Before reforming the pension system, it is necessary to correctly understand the functioning of the capital market, the theoretical design of the pension system within the capital market, differentiate the theoretical design from its implementation, establish what things are possible and what are not, among other aspects. To do this, here are some points to keep in mind. Points that seem quite forgotten in the current discussion and in the previous ones.
For presentation purposes, I have separated this column into two parts.
Points to consider in the design of the pension savings stage
Pensions are an essentially economic-demographic problem and alien – in its cause and responsibility – to the capital market. The capital market helps, but turning to it to solve the problem comprehensively is a utopia.
A pension system must be designed considering equilibrium conditions of the capital market and, in the case of money from future pensioners, the design must consider a safe operating model in a world with high uncertainty.
The capital market offers a spectrum of expected rates of return, ranging from the zero-risk default rates of triple-A economies to risk-rewarded expected returns. Every instrument has risks to changes in the interest rate, but zero risk can be obtained by the financial match of risk and term in assets and liabilities.
The spectrum of rates of return has a very relevant associated concept: the True Equivalent. If a risk-free instrument that yields X is worth the same as another that yields 10X, but the latter with risk, then both are equivalent. It is wrong to believe that having an asset for many years will gain the expected value without incurring risk. The Chilean pension system believes in this fallacy when making its projections. We would have discovered something that the international system has not discovered and consequently arbitrated.
The return on capital is decreasing and is a function, among other factors, of the degree of development of the economy. In Chile, the returns obtained in the coming decades will be considerably lower than those obtained in the past 40 years. On the other hand, yields are not unlinked from abroad; The parameters of interest rates will always be given, since the Chilean system is a drop of water in the world capital market. Any projections – some go as far as the year 2100! – It must be based on international capital market parameters adjusted for country risk, and without falling into the trap of expected return without considering the True Equivalent.
If the capital market is used in the savings stage, it should be borne in mind that the safest option is to invest in instruments free of non-payment risk of triple A economies (or in their derivative, risk-free instruments of the local economy, that is, only including country risk). Leaving this option and entering the risk-return dimension offered by the capital market is opening a door to a probability of ending up with an accumulated fund less than the linear sum of savings, that is, the option of ending up with losses is real and will have a certain probability of occurring. So, to seek an expected return is to get out of a safe environment design.
However, if you choose to enter the risk-return dimension in order to achieve an expected return, it must be borne in mind that, in equilibrium, ex-ante there is no dominance of one investment strategy over another, this means that, a higher return obtained by one strategy versus another, compensates for the greater risk assumed, and, Therefore, corrected for risk, no strategy is better than another ex-ante; none dominates.
By extension, in equilibrium, the True Equivalent of any investment strategy is at most the risk-free rate.
If you choose to look for an expected return, you should also keep in mind that the variance of the accumulated balance is expanding as the term increases: the worst scenario becomes increasingly adverse as the investment term increases.
Even if you insist on achieving an expected return, you must be honest and validate the design of the model before the citizens. This requires citizens to be in clear knowledge that the worst possible scenario, whose probability is not zero and its elimination cannot be guaranteed, is to lose money with their money. Would citizens validate a design with risk? Who is willing to report clearlymind this, without euphemisms?
Derived from point 7. It is possible to demonstrate mathematically that a) there is no statistically significant difference between the returns obtained by the same multifund between two AFPs and/or the system average (AFPs move in herd); and b) there is also no statistically significant difference between the return obtained between two multi-funds of the same AFP. Since no investment strategy dominates another, the only real and controlling variable in which a fund manager can differentiate itself from the rest is the commission it charges its clients.
Commissions do matter. This issue has been dealt with by the authority and by the AFPs without due relevance. The commissions have been measured as a percentage of the salary, as a percentage of the accumulated balance, or are compared with other investment alternatives in the market, all these forms of presentation being “misleading” because they do not deliver the relevant information for the client, namely, when the gross return reported by the AFP is reduced by the commissions charged, that is, what is the Internal Rate of Return for the client. The IRR is the only indicator that aggregates complete information regarding the investment of your funds. In the last 40 years, commissions can reduce gross return by 1/3 or more. Who reports that? Nobody.
As a reference, if it is believed that the safe return to offer is, say, 2% real per year (a fairly “kind” rate), then, for a self-financed pension system to deliver replacement rates of the order of 70% of the average salary of recent years, we must think about postponing the retirement age by at least 5 years and, At a minimum, double the monthly discount percentage. Both in parallel. And without pension gaps throughout working life. This is the sad reality, the numbers do not give; The capital market helps, but it is not enough. And the expected return has been the drug, whose use without having considered the True Equivalent has blinded reformists, defenders of the system, authorities, academics and even the so-called father of the system. That today an expected return continues to be used without considering the True Equivalent will only continue to feed false expectations regarding the true benefits of the system.
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The content expressed in this opinion column is the sole responsibility of its author, and does not necessarily reflect the editorial line or position of El Mostrador.
