## _wp0785 - References

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### I. Introduction — context and objectives
- Several factors prompted pension reform in India: central government and state government pension liabilities have increased considerably over the past decade and only 13 percent of the workforce is currently covered by pension schemes (government employees and organized private sector workers covered by the Employees’ Provident Fund (EPF) and the Employees’ Pension Scheme (EPS)).
- The government launched on January 1, 2004 a New Pension System (NPS) that shifted all new central government employees to a defined contribution plan from the previous noncontributory defined benefit scheme, shifting retirement-financing risk from the government to individuals.
- Interim arrangements: contributions from new civil servants are being deducted and matched by government contributions; a rate of return of 8 percent is being credited on these contributions.
- Chapter focus:
  - How NPS parameters compare with privately-managed systems elsewhere and whether NPS is likely to generate fast growth of pension assets and stimulate financial market development.
  - The extent to which regulatory limits, conservative investment practices, and restrictions on foreign investment have hindered pension fund managers’ ability to diversify and constrained pension sector growth; and other pre-conditions for pension reform to drive demand for bonds and equities.

### II. Benchmarking India’s pension system — summary of main comparisons
- Draft PFRDA Bill, 2005 provisions:
  - Allow personal pension accounts and make NPS available to workers in the unorganized private sector.
  - Be available on a voluntary basis (in addition to mandatory cover) to persons governed by organized private sector schemes.
- Key parameter comparisons:
  - Employee contribution rate: 10 percent (matched by an equal government contribution).
  - Targeted terminal replacement rate: 50 percent of the final wage.
  - Expected management costs: 0.5 percent of assets (Ministry of Finance, 2005).
  - Participants offered a menu of investment options and can switch between funds and schemes.
  - Every subscriber’s individual pension account is portable across jobs.
  - Voluntary participation beyond the mandated contribution rate is available (third pillar).

### III. Features that distinguish India’s reform and implications
- Distinguishing features:
  - Absence of a first pillar (minimum guaranteed pension): NPS provides only the second and third pillars.
  - Partially mandatory coverage: mandatory only for new central government employees and new employees of the 19 state governments that have joined the NPS; existing government employees and organized sector pension schemes/funds are exempt.
- Implications for asset accumulation and financial market development:
  - Absence of a first pillar may induce a safety bias: a relatively high share of participants could opt for conservative asset allocations to minimize the risk of unfavorable ex post returns.
  - A reform limited largely to new government workers may not generate sufficient critical mass early on to kick-start financial market development; the organized private sector will remain exempt except for voluntary third-pillar participation.
- Voluntary take-up determinants:
  - Relative attractiveness of new schemes compared with existing private savings instruments (small savings with tax-exempt above-market returns, real estate, own business for the self-employed).
  - International evidence: participation of the self-employed has remained low in countries that implemented similar reforms (example cited: Chile), while broad coverage was achieved by providing an option to switch to workers covered under the old system.

### IV. Key statistics and specific numeric parameters
- Workforce coverage: 13 percent.
- NPS launch date: January 1, 2004.
- Interim credited rate of return on contributions: 8 percent.
- Employee contribution rate under draft PFRDA Bill: 10 percent (matched by government).
- Targeted terminal replacement rate: 50 percent of the final wage.
- Expected management costs: 0.5 percent of assets (Ministry of Finance, 2005).
- U.S. federal Thrift Savings Program cost: 0.07 percent of assets (Faulkner-McDonagh, 2005).
- U.S. low-cost private providers fees: 0.2–0.3 percent of assets.
- Implicit pension debt (World Bank estimate): 25 percent of GDP.
- Number of state governments that joined the NPS: 19.

### Box 1. The New Pension System — system design and institutional structure
- Institutional actors:
  - Central recordkeeping agency (CRA), pension fund managers (PFMs), point-of-presence agencies (PoPs), and a two-pillar structure.
- CRA functions:
  - Maintain records, accounts, and effect all instructions regarding subscription, switching of options, and withdrawals by the subscriber.
  - Subscriber may access the CRA directly for information.
- PFMs:
  - Offer a set of schemes with varying risk-return profiles and manage the assets of subscribers.
- Individual pension account (IPA):
  - Every subscriber shall have an IPA with the option of selecting the PFMs and schemes composing his/her portfolio.
  - IPA will be portable in case of change of employment.
- PFRDA responsibilities:
  - Comprises a Chairman and up to 5 members appointed by the government for a five-year term.
  - Will register and regulate all intermediaries, including CRAs, PoPs, and PFMs.
  - Responsible for protecting the interests of subscribers and establishing a grievance mechanism.
  - Will approve schemes and norms (including investment guidelines) and ensure standardization and dissemination of information about performance of funds and benchmarks.

### Box 1. Retirement access, conversion, and two-tier features
- Exit and conversion rules (current government notification):
  - If the subscriber exits at the normal retirement age (60 years), he/she shall use at least 40 percent of accumulated pension wealth to purchase a lifetime annuity from a life insurance company.
  - If the subscriber exits the system any time prior to retirement, the minimum conversion is 80 percent of the accumulated pension wealth.
- Two-tier structure for government employees:
  - Tier-I: core level with the employee’s 10 percent contribution matched by the government, and no withdrawals authorized until exit.
  - Tier-II: optional withdrawable account to which the employee may contribute additional amounts; no government contribution.
- There will be no minimum guaranteed pension (the so-called “first pillar”).

### Box 1. Investment regimes, limits, and fees
- Regulatory approaches:
  - Mature markets (United Kingdom, United States) often use the “prudent person rule” (PPR).
  - Most emerging markets use quantitative investment limits, typically restricting equity and foreign investments and often corporate bonds and derivatives.
- Examples of quantitative limits (maximum limits, in percent of the fund size):
  - Argentina: Equity 50, Foreign securities 20
  - Chile: Equity 39, Foreign securities 30
  - Poland: Equity 40, Foreign securities 5
  - United Kingdom and United States: PPR / PPR
- Fee structure and incentives:
  - High management fees can dramatically reduce returns. Example: net real returns in Chile averaged only 3 percent into the late 1980s after fees equivalent to 6 percentage points (ppts) of gross returns.
  - Poland experienced net real returns averaging 3 percent in the first four years of reform due to total fees.
  - Upfront fee structures undermine PFMs’ incentives to compete on returns; a structure with fixed and variable components is preferred.
  - Example: in the Dominican Republic private pension funds can charge a monthly commission of up to ½ percent of the individual wage plus a percentage of annual returns above the benchmark.
- Cost control mechanisms:
  - Economies of scale and industry competition can reduce costs.
  - Centralization of administrative operations can lower costs.
  - Regulatory approaches that allow competition on rates of return and avoid minimum return requirements relative to industry averages are preferred.

### Box 1. Historical returns and volatility (India, 1995–2006; inflation-adjusted using CPI: industrial workers)
- Asset class arithmetic average return / standard deviation (in percent):
  - BSE Sensex: 6.83 / 32.6
  - Long-term government bond: 3.6 / 2.2
  - Short-term treasury bill: 2.2 / 2.5
- Memorandum items (1926–97, United States):
  - S&P 500: 9.72 / 20.5
  - Long-term U.S. government bond: 2.6 / 10.5
  - Short-term U.S. treasury bill: 0.7 / 4.2

### Box 1. Financial implications: replacement rates and illustrative pension projections
- Key assumptions for simulations (Table 1):
  - Monthly contributions invested in an IPA for 35 years.
  - Inflation-adjusted annual returns assumed conservatively as follows: government bonds (1.5); corporate bonds (3); equities (5).
  - Fees assumed to be 50 bps on assets per year.
- Estimated pensions and replacement rates under the NPS (simulation results 2/):
  - 100 percent government securities:
    - Replacement rate (in percent): 43–49
    - Wealth at age 60 (in Indian rupees): 744,203–3,190,314
  - "Safe:" 60 percent government securities, 30 percent corporate bonds, 10 percent equities:
    - Replacement rate: 49–56
    - Wealth at age 60: 855,458–3,625,766
  - "Balanced:" 40 percent government securities, 35 percent corporate bonds, 25 percent equities:
    - Replacement rate: 54–63
    - Wealth at age 60: 953,560–4,006,269
  - "Growth:" 20 percent government securities, 30 percent corporate bonds, 50 percent equities:
    - Replacement rate: 63–73
    - Wealth at age 60: 1,108,312–4,601,108

### Box 1. Asset allocation patterns and diversification
- Emerging market pension funds commonly show conservative portfolios concentrated in fixed income.
- India-specific points:
  - Indian pension funds historically have not participated significantly in the corporate debt market despite being allowed (Indian pension funds are allowed to invest up to 10 percent of new flows in private corporate bonds).
  - EPF-exempt corporate pension funds may avoid corporate debt due to fear of not meeting EPF returns.
- Diversification abroad:
  - Emerging market funds are often home-biased; notable exception: Chile.
  - Polish pension funds invest about 2 percent of assets in foreign securities.
  - Chile’s success factors: (i) permission to hedge foreign currency exposure using currency forwards; (ii) ability to invest in global mutual funds.
  - A law passed in August 2006 allows 10 percent of pension portfolios to be invested abroad in India.

### Box 1. Pension sector size, growth, and capital market effects
- India’s pension assets amount to only 5¾ percent of GDP.
- Cross-country comparative figures:
  - Chile’s pension AUM are nearing 65 percent of GDP after 22 years of its fully funded system.
  - Chile’s growth equivalent has been nearly 3 ppts per year.
  - In the rest of Latin America, pension assets have reached around 12 percent of GDP in AUM in the last decade, implying annual growth of 1–1½ ppts of GDP.
- Empirical findings:
  - Studies confirm a positive impact of institutional investment (including pension funds) on market capitalization, with Granger causality tests indicating causality predominantly runs from contractual savings to market capitalization.
  - The buildup of institutional assets contributed to financial deepening; in G-7 countries stock and bond market capitalization rose by more than 40 ppts and 20 ppts of GDP respectively between 1980 and 1998, led by a 20 ppts of GDP increase in pension AUM.
  - Walker and Lefort (2002) find pension funds’ AUM had a statistically significant effect on Chile’s equity prices and cost of capital.
- Risks and potential adverse effects:
  - Rapid growth of pension AUM may outpace supply of private local securities and magnify asset price swings and volatility.
  - Concentration in government securities or a few local companies may result from tight investment controls and minimum return requirements, increasing the risk of asset price bubbles and liquidity constraints for PFMs.

### Box 1. Policy recommendations and measures to enhance market development
- Achieve critical mass faster:
  - Grant permission for exempt workers to switch to the new system and shift all assets to private PFMs.
  - Less ambitious option: outsource management of accumulated reserves of partially funded schemes such as EPF to the private sector under competitive bidding.
- Adopt flexible investment regulations to enable faster growth in pension-led securities demand and optimal portfolio diversification.
- Improve capital market regulations, laws, and infrastructure to foster development of local securities markets; concurrent reforms are necessary to avoid imbalances between demand and supply of local securities.
- Debt management and regulatory measures:
  - Ensure liquid government bonds that serve an important benchmark function.
  - Issue price-indexed bonds to support price-indexed annuities.
- Allow limited foreign investment options over time to:
  - Help PFMs diversify country risk.
  - Gain expertise and familiarity with new instruments.
  - Relieve pressures in local markets when the supply of securities is restricted in the short term.
  - Immediate liberalization may not be viable; consider gradual liberalization as PFMs’ efficiency and effectiveness improve.

### APPENDIX I: International experience with privately-managed pension plans — selected highlights
- Coverage examples:
  - Chile: achieved fast coverage, with 40 percent of the labor force and nearly half of employees covered within five years of implementation (Faulkner-McDonagh, 2005); participation initially mandatory only for new entrants.
  - El Salvador: new system introduced in 1998; participation mandatory for workers under 36 years old and new entrants; coverage reached about a quarter of the economically active population after one year (Samuel, 2006).
- Fees:
  - Chile: management costs initially totaled up to 4 percent of wages (almost double their current levels).
  - El Salvador: pension law initially limited pension fund fees to 3½ percent of wages, lowered to 3 percent in 2001, and further reduced to 2¾ percent in 2005 (Samuel, 2006).
- Replacement rates:
  - Chile: recent estimates — average worker’s pension income would replace 50–60 percent of the final salary over the medium term (2030–40); over the longer term decline to just over 40 percent.
- Table I.1 — Selected country data (extract):
  - Year of implementation of individual account reforms:
    - Argentina: 1994
    - Chile: 1981
    - Mexico: 1992
    - Peru: 1993
    - Hungary: 1998
    - Poland: 1999
    - India: 2005
    - United Kingdom: 1988
  - Number of participants (Million):
    - Argentina: 4.9
    - Chile: 3.8
    - Mexico: 36.2
    - Peru: 3.9
    - Hungary: 2.4
    - Poland: 13.1
    - India: 0.3
  - Contribution rate (percent of gross wage) 1/ (to the privately-managed mandatory pension funds):
    - Argentina: 7.0
    - Chile: 12.3
    - Mexico: 6.5
    - Peru: 10.9
    - Hungary: 8.0
    - Poland: 7.3
    - India: 10.0
    - United Kingdom: 2.5–5.25
  - PFM's fee (percent):
    - Argentina: 1.12
    - Chile: 0.99
    - Mexico: 1.47
    - Peru: 1.99
    - Hungary: 0.97
    - Poland: 1.6
  - Investment performance:
    - Average real rate of return on assets (2001–05) 2/:
      - Argentina: -7.1
      - Chile: 7.0
      - Mexico: 6.3
      - Peru: 15.1
      - Poland: 9.8
    - Average annual real rate of return (net of fees) 3/:
      - Chile: 5.0
      - Hungary: 3.9
  - Projected replacement ratio by 2030:
    - Chile Men: 40
    - Chile Women: 60
    - Mexico: 50–60
    - Peru: 45
    - Hungary: 45
    - India: 43–95
    - United Kingdom: 48
  - Note 4/: Mandatory only for central government employees recruited after January 1, 2004, and new employees of 19 state governments that have joined.

*Source: _wp0785 - References (https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp0785.pdf).*

### References..............................................................................................................

### _wp0785 - References

### I. Introduction — context and objectives
- Several factors prompted pension reform in India: central government and state government pension liabilities have increased considerably over the past decade and only 13 percent of the workforce is currently covered by pension schemes (government employees and organized private sector workers covered by the Employees’ Provident Fund (EPF) and the Employees’ Pension Scheme (EPS)).
- The government launched on January 1, 2004 a New Pension System (NPS) that shifted all new central government employees to a defined contribution plan from the previous noncontributory defined benefit scheme, shifting retirement-financing risk from the government to individuals.
- Interim arrangements: contributions from new civil servants are being deducted and matched by government contributions; a rate of return of 8 percent is being credited on these contributions.
- Chapter focus: draw lessons from international experience on financial market implications of India’s pension reform, addressing:
  - How NPS parameters compare with privately-managed systems elsewhere and whether NPS is likely to generate fast growth of pension assets and stimulate financial market development.
  - The extent to which regulatory limits, conservative investment practices, and restrictions on foreign investment have hindered pension fund managers’ ability to diversify and constrained pension sector growth; and other pre-conditions for pension reform to drive demand for bonds and equities.

### II. Benchmarking India’s pension system — summary of main comparisons
- The draft Pension Fund Regulatory and Development Authority (PFRDA) Bill, 2005, sets a framework to promote old age income security and, once passed, will:
  - Allow personal pension accounts and make NPS available to workers in the unorganized private sector.
  - Be available on a voluntary basis (in addition to mandatory cover) to persons governed by organized private sector schemes.
- The preliminary provisions place the NPS within international norms; key parameter comparisons:
  - Employee contribution rate: 10 percent (matched by an equal government contribution) — described as broadly within the international range.
  - Targeted terminal replacement rate: 50 percent of the final wage — in line with international experience and World Bank recommendations, and matches benefits under the existing system for government employees.
  - Expected management costs: 0.5 percent of assets (Ministry of Finance, 2005) — comparable to other emerging markets but high relative to low-cost providers in advanced economies (U.S. federal Thrift Savings Program costs about 0.07 percent of assets; U.S. low-cost private providers such as Vanguard and Fidelity charge fees of 0.2–0.3 percent of assets).
  - Participants are offered a menu of investment options and can switch between funds and schemes.
  - Every subscriber’s individual pension account is portable across jobs.
  - Voluntary participation beyond the mandated contribution rate is available (third pillar).

### III. Features that distinguish India’s reform and implications
- Two distinguishing features:
  - Absence of a first pillar (minimum guaranteed pension): NPS provides only the second and third pillars. Other reforming countries typically retain a first pillar or consider comprehensive reform legislation to introduce one.
  - Partially mandatory coverage: participation is mandatory only for new central government employees and new employees of the 19 state governments that have joined the NPS; existing government employees and organized sector pension schemes/funds are exempt. Other countries mandated participation for all new entrants and sometimes for younger workers.
- Implications for asset accumulation and financial market development:
  - The absence of a first pillar may induce a safety bias: a relatively high share of participants could opt for conservative asset allocations to minimize the risk of unfavorable ex post returns. This bias could be magnified if the regulator imposes excessive investment restrictions.
  - A reform limited largely to new government workers may not generate sufficient critical mass early on to kick-start financial market development; while coverage for the entire government sector will expand over time, the organized private sector will remain exempt except for voluntary third-pillar participation.
- Voluntary take-up determinants:
  - Relative attractiveness of new schemes compared with existing private savings instruments (small savings with tax-exempt above-market returns, real estate, own business for the self-employed).
  - International evidence: participation of the self-employed has remained low in countries that implemented similar reforms (example cited: Chile), while broad coverage was achieved by providing an option to switch to workers covered under the old system (either initially or via subsequent amendments).

### IV. Key statistics and specific numeric parameters (as stated)
- Workforce coverage: 13 percent.
- NPS launch date: January 1, 2004.
- Interim credited rate of return on contributions: 8 percent.
- Employee contribution rate under draft PFRDA Bill: 10 percent (matched by government).
- Targeted terminal replacement rate: 50 percent of the final wage.
- Expected management costs: 0.5 percent of assets (Ministry of Finance, 2005).
- U.S. federal Thrift Savings Program cost: 0.07 percent of assets (Faulkner-McDonagh, 2005).
- U.S. low-cost private providers fees: 0.2–0.3 percent of assets.
- Implicit pension debt (World Bank estimate): 25 percent of GDP.
- Number of state governments that joined the NPS: 19.

*Source: _wp0785 - References (https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp0785.pdf).*

### Box 1. The New Pension System

### Box 1. The New Pension System

### System design and institutional structure
- The system comprises one (or more) central recordkeeping agency (CRA), a set of pension fund managers (PFMs), point-of-presence agencies (PoPs), and a two-pillar structure.
- CRA functions:
  - maintain records, accounts, and effect all instructions regarding subscription, switching of options, and withdrawals by the subscriber.
  - the subscriber may access the CRA directly for information.
- PFMs will offer a set of schemes with varying risk-return profiles and manage the assets of subscribers.
- Every subscriber shall have an individual pension account (IPA) with the option of selecting the PFMs and schemes composing his/her portfolio.
- The IPA will be portable in case of change of employment.
- The PFRDA shall regulate the NPS and other pension schemes under its purview:
  - comprises a Chairman and up to 5 members appointed by the government for a five-year term.
  - will register and regulate all intermediaries, including CRAs, PoPs, and PFMs.
  - responsible for protecting the interests of subscribers and establishing a grievance mechanism.
  - will approve schemes and norms (including investment guidelines) and ensure standardization and dissemination of information about performance of funds and benchmarks.

### Retirement access, conversion, and two-tier features
- Exit and conversion rules (current government notification):
  - If the subscriber exits at the normal retirement age (60 years), he/she shall use at least 40 percent of accumulated pension wealth to purchase a lifetime annuity from a life insurance company.
  - If the subscriber exits the system any time prior to retirement, the minimum conversion is 80 percent of the accumulated pension wealth.
- Two-tier structure for government employees:
  - Tier-I: core level with the employee’s 10 percent contribution matched by the government, and no withdrawals authorized until exit.
  - Tier-II: optional withdrawable account to which the employee may contribute additional amounts; no government contribution.
- There will be no minimum guaranteed pension (the so-called “first pillar”).

### Investment regimes, limits, and fees
- Regulatory approaches:
  - Mature markets (United Kingdom, United States) often use the “prudent person rule” (PPR).
  - Most emerging markets use quantitative investment limits, typically restricting equity and foreign investments and often corporate bonds and derivatives.
- Examples of quantitative limits (maximum limits, in percent of the fund size):
  - Argentina: Equity 50, Foreign securities 20
  - Chile: Equity 39, Foreign securities 30
  - Poland: Equity 40, Foreign securities 5
  - United Kingdom and United States: PPR / PPR
  - (Table 3 shows assorted country limits as provided.)
- Fee structure and incentives:
  - High management fees can dramatically reduce returns. Example: net real returns in Chile averaged only 3 percent into the late 1980s after fees equivalent to 6 percentage points (ppts) of gross returns.
  - Poland experienced net real returns averaging 3 percent in the first four years of reform due to total fees.
  - Upfront fee structures undermine PFMs’ incentives to compete on returns; a structure with fixed and variable components is preferred.
  - Example: in the Dominican Republic private pension funds can charge a monthly commission of up to ½ percent of the individual wage plus a percentage of annual returns above the benchmark.
- Cost control mechanisms:
  - Economies of scale and industry competition can reduce costs.
  - Centralization of administrative operations (e.g., collecting contributions) can lower costs.
  - Regulatory approaches that allow competition on rates of return and avoid minimum return requirements relative to industry averages are preferred.

### Historical returns and volatility (India, 1995–2006; inflation-adjusted using CPI: industrial workers)
- Asset class arithmetic average return and standard deviation (in percent):
  - BSE Sensex: 6.83 / 32.6
  - Long-term government bond: 3.6 / 2.2
  - Short-term treasury bill: 2.2 / 2.5
- Memorandum items (1926–97, United States):
  - S&P 500: 9.72 / 20.5
  - Long-term U.S. government bond: 2.6 / 10.5
  - Short-term U.S. treasury bill: 0.7 / 4.2

### Financial implications: replacement rates and illustrative pension projections
- Key assumptions for simulations (Table 1):
  - Monthly contributions invested in an IPA for 35 years.
  - Inflation-adjusted annual returns assumed conservatively as follows: government bonds (1.5); corporate bonds (3); equities (5).
  - Fees assumed to be 50 bps on assets per year.
- Estimated pensions and replacement rates under the NPS (simulation results 2/):
  - 100 percent government securities:
    - Replacement rate (in percent): 43–49
    - Wealth at age 60 (in Indian rupees): 744,203–3,190,314
  - "Safe:" 60 percent government securities, 30 percent corporate bonds, 10 percent equities:
    - Replacement rate: 49–56
    - Wealth at age 60: 855,458–3,625,766
  - "Balanced:" 40 percent government securities, 35 percent corporate bonds, 25 percent equities:
    - Replacement rate: 54–63
    - Wealth at age 60: 953,560–4,006,269
  - "Growth:" 20 percent government securities, 30 percent corporate bonds, 50 percent equities:
    - Replacement rate: 63–73
    - Wealth at age 60: 1,108,312–4,601,108

### Asset allocation patterns and diversification
- Emerging market pension funds commonly show conservative portfolios concentrated in fixed income.
- India-specific points:
  - Indian pension funds historically have not participated significantly in the corporate debt market despite being allowed (Indian pension funds are allowed to invest up to 10 percent of new flows in private corporate bonds).
  - EPF-exempt corporate pension funds may avoid corporate debt due to fear of not meeting EPF returns.
- Cross-country allocations (Table 4 summary):
  - Wide variation across countries in allocations to Bills and Deposits, Bonds, Equity shares, CIS, insurance contracts, and other investments.
- Diversification abroad:
  - Emerging market funds are often home-biased; notable exception: Chile.
  - Polish pension funds invest about 2 percent of assets in foreign securities.
  - Chile’s success factors: (i) permission to hedge foreign currency exposure using currency forwards; (ii) ability to invest in global mutual funds.
  - A law passed in August 2006 allows 10 percent of pension portfolios to be invested abroad in India.

### Pension sector size, growth, and capital market effects
- India’s pension assets amount to only 5¾ percent of GDP.
- Cross-country comparative figures:
  - Chile’s pension AUM are nearing 65 percent of GDP after 22 years of its fully funded system.
  - Chile’s growth equivalent has been nearly 3 ppts per year.
  - In the rest of Latin America, pension assets have reached around 12 percent of GDP in AUM in the last decade, implying annual growth of 1–1½ ppts of GDP.
- Empirical findings:
  - Several studies confirm a positive impact of institutional investment (including pension funds) on market capitalization, with Granger causality tests indicating causality predominantly runs from contractual savings to market capitalization.
  - The buildup of institutional assets contributed to financial deepening; in G-7 countries stock and bond market capitalization rose by more than 40 ppts and 20 ppts of GDP respectively between 1980 and 1998, led by a 20 ppts of GDP increase in pension AUM.
  - Walker and Lefort (2002) find pension funds’ AUM had a statistically significant effect on Chile’s equity prices and cost of capital.
- Risks and potential adverse effects:
  - Rapid growth of pension AUM may outpace supply of private local securities and magnify asset price swings and volatility.
  - Concentration in government securities or a few local companies may result from tight investment controls and minimum return requirements, increasing the risk of asset price bubbles and liquidity constraints for PFMs.

### Policy recommendations and measures to enhance market development
- Achieve critical mass faster:
  - Grant permission for exempt workers to switch to the new system and shift all assets to private PFMs.
  - Less ambitious option: outsource management of accumulated reserves of partially funded schemes such as EPF to the private sector under competitive bidding.
- Adopt flexible investment regulations to enable faster growth in pension-led securities demand and optimal portfolio diversification.
- Improve capital market regulations, laws, and infrastructure to foster development of local securities markets; concurrent reforms are necessary to avoid imbalances between demand and supply of local securities.
- Debt management and regulatory measures:
  - Ensure liquid government bonds that serve an important benchmark function.
  - Issue price-indexed bonds to support price-indexed annuities.
- Allow limited foreign investment options over time to:
  - Help PFMs diversify country risk.
  - Gain expertise and familiarity with new instruments.
  - Relieve pressures in local markets when the supply of securities is restricted in the short term.
  - Immediate liberalization may not be viable; consider gradual liberalization as PFMs’ efficiency and effectiveness improve.

*Source: Box 1. The New Pension System (excerpt).*

### APPENDIX I: INTERNATIONAL EXPERIENCE WITH PRIVATELY MANAGED

### APPENDIX I: INTERNATIONAL EXPERIENCE WITH PRIVATELY MANAGED PENSION PLANS

### Coverage
- Chile:
  - Achieved fast coverage, with 40 percent of the labor force and nearly half of employees covered within five years of implementation (Faulkner-McDonagh, 2005).
  - Participation was initially mandatory only for new entrants to the work force.
  - Government incentives to switch included tax deductibility of contributions to the new system, not increasing the generosity of benefits of the old system, and lowering contribution rates dramatically.
- El Salvador:
  - New system introduced in 1998; participation mandatory for workers under 36 years old and new entrants to the labor force; women 50 and over and men 55 and over remained in the old system; others had the option to switch.
  - Provided strong incentives to switch, including income tax deductibility.
  - Majority of participants in the old system who had a choice transferred to the new system, and coverage reached about a quarter of the economically active population after one year (Samuel, 2006).

### Fees
- Chile:
  - Management costs initially totaled up to 4 percent of wages (almost double their current levels).
  - High fixed start-up costs contributed, e.g., computerization to manage millions of individual accounts and marketing campaigns to entice contributors to switch.
- El Salvador:
  - Pension law initially limited pension fund fees to 3½ percent of wages, lowered to 3 percent in 2001, and further reduced to 2¾ percent in 2005 (Samuel, 2006).
  - Law specifies services for which private administrators (AFPs) can charge, including administration of individual accounts, inactive accounts, and programmed withdrawals.
  - At the outset, fees were set competitively to attract participants; in recent years the regulated maximum has been binding.

### Replacement Rates
- Chile:
  - Recent estimates: the average worker’s pension income would replace 50–60 percent of the final salary over the medium term (2030–40).
  - Over the longer term, the average replacement rate would substantially decline to just over 40 percent.
  - These replacement rates are significantly lower than the 80 percent level promised at the time of the reform (Faulkner-MacDonagh, 2005).

### Table I.1 — Selected Countries: Main Features of Privately-Managed Pension Systems (extract)
- Countries listed: Argentina, Chile, Mexico, Peru, Hungary, Poland, India, United Kingdom
- Year of implementation of individual account reforms:
  - Argentina: 1994
  - Chile: 1981
  - Mexico: 1992
  - Peru: 1993
  - Hungary: 1998
  - Poland: 1999
  - India: 2005
  - United Kingdom: 1988
- Mandatory (M) or voluntary (V) for new entrants to workforce?
  - Entry shows: MMMMMMM4/ V
- Number of participants (Million):
  - Argentina: 4.9
  - Chile: 3.8
  - Mexico: 36.2
  - Peru: 3.9
  - Hungary: 2.4
  - Poland: 13.1
  - India: 0.3
  - United Kingdom: ...
- Percent of the potential contributor base:
  - Chile: 58.0
  - Poland: 70.0
  - Other entries: ...
- Contribution rate (percent of gross wage) 1/ (to the privately-managed mandatory pension funds):
  - Argentina: 7.0
  - Chile: 12.3
  - Mexico: 6.5
  - Peru: 10.9
  - Hungary: 8.0
  - Poland: 7.3
  - India: 10.0
  - United Kingdom: 2.5–5.25
- Of which: PFM's fee:
  - Argentina: 1.12
  - Chile: 0.99
  - Mexico: 1.47
  - Peru: 1.99
  - Hungary: 0.97
  - Poland: 1.6
  - India: ...
  - United Kingdom: ...
- Investment performance:
  - Average real rate of return on assets (2001–05) 2/:
    - Argentina: -7.1
    - Chile: 7.0
    - Mexico: 6.3
    - Peru: 15.1
    - Poland: 9.8
    - Other entries: ...
  - Average annual real rate of return (net of fees) 3/:
    - Chile: 5.0
    - Hungary: 3.9
    - Other entries: ...
- Projected replacement ratio by 2030:
  - Argentina: – 
  - Chile Men: 40 (percent)
  - Chile Women: 60
  - Mexico: 50–60
  - Peru: 45
  - Hungary: 45
  - Poland: ...
  - India: 43–95
  - United Kingdom: 48
- Notes and data sources included in the table:
  - 2/ Adjusted for inflation in U.S. dollar of each year. 2000–04 average for Poland. 2005–03 average for Peru.
  - 3/ 2001–05 average for Chile. 1999–03 average for Poland. 1998–2005 average for Hungary.
  - 4/ Mandatory only for central government employees recruited after January 1, 2004, and new employees of 19 state governments that have joined.
  - 1/ To the privately-managed mandatory pension funds. For Argentina, the legally set contribution rate is 9 percent, but was modified by the government in 2002 using temporary emergency powers.

*Source: APPENDIX I: INTERNATIONAL EXPERIENCE WITH PRIVATELY MANAGED PENSION PLANS (extracted content).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2007/_wp0785.pdf_