The answer boils down to one painful fact: the combined effect of a number of implementation missteps that led, inevitably, to a snowball of discontent. Chiefly among the missteps are: a low mandatory contribution plus a faulty set of investment regulations. Chilean workers are mandated to contribute 10% of their monthly salaries to their DC plan. Although what is an acceptable monthly payment is somewhat debatable, it is reasonable to assume that a replacement rate of 70% might be considered satisfactory. Unfortunately, if we also assume, conservatively, that a person works continuously for 30 years, a simple calculation suggests that on average the retirement portfolio must deliver an annual return (in real terms) of roughly 9% to achieve such replacement rate. This is a very tall order. More realistic return assumptions indicate that a contribution of approximately 16% of the salary is required to achieve this replacement rate. Regrettably, neither the pension regulator nor any other government authority ever stated clearly what replacement rate workers should expect based on a 10% contribution; consequently, most workers assumed, naively, that the 10% was sufficient to maintain a post-retirement income comparable to their most recent pre-retirement income: clearly, a sure recipe for retirement unhappiness.
Now let us turn to the investment regulation. The Chilean retirement system offers five investment options known as Funds A, B, C, D and E. Fund A is supposed to be the riskiest and Fund E the most conservative, and hence, Fund A was expected to yield returns higher than those of Fund B, and Fund B higher than Fund C, and so on. Lamentably, recent studies have demonstrated that these funds have delivered returns contrary to the originally intended risk-return profile. More to the point, rank-ordering the five funds according to their cumulative returns over a five-year period shows, for example, that in more than 40% of the cases Fund E outperformed Fund A. (Comparisons based on other time-windows reveal similar patterns.) Also, an ex-post comparison of the funds' Sharpe ratios show that the funds are completely misaligned. In brief, investors in the riskiest funds only got more risk, but did not receive returns commensurate with the risk they took. The reason behind this unfortunate outcome is a faulty investment regulation that attempted to control the risk in the funds via limits by asset class (low and high), instead of relying on portfolio-level risk metrics such as the value-at-risk (VaR) or conditional-value-at-risk (CVaR). The Mexican retirement system offers an interesting counterexample. Such system offers also several investment funds. However, unlike the Chilean regulation it incorporates VaR-based limits for each investment option. The result? The Mexican funds are correctly aligned in terms of their returns.
Two additional factors that have also impacted negatively the funds' performance are the ill-advised restrictions related to alternative assets and foreign investments.
Pension funds, since they are not subjected to unpredictable liquidation events are ideally suited to capture the liquidity premium offered by alternative investments, not to mention the diversification benefits these instruments bring. Yet, Chilean funds are forced to keep a very low exposure to this asset class. The upper limit for Fund A (the highest) is 13%; for the other funds the limits are much lower. Also restrictive is the definition of alternative assets; the Chilean regulation groups in the same bucket private debt, real estate, infrastructure projects, private equity and hedge funds.
Furthermore, foreign investments, that is, non-Chilean peso denominated positions, are required to be hedged, albeit partially, against currency movements. This constraint is difficult to reconcile with the fact that exposure to different currencies — in themselves a legitimate asset class — can offer diversification benefits. And the additional burden of having to construct the hedges on an investment-by-investment basis, and not at the aggregate portfolio level, has contributed to magnify the inefficacy.
In short, the current investment regulation of the funds has not only resulted in five funds whose risk-return profiles are contrary to the original intention; it has also been detrimental to the returns of these funds. Which, in turn, has been damaging for future retirees' benefits. For instance, having a sub-optimal exposure to alternative assets can diminish the overall portfolio return in at least 1% per annum. And the difference between an annual return of, say, 5% vs. 6% over a 30-year period, can imply a 20% difference in the monthly benefits.
At present, the so called "pension problem" is a hotly debated issue in Chile and most likely some reforms will soon be enacted. Unfortunately, the discussion has been centered around public policy issues, e.g., should an increase in the monthly pension contribution go to the worker's pension, or, should it go to a common ("solidarity") fund managed by the State? Modifications to the current investment regulation have been almost totally ignored by both lawmakers as well as pundits. A case in point: the Bravo commission, the most recent of the many commissions of experts appointed to suggest improvements to the current system, prepared a 250-page report, of which, not a single recommendation refers to changes to the investment regulations.
In conclusion, two things are clear. One, the Chilean retirement system will soon be modified. And two, the modifications — which at the moment are driven by the view that defined contribution schemes are a failure (a view that has been marshaled by the current left-oriented government) — are likely to leave the investment regulation untouched. The almost certain outcome of these unfortunate circumstances is that future Chilean retirees will continue to experience suboptimal returns caused by suboptimal asset allocations. And therefore, there will be another generation of workers unhappy with their retirement benefits.
Arturo Cifuentes is a principal investigator at Clapes UC, a public policy center which is part of the Catholic University of Chile. He was previously president of the Chilean Wealth Fund Investment committee and taught at Columbia University in New York. Bernardo Pagnoncelli, who taught for 10 years at Adolfo Ibanez University in Santiago, Chile, is currently a full professor at SKEMA Business School in Lille, France. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.
