The author analyzes the typical model for regulating investments in private pension funds. Pension reforms like those pioneered by Chile are being initiated or considered in Argentina, Bolivia, China, Colombia, Costa Rica, Hungary, Mexico, Peru, Uruguay, and elsewhere. Such reforms greatly improve fiscal discipline, make social security benefits and burdens equitable, and deepen financial markets. But they are also typically accompanied by: tight restrictions on the investments in pension fund portfolios; restrictions on the management of mandated retirement savings (to newly created legal entities called pension administrators, to the exclusion of such financial intermediaries as banks and mutual funds); minimum-return guarantees from the state and/or pension funds; and commissions based on salary rather than on the volume of assets managed. Illustrating his conclusions with case studies from Chile and Peru, the author shows that these restrictions, though well-meant, are poorly justified by financial theory, distort incentives for competition based on product choice and efficiency, increase administrative costs, and seriously reduce the affiliates'appropriate risk-return choices and returns. And the resulting potential losses in retirement income are great. The author recommends a significant departure from the Chilean-style model of a private pension fund system. He briefly describes implementation and transition issues for the alternative system that he proposes, which would: permit diverse intermediaries -including banks and mutual funds that meet appropriate prudential standards- to manage retirement savings; allow a greater choice between investment products; require that returns be reported on a net basis; and charge commissions as a fraction of assets managed.
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