As the world's sixth largest economy with a sizable portion of its workforce moving to the middle class from lower-wage, lower-skilled positions, Brazil is in a position to learn from generations of pension evolution in other parts of the world.
The current workforce and pool of contributors exceeds beneficiaries by a factor of nearly 3-to-1. Inflation rates have been under control and within a target ceiling of 6.5% as established by the Brazilian central bank. Population has grown 115% in the past 40 years and provides ample pools of able-bodied workers (68% of the population is between 15 and 64 years of age, according to Brazilian Institute Of Geography and Statistics). Other, broader economic factors are trending favorably and should provide for continued contributions into the country's $300 billion pension sector, according to ABRAPP.
Although the country's pension system has the underpinnings of long-term success, the system is wrought with concerns. Brazilian pension systems are viewed as some of the most generous in the world, replacing 75% of average income, according to The Economist. The country spends approximately 13% of its GDP on pension benefits with 35 pensioners for every 100 workers (there are approximately 10 Brazilians over the age of 65 for every 100 between the ages of 15 and 64). Legacy rules, driven by a combination of years worked and age, allow workers to retire at earlier ages with higher benefits than equivalent plans in other developed nations. The average man in Brazil retires at 54 and the average woman retires at 52 – and all pensions must pay the minimum wage (currently about $4,100 per year, but expected to reach around $5,310 per year by 2015, according to the Rio Times). With average life expectancy up by nearly 15 years since 1970, future payouts have the potential to exceed plan resources and reforms will inevitably need to occur, according to a United Nations report.
The majority of these problems are policy driven. All workers might ultimately have to accept reduced benefits and later retirement ages. Younger workers might have to accept higher contribution rates. Employers might have to pay higher payroll taxes. Unfortunately, these issues may not be addressed for several years as they are debated and altered through the legislative process.
Why diversify globally?
The global economic slowdown produced additional challenges to a Brazilian pension system that traditionally has relied on less-than-diversified investment strategies. Deliberate efforts by Brazil's central bank have lowered benchmark overnight rates to the current 7.25% from 25% in 2002, according to Banco Central do Brasil. For an extended period of time, Brazilian pension plans were able to make risk-free investments and achieve returns that far exceeded the actuarial target return of about 6%. Pension funds have had the luxury of ample investment opportunities providing returns that have well exceeded liability costs in their local market. The recent efforts of the central bank to stimulate domestic demand as an offset to reductions in exports to key trading partners in China and Western Europe are reducing spreads that ultimately will force pension fund boards to rethink Brazil-only investment strategies and consider new approaches.
Portfolio globalization will be a natural next step for Brazilian pension plans. Changing government policies and the impact of globalization on the Brazilian economy will force pension fund boards to consider investments in external markets to mitigate the following:
- Brazil country risk (including inflation and political risks);
- interest-rate risk;
- asset/liability matching; and
- decoupling from downstream markets (i.e. China and Europe)
The regulatory environment dictates how and where Brazilian pension plans are allowed to invest. With respect to foreign investments, plans are restricted to issuances of companies domiciled in other Mercosul countries (Argentina, Paraguay, Uruguay and Venezuela), Brazil-listed depository receipts and funds that invest in fixed income, equities or indexes, according to Central Bank of Brazil. Pension plans also will need to develop more robust methods for factoring in alpha requirements for their foreign investment programs while taking into consideration the overall portfolio beta (and the potential to lower this through global investing). Highly rated countries with diversified economies and liquid securities markets such as the United States, Australia, South Africa, Germany and Canada offer opportunities that address diversification needs while also delinking from established downstream demand markets.
Currently, the combined pension market in Brazil invests 0.1% or about $300 million in external markets. This is far below the 10% legal limit. Existing conditions present an opportunity for pension plans to explore external markets given lower returns in the local market. Plans can start today with pilot programs and grow over time as they gain comfort with external markets. The market will benefit from investment products and services that are designed specifically to meet the needs of pension plans within the framework of the law. These products should include structured offshore investment vehicles that adhere to regulatory ownership restrictions (25% or less of the assets under management per vehicle per plan) while providing targeted exposure to the desired investment strategy. The products will also require the administration, reporting, governance, compliance and risk management needed to satisfy the fiduciary requirements of pension boards of directors along with regulatory demands.
Brazil achieved a 0.9% annual GDP growth rate in 2012 — well below the initial forecast of 4.5%. Economists are forecasting a recovery in 2013 with a GDP growth target of 3.4%. Notwithstanding, Brazilian pension managers need to take a short- to intermediate-term approach to portfolio globalization. A gradual entry into global markets through structured products is ideal.
Cedrick Reynolds is an executive director in J.P. Morgan's Corporate & Investment Bank.