Chapter 1. Introduction to the review of the Peruvian pension system

This chapter presents the main structure of the report and an overview of the objectives of the OECD Pension Review of Peru.

    

1.1. Objectives of the review

The Superintendence of Banking, Insurance, and Private Pension Administrators of Peru (Superindendencia de Banca, Seguros y AFP, SBS), the regulator and supervisor of the financial system in Peru, requested the OECD to conduct a comprehensive review of their pension system. The objective of this review is to help the Peruvian authorities better understand the challenges facing the pension system and the potential solutions to address these challenges in light of international experience and practices.

The purpose of this review is therefore to provide recommendations, using OECD’s best practices in pension design, on how to improve the Peruvian pension system with the goal of improving the retirement income that people receive.

Box 1.1. Terms of reference for the OECD review of the Peruvian pension system

BACKGROUND

The Superintendence of Banking, Insurance and Private Pension Funds Administrators, the Peruvian Private Pension System’s (SPP) regulator and supervisor, is interested in the OECD conducting a review of the Peruvian pension system based on the OECD’s best practices in pension design and presenting various proposals to improve the Peruvian pension system and guarantee its sustainability in the long term. The review will also take account of recent amendments to the regulatory framework, and current proposals to reform the SPP.

OBJECTIVE

The purpose of the review is to provide recommendations, using OECD’s best practices in pension design, on how to improve the Peruvian pension system with the goal of improving the retirement income that people may receive from the pension system.

ASPECTS COVERED

The aspects for examination will consider:

i) The adequacy of pensions given current levels of mandatory contributions, retirement age, voluntary savings, and short contribution densities.

ii) Mechanisms to increase coverage and the amount of contributions, in order to ensure adequate income in retirement with a particular focus on lower- and middle-income groups, independent workers and informal workers.

iii) Tax system and retirement savings. Fiscal and other incentives to promote participation and higher retirement savings.

iv) Improving the design of the overall pension system:

a. Improving the interaction between the labour market and the pension system, including mechanisms to work longer, or other parametric solutions.

b. An analysis of the best way to design the basic pension to protect low-income groups in the light of the funded private pension system: Pension 65, the Peruvian non-contributory pension system, and matching contribution for low income workers.

c. The convenience of maintaining a defined benefit pay-as-you-go system and a funded defined contribution system as competitors for new entrants.

d. Analysis of other specific Peruvian pension regimes.

v) Improving the design of the accumulation phase:

a. Approaches to promote low-cost retirement savings instruments.

b. Default investment strategies and life cycle strategies.

c. The wisdom of investment restrictions, in particular on foreign securities.

d. Risk-based supervision.

vi) Improving the design of the pay-out phase:

a. Different mechanisms to allocate assets accumulated at retirement: lump-sums, programmed withdrawals and life annuities.

b. Pay-out phase and annuity markets.

c. Managing longevity risk (mortality tables, financial instruments to mitigate longevity risk, including longevity bonds).

vii) Policies to increase public understanding and the public’s confidence in the pension system:

a. Strengthening the regulatory framework and governance of private pension funds (AFP).

b. Pension statements and National Pension Communication Campaigns.

The review should also take account of the views of relevant stakeholders by way of a targeted consultation process.

1.2. Structure of the review

This review is comprehensive and addresses all aspects of the Peruvian pension system, including both the public and private components. It assesses the entire Peruvian pension system given the current structure and rules in place, and aims to identify areas that need improvement and to provide guidance on how these improvements can be implemented in practice.

The policy proposals presented in this report to improve the Peruvian pension system should be implemented comprehensively as a package. All the pieces in the policy proposals work together to balance the positive and negative implications of each measure. Implementing them separately in a piecemeal manner will break the balance and lead to winners and losers that could jeopardise the whole reform. Nevertheless, the implementation of the reform could be done in a gradual and incremental manner taking into account fiscal capacity, institutional capability, regulatory powers and labour market developments. Even if the implementation of reforms is gradual, it is essential to agree upon the whole package of policy proposals and its ultimate long-term objective of improving the pension system, and thus work towards that objective implementing all the measures independently of the short-term political agendas.

The recommendations from this review draw upon the OECD best international practices on designing and regulating pension systems that have been put forward in the OECD Roadmap for the Good Design of Defined Contribution Pension Plans, the OECD Core Principles of Private Pension Regulation, the OECD Pensions at a Glance Series, the OECD Pensions Outlook series, as well as relevant Principles that the OECD has established relating to financial incentives, mortality tables, retirement income products, financial education and corporate governance.

Chapter 2 of this report describes the Peruvian pension system and the context in which it has developed and currently exists. The chapter first describes the current macroeconomic and demographic contexts that define some of the challenges that the pension system needs to address in order to be sustainable and achieve its objectives. The chapter then summarises the main reforms and initiatives that have led to the structure of the current pension system. It also describes the structure and rules of the current pension system in order to provide a basic understanding of how it operates and a reference to refer to when discussing challenges and potential solutions in later chapters.

The key issues that this report identifies that need to be addressed in the Peruvian pension system are summarised in Figure 1.1. First, the system needs to tackle old-age poverty by establishing a non-contributory pension that provides a universal safety net for all Peruvians (Chapter 3). It then needs to establish a solid framework for the contributory pension system that operates coherently to meet its objective of providing a retirement income for those who contribute (Chapter 4). In order to maximise the number of Peruvians who benefit from the contributory system and ensure that the benefits received are adequate, measures need to be taken to improve the coverage of the system and increase the level of benefit that individuals can ultimately expect to receive (Chapter 5). The design of the private component of the pension system also needs to be optimised, namely in terms of the investment strategies and costs incurred and the options that individuals have to withdraw their accumulated assets at retirement (Chapter 6 and Chapter 7). Finally, Peru needs to address the fundamental problem of a lack of trust and confidence in the pension system in order to ensure that Peruvians will effectively participate in the system (Chapter 8).

Figure 1.1. Key issues to address in the Peruvian pension system

The foundational recommendation from this review is to maintain both the public pay as you go (PAYG) and the funded individual account components of the system, but make them complementary rather than functioning as two separate alternatives for participating in the pension system. In addition to improving the coherence of the pension system, this solution also has the benefit of smoothing the transition to a new system that would remove the competition between the public and private components.

Chapter 3 addresses the need for the pension system to have a non-contributory pension component to tackle poverty in old age and ensure that all Peruvians can receive an income to provide for some basic needs in retirement. While the current benefit provided by the Pensión 65 programme has been successful in alleviating extreme poverty in old age, benefit levels remain extremely low and the programme’s coverage should be expanded and better integrated with the provision of the minimum pension from the contributory system.

Chapter 4 tackles the structural problem of the current pension system, in which the public and private components operate in parallel in a fragmented and incoherent manner and compete with one another. Individuals currently have to choose to contribute to the public or private system, which can provide very different levels of benefits. In addition to being difficult for people to understand, the lack of an integrated system increases the risk of administrative and procedural errors that can significantly harm members. Past reforms to improve the financial sustainability of the public system, namely by increasing the minimum number of years of contributions to be eligible to 20 years, have undermined the system’s objective to provide a pension to its members. The OECD review recommends policy options that aim to establish a solid framework for its contributory pension system where the public and private components are complementary and the system operates in an integrated and efficient manner, while addressing the sustainability of the entire system going forward.

Chapter 5 addresses the problem of low coverage of the pension system and low levels of expected benefits. It assesses the coverage of the system in terms of demographics and discusses the problem of high informality in Peru’s labour market, which is a main driver of low coverage rates. The chapter also looks at the levels of income that those participating in the system can expect, and shows that this is much lower than the expected benefits due to low contribution densities and the possibility to make early withdrawals from the private system, either by purchasing a first home or through early retirement. The chapter also argues that the financial incentives in place do not seem to be effective in encouraging people to contribute voluntarily. Policy options to improve the coverage of the system need to encourage higher rates of formal employment, provide more effective incentives for underrepresented groups to participate in the system, and encourage voluntary contributions beyond the mandated level. Furthermore, to improve the adequacy of benefits, the ability for individuals to take their benefits from the system before the legal retirement age ideally needs to be limited. Where allowed, however, incentives should be in place to discourage early withdrawal of pension assets.

Chapter 6 and Chapter 7 discuss how to optimise the funded component of the pension system. First, Chapter 6 focuses on the accumulation phase, and looks at the investment strategies and results of the pension fund administrators (Administradoras de Fondos de Pensiones, AFPs), as well as the competitive landscape, costs and fees, and the services that the AFPs provide to their members. The proposed policy options to optimise the period of asset accumulation in the private pension component focus first on the investment strategies and fund offering of the AFPs. It suggests to improve the risk profile of the default investment strategy to be more appropriate for an individual approaching retirement. To address a potential issue of investment herding behaviour by the AFPs, it proposes to establish more appropriate performance benchmarks and eliminate the minimum guarantee, which serves as an incentive for such behaviour. The chapter also discusses how the incentives of the AFPs could be better aligned with member interests through the use of performance management fees, as well as other options aiming to reduce costs and fees in the system and promote efficient operations.

Chapter 7 then focuses on the pay-out options of the private pension component. The objective of the pension system to provide an income in retirement is currently undermined by the fact that members are allowed to take their assets as a lump-sum at retirement. In addition, the incentives for them to take an income option are not sufficient. Reforms need to address these poor incentives and ensure that all pension members receive at least a minimum level of income in retirement, and encourage them to take an income option while being confident that those benefits will be secure.

Chapter 8 addresses a broader and more fundamental issue of the pervading lack of trust and confidence in the pension system. It concludes that low levels of understanding of the system and a mistrust of the institutions managing the system are at fault. Policy options discussed to improve understanding and trust include measures to increase financial education, to better align the accountability of both the private and public institutions with their responsibilities and to have an integrated regulation and supervision of the entire system.

To conclude, Chapter 9 summarises the challenges that the Peruvian pension system is facing and the recommendations that this Review makes to address these challenges and ensure that the pension system will be able to achieve its objectives.

Chapter 1. Introduction to the review of the Peruvian pension system