going in the other direction is not an obvious choice.
“For most Latin American investors, it’s more challenging today than ever before to find attractive opportunities outside the region,” says Maxi Rohm, who heads Neuberger Berman in Latin America.
“Although pension funds and other professional investors understand the need to diversify their portfolios into other regions and asset classes, it’s challenging to do so when there are better opportunities in local markets.”
The conundrum is evident in Chilean pensions. They have slightly more than $62 billion equivalent invested internationally. That is 38.5% of their total assets and around half of what they are allowed to allocate out of the country.
They learned about global volatility the hard way in 2008. All but the most conservative funds lost 40% to 50% of their investments outside Chile that year. But the funds largely joined the global bounce in 2009, and by 2010 had close to half their assets offshore.
However, since then they have relied on decent yields in the domestic market to make up for weaker returns internationally, says Marlon Valle, research analyst at investment consultancy Strategic Insight.
Data from Chile’s pension regulator shows the funds did not have a bad year in international markets in 2012. The riskier, Type A, funds returned 7.7% in peso terms on those holdings. But that did little to compensate for bigger losses the previous year for all but the most risk-averse funds.
Yet, in spite of the volatility, spreading the risk is important. Neuberger’s Rohm says LatAm funds look at international investments for diversification more than anything.
“For the most part, investors are not looking at investment-grade fixed income abroad,” he says. “However, they need to continue to address home bias issues and thus grow their offshore investment programs. Offshore investing, especially in fixed income, is really driven more by diversification than by relative value at this point.
“So, investors in the region are fine going abroad even when local interest rates are more attractive, but they tend to focus on fixed income asset classes that offer sufficiently attractive yields, liquidity levels and issuer diversification that can be at times harder to find within the region.”
Regulators in other parts of Latin America are a long way from allowing pension funds the freedom to invest internationally that the Chileans have. But changes are afoot.
Mexico’s pension regulator is clear that the 20% offshore investment cap needs to be raised. The country’s pension assets are not just growing impressively – they are becoming an increasingly large proportion of the domestic market.
“Savings are growing much faster than the Mexican financial system,” says Consar’s Ramírez. “If you don’t open the 20% limit, what’s going to happen? The pension funds will continue looking for best alternatives in Mexico. But if they will continue only investing domestically, that will pressure prices up and returns down in the Mexican market. If you pressure prices up, there’s a risk eventually of creating a bubble.”
Allowing the funds to diversify beyond Mexico will also reduce the country risk in their portfolios. That’s important to do, despite the positive forecasts for the country, says Ramírez.
Already Mexico’s pension funds have gotten the swing of diversification, broadening their portfolios from nearly 100% allocations to government bonds in 2000 to just over half that today. But they are taking to the offshore investment limits slowly. While some are close to the 20% cap, on average across the system pension funds have invested just 15% internationally.
Across LatAm, rapidly growing pension savings are providing support to sovereign paper – and that brings down the benchmark rates for corporate borrowing as well. The need for diversification outweighs the need to channel local pension savings into the domestic economy, says Ramírez.
“We want the money the Afores are managing to be used domestically to help the Mexican economy and to be invested in productive activities in the economy,” says Ramírez. “But at the end of the day what we want more is that this money is better invested with better yields, in a safer way, and at the end of the day that’s going to translate into better pensions.”
In Mexico, despite the regulator’s view that the offshore investment cap must be loosened, change is not imminent. That requires approval from Mexico’s congress – so far, it has had more pressing reforms to deal with. What is expected soon, though, is the announcement of a handful of mandates for external asset managers.
Mexico allowed pension funds to use third party managers in 2011. Since then, Consar has been in discussions with the Afores over the external asset management mandates. As of late April, five agreements were close to being finalized.
“We’ve had more than a year of very tight and not easy negotiations between the Afores that are interested in using this instrument, between the Consar, and the foreign asset managers,” Ramírez says.
Among other stipulations, Consar calls for third party managers to have at least 10 years experience in asset management and, for investing the cash offshore, at least $50 billion assets already under management.
Ramírez says he expects other Afores could follow with third party mandates, once the first examples hit the market.
That is an opportunity for local and international asset managers, says Carmen Campollo of Campollo Consulting. “The pension funds have been very good at posting their requests for proposals, in terms of the size of the managers that they need to have, their capital, and experience with strategies and products that are going to allow them to compete to manage funds.”
Afore XXI-Banorte is one that is already looking at the possibility. It would like to see the offshore investment limited to 40% of the total portfolio.
“We think the optimal thing is for the limit of investment in foreign assets to open up and how Afore XXI plans to prepare for that is through mandates,” says CIO Ignacio Saldaña. “If we don’t know Asia, I don’t want to [invest there] with my team. We want to allocate resources to that market, but we want to do it via a professional investor.”
In the meantime, XXI-Banorte is targeting the better returning international assets – preferring equity over fixed income – to make the most of that allocation. That is a theme for others.
Across the board, Mexican funds have over 13% of their assets invested in international equities, and just 2.1% in international debt.
Chilean funds also target paper with higher yield when they look globally. Close to three-quarters of the cash they have invested outside Chile is in variable rate instruments. And most of what they put into bonds goes into high yield and emerging market funds.
The biggest geographical allocation is in the US – Chilean funds put about a third of international investments there. Roughly half go to emerging markets, with 15% in other Latin American countries.
The paradox of investors from a high growth jurisdiction wanting to diversify away from those yields is perhaps most striking in Peru. The country had the highest growth rate in South America last year.
But funds here have been particularly vocal in insisting on the need for greater room to invest internationally. The regulator has acquiesced, increasing the offshore investment limit in April for the third time this year, by two percentage points to 36%.
“Yields in Peru should be higher that outside, even over the longer term, since we are a faster growing economy,” says SBS’s Schydlowsky. “In addition, we have so far successfully avoided being sucked into the world recession.”
Yet it is crucial that pension funds take a long-term view, he says.
“At a fundamental level, the issue is how to generate healthy returns in the medium to long term. Policy holders can see their fund go down over the course of a week or a month, but what we really should be looking at is returns over 20 or 30 years.”
For international asset managers, the bid to invest offshore offers increasingly many opportunities. Funds in Chile, Colombia and Peru have around $100 billion in assets they could invest internationally, if they chose to fill their regulatory limits, says Strategic Insight’s Valle.
Not all funds use managers for offshore investing though. Colombia’s Colfondos, for example, conducts its own research in house. It invests in Latin America and other emerging markets, as well as the US.
“We are a conservative pension fund, and we invest in regions that we know well,” says president Alcides Vargas. “We avoid highly uncertain investments, and in general we follow a policy of simplicity.”?
Delivering the goods
With their high targets, falling domestic yields, and virtual absence of international investments, Brazilian funds are perhaps the most in need of fresh investment strategies.
The defined benefit system translates into ambitious targets for managers. Until now, high local yields have allowed them to hit that threshold. But that is changing, and the funds are looking overseas for help.
“In the whole of the Brazilian industry, there is less than $100 million invested abroad,” says Previ’s Sanda. “We think this is going to change. The interest rate in Brazil has declined very fast.”
Virtually all Brazil’s pension fund assets are invested domestically, a result of onerous rules for investing internationally as well as domestic yields that were until recently very high. Falling returns locally are now forcing pension funds to deal with the complicated rules for international investments.
To invest offshore, Brazilian pension managers must go through an investment vehicle in which they have a stake of not more than 25%. That means teaming up with competitors and to agree on what they will buy.
Previ is already in discussions with other funds to set up an offshore vehicle. It plans to contribute a modest $200 million initially. That will go to an asset manager to invest internationally.
“The mandate that we’re going to give to this manager is to find very plain vanilla stocks, long only,” Sanda tells LatinFinance. “Without derivatives. Companies will need to be good payers of dividends, and with names that are easy to sell in Brazil, large caps. I think this is going to be the first movement. That is very easy to do. Probably in a couple of years we’ll be more aggressive, but the first move will be very plain vanilla.”
As a consistent, long-term buyer base, pension funds across Latin America have provided solid support to their governments’ debt. Heads of public credit across the region point to pension funds as a crucial support when they come to issue in the local market.
“Pension funds have 28% of total TES,” says Miguelángel Gómez, Colombia’s sub-director of public credit. “Those are the largest holders of our local market. That creates a lot of stability for the product. They buy, they hold, they have long-term view.”
Relaxing the rules around how much pension funds can invest overseas may knock that support. But the funds are also being given greater opportunities to pick up other paper that supports their local economies.
As pension assets have grown in Mexico, funds have been given greater freedom to invest. Since 2010 they have been allowed to buy shares in IPOs and from 2011, commodities. Last year, the riskier funds had their caps on structured products like real estate investment trusts raised.
Peruvian funds will be able to take on alternative investments from August – that includes hedge funds, private equity, and, crucially, infrastructure.
“This broadens the investment possibilities,” says Michel Canta, deputy superintendent at the SBS. “We are opening the range of instruments they can invest in, to better diversify their portfolios both inside and outside the Peruvian economy.”
At the same time, the rapid growth of retirement savings means that even if greater proportions of the funds are invested away from national government debt, the absolute numbers may not drop much. Given the scope still left for pension funds to expand their reach in the region, their assets are set to continue expanding.
“We see a trend that towards a larger penetration in the lower income population,” says Grupo Sura CIO Ignacio Calle. The firm owns a growing number of pension funds across LatAm, most recently buying part of Spanish bank BBVA’s Horizonte fund in April. Calle points to plans in progress in Colombia to improve financial inclusion as a sign that client bases will continue to grow.
“In Colombia [in March], the government announced a program to increase coverage of low income population, in order for these people to have pension plan at the end of their working periods.
“If we implement system with full coverage to the full labor population, that would be a major advance.” LF