copy the linklink copied!Chapter 9. Summary of recommendations from the OECD review of the Peruvian pension system

copy the linklink copied!9.1. Tackle old-age poverty

Poverty rates have been declining in Peru, but it remains a much larger problem in rural areas and for the elderly in particular. The programme Pensión 65, that provides a flat-rate benefit for the elderly in extreme poverty, has largely been a success, with 1 in 4 elderly Peruvians now receiving benefits. Nevertheless, benefit levels remain extremely low compared to the level of safety-net benefits provided in OECD countries, even when accounting for the difference in economic development. Furthermore, the benefit level has not been adjusted in nominal terms and has therefore been declining in real terms.

The coverage of Pensión 65 should be expanded to better tackle old-age poverty. There is some evidence that not all eligible individuals are receiving benefits. Therefore, the coverage of the programme can be expanded through publicity campaigns to make people more aware of the programme and its eligibility criteria in order to encourage those who are eligible to apply for benefits. In order to address poverty and not only extreme poverty, eligibility criteria can also be expanded to reach a larger population.

Benefit levels should also be improved. This could be achieved by adjusting benefit levels upward in a one-off increase to make it more meaningful as a mechanism to address poverty. They should also be indexed going forward so that they retain their value in real terms. This could be done by indexing the benefit level to inflation, for example.

Finally, the benefit should be better integrated with the minimum pension in the contributory system, and take the form of a top-up payment rather than a flat-rate payment, as discussed later on.

copy the linklink copied!9.2. Establish a solid framework for the contributory pension system to meet its objectives

The design of the current pension system is not conducive to achieving its objectives. The public and private pension systems operate in parallel rather than being complementary, competing with each other to provide not only old-age pensions but also disability and survivor benefits. While in total the private system has more affiliates than the public system, more new affiliates have been joining the public system recently. The main benefit of joining the public system as opposed to the private system is the provision of a minimum pension benefit if twenty years of contributions are achieved. However, low contribution densities on average and the ability to access the capital accumulated in the private system has induced a large number of individuals to switch from the public to the private system, even though any benefits accumulated since 2001 are not recognised when switching.

These trends imply that pensioners are losing out. Individuals unable to achieve twenty years of contributions will receive no benefits from the public system, and will lose any benefits accumulated since 2001 if they switch to the private system. They will also lose access to minimum pension benefits. In addition, if individuals decide to take a lump-sum instead of a programmed withdrawal or life annuity product, they may be at increased risk of old-age poverty.

The fragmented pension system also results in processes that are not integrated and a significant lack of coordination among the public institutions overseeing the system. This has led to costly errors that further harm pensioners in terms of lost benefits. One such error has been the mismanagement of contributions that have been mistakenly sent to the public system rather than to an AFP. Those affected have not been compensated for this error.

The public PAYG and the private funded pension systems should be complementary to each other. In order to have a more coherent pension system, the competition and duplication in the benefits provided by the public and private system need to be removed, and the two sources of pensions and related benefits should be designed to be complementary. While the system could rely primarily on either public or private provision, combining both a mandatory public system and individual capitalisation accounts would result in a more robust pension system that is more resilient to the many risks that can threaten the sustainability and adequacy of retirement income. In addition, retaining both systems would minimise the implementation costs and smooth the transition to the improved new system.

The new framework for the complementary public and private pension provision needs to adhere to the principles of complementarity, accessibility, sustainability, and equity.

First, the design of the pension system needs to make both components complementary, take into account the different sources of pensions, and provide the proper incentives to contribute. Eligibility requirements will need to be coordinated with the safety net in order to avoid duplicating pension provision, particularly with respect to the minimum pension. The minimum pension should also be designed so as to provide both proper incentives to contribute to the pension system and higher pension benefits as the number of years of contributions increases.

The eligibility requirements should make the pension system accessible. For the individual accounts in the private system, this is automatic, as individuals will eventually receive the assets that they have accumulated in their account. For the public benefit, however, the current requirement to contribute 20 years makes benefits inaccessible to a significant proportion of affiliates. The minimum number of years required to contribute before being eligible for benefits needs to be significantly reduced so that most people who contribute to the system can expect to receive benefits in return.

Financial sustainability should be ensured. The level of benefits that affiliates can expect to receive needs to be linked to the contributions made to the system to make sure that contributions will be sufficient to finance the benefits. In individual accounts, this link is automatic, as the accumulated assets will directly finance the benefits. However, the PAYG public component will need automatic mechanisms to ensure this balance now and going forward, both in accumulation by linking the accrual of benefits with the macroeconomic situation, and in pay-out by accounting for the length of time that payments are expected to be made.

Finally, the transition to the new improved system will need to ensure that the current members of the pension system are treated fairly and will not receive significantly lower benefits than those that they have already been promised. Regardless of how this is done, all future entitlements should accrue under the new rules so as to limit the length of this transition process and the related costs.

Duplication will also need to be removed with respect to the disability and survivor pension benefits. Benefits may continue to be provided by the public and private system for their respective portion of retirement benefits. However, for those in risky occupations, competition between the public and private sector should be removed for SCTR insurance. Having the private sector only providing this insurance would help to align the incentives employers have to ensure the safety of their employees and to ensure that premiums continue to be in line with the underlying risk. Nevertheless, the ONP may still have an important social supplementary function to fulfil in the context of workers in risky occupations that the private sector does not cover because the risk is too high for the premium to be affordable.

Finally, in order to have a coherent system in which all institutions work together to achieve the objectives of the pension system, there needs to be better coordination and cooperation among these institutions. All institutions should have access to timely and accurate data on the pension system, and the processes to share information need to be more flexible and adaptable to ad-hoc needs. This could be accomplished through a centralised platform jointly operated by the public and private sector, PensionsNet. This platform could centralise the collection of information and the administrative tasks such as the collection and enforcement of contributions for both the public and the private components of the pensions system, and capitalise on the efficiency gains brought with the existing AFPnet platform.

copy the linklink copied!9.3. Improve the coverage and level of pensions

Coverage of the Peruvian pension system remains low, with less than two-thirds of the economically active population (PEA) affiliated with either the public or private system, and only around a quarter of the PEA are actively contributing. These low levels of coverage are driven primarily by the high levels of informal employment, which includes the self-employed and independent workers, as they are not required to contribute to the system. Over 70% of the workforce is in informal employment, but in rural areas, the problem is much larger with the level of informality at over 95%. Most of those in informal employment do not choose to contribute to the pension system, with recently less than 6% of new affiliates joining voluntarily.

Efforts to increase coverage will need to focus on reducing the high levels of informality and promoting participating in the pension system by informal workers.

One way to reduce levels of informality would be to increase the relative cost of being informal compared to being formal. Because of the high cost of becoming formal, particularly for low-income workers, these workers have more of an incentive to remain in informal employment. To reduce this cost, the government could subsidise the pension contributions of low-income workers.

Otherwise, providing incentives for informal workers to contribute or making it compulsory could increase the coverage of the pension system. For low-income workers, matching contributions where the government matches a certain proportion of contributions made by the individual can be an effective incentive to contribute. However, this would have to be coordinated with the financial incentives provided to formal workers in order to avoid creating incentives to remain informal. For independent workers, the requirement to contribute to the system could be reintroduced. To make it more effective this time, this measure could be accompanied by the possibility to have a more flexible contribution schedule and innovative collection mechanisms such as through utility bills. Behavioural nudges that increase the likelihood that they will contribute could accompany those measures.

Improving the levels of pensions given the low level and density of contributions will require raising the amount and frequency of contributions made. However, any increase in the level of mandatory contributions for individuals should ensure that these increases do not result in an immediate reduction of nominal wages. The increase could be implemented gradually over time and linked automatically to wage increases. Alternatively or in parallel, the additional contributions could come from the employer, who currently does not share the social security contributions of its employees.

There is also a need to improve incentives to increase voluntary contributions. As a starting point, everyone should be able to open up a voluntary pension account if they want to, which is not currently the case. Once this is allowed, financial incentives for voluntary contributions could be improved. In order to ensure that low-income individuals benefit from these incentives, a flat subsidy or matching contributions that are paid directly into the affiliate’s account (as discussed for providing incentives for informal workers to contribute) could be implemented. In order to also promote more frequent contributions to pension accounts, such incentives could be linked to contribution density. Automatic enrolment could also be introduced to nudge individuals into saving more.

Another way to improve the level of pensions would be to limit the early withdrawal of assets from the pension accounts. Currently, individuals can withdraw 25% of their assets before retirement for the purchase of a first home, and retire from the age of 50/55 for females/males if eligible for early retirement.

To address early withdrawals from the SPP before retirement, withdrawals could be limited to assets accumulated from voluntary contributions, though a higher rate could be allowed. However, any matching contributions or subsidies provided on these contributions would need to be removed to avoid adverse incentives to game the system.

With respect to early retirement, first the gender gap in the early retirement age should be eliminated. While the legal retirement age is the same for both genders, there remains a difference of five years for early retirement, which puts women at a disadvantage in retirement given their lower average wages and higher life expectancies. Secondly, the criteria for early retirement should be more restrictive for those who are able to continue working. Minimum income requirements should be imposed, and benefits should be adjusted downward in an actuarially fair manner to reflect the longer expected time in retirement.

copy the linklink copied!9.4. Optimise the design of the private pension system to improve outcomes

The AFPs are required to offer four investment funds of varying levels of conservatism, from mostly equities to mostly cash and deposits. The default investment strategy for new affiliates is a balanced risk fund. At age 60, their assets are automatically moved to the conservative fund, and at age 65 to the most conservative cash and deposit fund until they make a decision regarding pay-out.

While it is common and considered best practice for default funds to de-risk as individuals approach retirement, it would be more appropriate to gradually de-risk the investment rather than immediately when individuals reach the specified age. Furthermore, individuals could be allowed to invest different sources of pension savings into different funds and providers in order to better diversify their risk exposure according to their preferences.

To promote better value from investments with the AFPs, the fee structure could be adjusted to better align the interests of the AFPs and the members. Charge structures are now in the process of transitioning from upfront charges based on salaries to ongoing charges based on assets under management (AUM). However, the AUM-based fee structure does not necessarily provide incentives for the AFPs to improve efficiency or reward performance.

Moving towards a performance-based fee structure, where providers receive more fees if the funds outperform the market, would better align the incentives of the fund managers with the interest of the affiliates. Independent performance benchmarks could be relied upon to this effect in order to reduce the incentives for herding that a peer-based benchmark could present.

There is a need to revisit the minimum return guarantee required from AFPs. AFPs are required to guarantee a minimum return for each fund calculated as a percentage of the average returns of that fund for all AFPs over the last 36 months. Having a minimum guaranteed return that references the returns of other AFPs provides an incentive for AFPs to adopt similar investment strategies, and indeed, there is evidence of investment herding behaviour.

Alternative mechanisms exist to achieve the objectives of the minimum return that would reduce the incentives for herding, eliminating the need for an investment guarantee. The purpose of this minimum return seems to be two-fold. Firstly, it serves as a peer benchmark to judge the performance of funds, and secondly it effectively puts limits around the volatility of the fund and how much it can deviate from the expected average returns.

To benchmark performance, independent investment benchmarks that are tailored to each fund could provide a benchmark that would be independent of the other AFPs’ strategies. A common, independent benchmark could also be established for each fund to promote comparability and provide a reference for performance-based fees.

To limit fund volatility, imposing explicit limits on the funds as opposed to the indirect limits from the minimum return guarantee would also reduce incentives for herding. This could be done, for example, through targets around the probability of achieving a certain level of retirement income.

Measures have been taken to improve the competitive landscape for pensions, namely through the introduction of a tender mechanism through which AFPs compete to receive all new affiliates over a period of two years. While this has reduced fees charged on average, there is room to go further.

Improving the disclosure of the costs and fees is a key policy tool to reduce costs and fees where market mechanisms have been less effective. The resulting transparency can increase competitive pressure on providers as affiliates can more easily compare the fees they are paying and change providers if they choose. In addition, more granular disclosure can also help the providers themselves to better understand all the costs they incur, allowing them to take action to reduce these costs.

The fees charged on voluntary contributions should be aligned with those for mandatory contributions in order to promote voluntary contributions and ensure that these contributions are just as valuable for pension savings as mandatory contributions. While the tender mechanism has brought down the charges for mandatory contributions, the fees charged for voluntary contributions remain significantly higher on average. Average fees charged on voluntary contributions, weighted by the asset allocation to each fund, are over 50 basis points higher than fees on mandatory contributions. These high fees may act as a disincentive for individuals, especially those in informal occupations, to contribute voluntarily to the pension system. It also means that individuals who do decide to save more are getting much less out of their additional savings than they would otherwise.

The ability for affiliates to switch providers is a positive aspect of the system to promote healthy competition, however there should be mechanisms in place to prevent negative consequences such as excessive marketing expenditure or market instability. One approach is to impose limits on the frequency with which affiliates can change providers or investment funds. Another option would be to limit commissions that AFP representatives receive for getting an affiliate to frequently switch providers.

The rules in place should also ensure that the responsibilities of the AFP are appropriate and promote effective governance and resource allocation. Several mechanisms have been introduced that go in this direction, namely the introduction of AFPnet to improve the efficiency of the management of contributions and the introduction of SISCO that improves the transparency and governance around disability and survival insurance.

Having a centralised platform, PensionsNet, managing the administration of the entire pension system would streamline the system. It could also incorporate validation checks and a collection of the information necessary to enforce contribution payments to the system. AFPs do not always have the mechanisms to carry out their responsibilities effectively. This is the case particularly in determining whether employers owe contributions of their employees, as AFPs do not necessarily have information on employers.

In other cases, AFPs could allocate some responsibility to promote more balanced outcomes. For example, AFPs are the sole representative from the private sector in determining the validity of disability claims. Decision-making responsibility could be shared with the insurance industry, which should be involved in such processes as they are directly impacted.

Once an individual reaches retirement, the options they have to take their accumulated assets should be aligned with the pension system’s objective of ensuring people’s financial well-being throughout their retirement. The option that affiliates have had since 2016 to take their assets as a lump sum increases the risk that this objective will not be met and provides harmful incentives to members.

Ideally, the ability to withdraw pension assets as a lump-sum should be eliminated. As a second-best option, the pension system should at least be required to pay a minimum level of income in retirement. This minimum could be met through a combination of both the public and private components, and set at a level such as the minimum pension paid to everyone contributing.

Another way to encourage the uptake of a pension income rather than a lump-sum could be to remove the accumulated financial advantage that individuals have received on the preferential tax treatment of their pension savings. Under the current tax regime where investment returns on pension savings are tax exempt, this would represent an additional tax that would need to be paid back of nearly 6% of the account value. Any matching contributions or subsidies that are adopted as a way to encourage savings could also be taken back if individuals opt to take a lump-sum.

Other incentives to encourage the uptake of a pension income and prevent gaming the system could be linked to the eligibility or cost of health coverage in retirement from EsSalud. This could be done by linking the eligibility of coverage to a minimum number or density of contributions. Health coverage when taking a lump-sum option should also be linked to the age of retirement. Those retiring early should be required to pay a higher contribution to be covered or not allowed to take a lump-sum at all.

Even if the individual decides to not take a lump-sum, however, the alternative options for pay-out that are available are overly complex and present a risk of confusion and choice overload. This could lead even more people to choose the lump-sum option, which is arguably the easiest option to understand. Given this observation combined with the lack of demand for more complex products, the options available to individuals at retirement should be restricted to the simplest products available.

When individuals choose to draw a pension from the system, the security of these benefits should be ensured through appropriate assumptions and product designs that aim to reduce risks for pensioners.

The pay-out option combining programmed withdrawals and a deferred annuity should also be modified to better protect individuals from the longevity risk of not having sufficient income for life in retirement. The current annuity purchased with 50% of accumulated assets and a deferral period of five years will result in a significantly lower income than pensioners could otherwise obtain. The deferral period for this option should therefore be extended to increase the amount of income that the deferred annuity will provide.

The SBS should also continue to regularly update the mortality tables for the private pension system to ensure that these assumptions continue to be in line with actual mortality experience. This will help to ensure that insurance companies have sufficient reserves to back the annuity payments that are promised to pensioners.

In the event that an insurer does become insolvent, however, the appropriate mechanisms should be in place to safeguard pensioners’ benefits. This can be done through the wind-up procedure, or alternatively through an Insurance Policy Coverage Fund.

copy the linklink copied!9.5. Improve trust and confidence in the pension system

Efforts need to be made to improve trust and confidence in the pension system. Unless the Peruvian people understand how the pension system can benefit them and trust that the institutions involved in the system will ensure that it does so, the system will fail to achieve its objective of ensuring the financial well-being of retired Peruvians regardless of the improvements that are made to its design.

First, more efforts need to be made to promote knowledge of the pension system and how it works. More Peruvians expect to rely on Pensión 65 in retirement than the contributory pension system, demonstrating a significant lack of understanding of the benefits that the system can provide. Education about the pension system should be incorporated into the financial literacy programmes in schools. For adults, public awareness campaigns should be used to educate the general public and encourage them to save into the system.

The public also needs to trust the financial institutions that are managing their pension savings. The public tends to distrust the AFPs, who take the blame for failures in the system that they do not necessarily have any control over such as missing contributions or the late payment of recognition bonds. The responsibility that the AFPs have relating to the pension system therefore needs to be better aligned with the responsibilities over which they have control, and for these responsibilities only should they be held accountable to the public. Making the centralised platform PensionsNet the main point of contact of affiliates would help to mitigate the public’s perception of who is responsible for errors, and minimise the opportunity for procedural failures. In addition, while there are rules requiring AFPs to avoid and/or manage the conflicts of interest they face, more could be done to ensure that these conflicts are not inappropriately affecting business decisions.

Trust and confidence are also low with respect to the public institutions responsible for overseeing the pension system. These institutions therefore need to take concrete steps to demonstrate that they are acting in the best interest of affiliates and pensioners. One such step would be to ensure that pensioners are compensated for any contributions to the private system that were misdirected to the public system. Another would be to strengthen the independence and enforcement power of the SBS to show the public that the institutions operating within the pension system are subject to the rules in place and that there will be consequences if the best interests of the people are not put first.

Finally, an independent committee of experts could be established that would be responsible for the implementation and monitoring of the reform. This committee should be charged with reaching the agreed upon reform package and objective in a gradual manner and, hopefully, independently from the political process.

Implementing comprehensively the recommendations laid out in this report would put the Peruvian pension system in a much stronger position to achieve its objectives and improve the financial outcomes of the Peruvian population during retirement.