Risk management and regulation of defined contribution schemes

1. Risk management and regulation of defined contribution schemes Mexican pension reform and risk management framework

2. Background Pension system in Mexico

3. Background • The Mexican Social Security Institute (IMSS) was created in 1943 to administer 4 social security programs: • work injuries • old age, disability, survivorship, and unemployment in old age • sickness and maternity • nurseries and social benefits

4. IMSS • 14 million affiliated workers • 50+ million beneficiaries • 2 million pensioners • IMSS is the second fiscal authority in the country, collecting more than 9 bn. USD of contributions from workers and employers • IMSS annual budget is over 17 bn. USD • child care to 115 thousand children • 33 % of population born in IMSS hospitals

5. Diagnosis • In 1995, a review was conducted to assess, among other issues, the financial viability of the pension system • It was estimated that, in order to sustain the PAYG system, contributions would have to be increased from 7.0* % to: • 10% for the period 2000-2009 • 15% for the period 2010-2019 • 25% for the period 2020-2030 * Including 2.5 of disability and survivorship

6. New law • As a result from the diagnosis and after intensive public consultation and debate, Congress repealed the existing Social Security Law (last amended in 1973) and introduced an important pension reform

7. New law • The new Law replaced the defined benefits PAYG publicly managed pension system with a defined contribution, individual accounts, privately managed system • The new Law introduced a minimum pension guarantee (equivalent to one minimum salary) and a “grandfathered” previously affiliated workers

8. Old vs. new pension systems Old pension system New pension system

9. Transition • Transition costs absorbed via general taxation and payroll taxes • Federal Government absorbed pension liabilities generated as of June 30,1997 • Individual accounts funded through tripartite payroll taxes • Generation in transition incorporated immediately to the new pension scheme • IMSS continues as pension payment agent

10. Fund managers • Specialized companies were created to manage pension funds (AFORES) • Investment vehicles (SIEFORES) were also created to isolate funds from AFORES and prevent bankruptcy risks • The housing agency (INFONAVIT) also acts as fund manager and funds saved in the “housing sub-account” are also used to purchase the annuity, at the time of retirement, if housing benefit was not used during the worker’s active life

11. Players • The pension system also involved a new improved fiscal and data collection process (based on a central processing agency, PROCESAR) • 17 AFORES were originally set up, 12 remain after initial consolidation, all AFORES reported a net profit in 2001 • Assets have grown to $27 bn. USD, equivalent to 4% of the 2001 GDP equivalent to 60% of international reserves • Annuity insurance companies were also created and now manage $6 bn. USD in assets • AFORES are regulated by an independent supervisory body (CONSAR)

12. New pension system Results

13. Historical investment results (in real terms, as of March 2002, not considering commissions)

14. Assets under management (as of March 2002, in millions of pesos) Voluntary contributions Old age Housing Total

15. Portfolio composition International comparison In Mexico, the portfolio composition has changed in the last two years, investments in Government instruments are now down to 85.8% (as of March 2002)

16. New pension system Opportunities

17. Mobility & competition (transfered accounts between AFORES, as of March 2002) % of real returns % of salary % of balance

18. Commission structure % of real returns % of salary % of balance

19. Assets under management (as of March 2002, in millions of pesos) Voluntary contributions Old age Housing Total

20. Risk Management

21. However, it is necessary to adapt the general definition to the particular circumstance Particular definition of risk The likelihood that a particular threat using a specific attack, will exploit a particular vulnerability of a system that results in an undesirable consequence ( Definition from National Information Systems Security INFOSEC) Glossary, NSTISSI No. 4009, Aug. 1997) The definition of risk depends on the field of study, the particular circumstances and it is “subjective”

22. Definition of risk management The process concerned with identification, measurement, control and minimization of risks in particular field (i.e. information systems) to a level commensurate with the risk “appetite”

23. Risk Management Process Identify the Risk Areas Re-evaluate Risks and Control actions Risk Management Cycle Assess the Risks Develop Risk Management Plan Implement Risk Mitigation Actions Risk Assessment Risk Mitigation

24. Risk tolerance or “appetite” Ignore Control Risk management depends on subjective values

25. The Four T´s Transfer: A risk control technique that involves the contractual shifting of a pure risk from one party to another. Contractual agreement and payment for insurance. Transform: modification of the risk “nature” to make it safer, through coverage products, like FRA´s, future contracts, swaps, hedge positions, etc. Terminate:through control actions eliminate risk (sometimes it is very expensive or due to the nature of the risk, impossible to eliminate) Tolerate: risk has been detected, can be monitored, cost-benefit analysis shows no actions required (but have contingency plans)

26. Value at Risk (VaR) Summarized measurement of market risk • Deals with market risk ( i.e. changes in interest rates) • VaR is a method to quantify the risk using standard • statistical techniques. • VaR measures the worse loss in a certain period under • normal market conditions given a certain confidence level. • Structured approach (methodology) to think critically about • risk. • Common methods Markowitz and Montecarlo

27. Other common risk types • Credit : Occurs when counterpart is unable to fulfill its • contractual obligations due to financial problems. • Liquidity : When a transaction cannot be fulfilled at • prevailing market prices due to low “bursatility” • or market “volume” • Operational: Refers to the resulting losses of inadequate • systems, administrative faults, defective controls, • fraud, or human error. • Legal : When one counterpart does not have the legal or • regulatory authority to “adequately” complete the • transaction.

28. Stress Testing • This method, denominated some times like scenario analysis, • examines the simulated effect on the portfolio of significant • movements in key financial variables. • All the assets of portfolio are evaluated using the new assumptions, and the yield of portfolio is re-calculated. • Naturally, different scenarios generate different returns. • When specifying the probability for each scenario, a distribution • of yields of the portfolio is created, which the VAR can be • obtained. • The advantage of this method is that it can review situations • completely different to the historical data.

29. Asset – liability management • Problem defined as “ability of assets to match or pay • liabilities”, not just investment of assets • Ultimate surplus = assets remaining once liabilities paid • 3 dimensions, market value, surplus, variance of surplus • ensure positive mean of surplus and a “reasonable” probability that it will be positive • computer simulation (many scenarios) • limit number of asset classes -> optimize strategic allocation (individual asset through traditional techniques)

30. Regulations (based in Basel Committee resolutions) Issue date • Board participation • Risk Committee • Risk Management Unit (RMU) • Risk manual (with limits) • Procedures for measurement, monitoring and control • Models, methodology and measurement systems • Sensitivity analysis • Stress testing • Contingency plans • Independence of RMU • VaR • RMU responsible for compliance • Risk audit IMSS Financial Investment Unit December 1999 Banking system December 2001 AFORES (Circular 15-5) December 2001

31. Ed Tamagno’s 6 Principles • Clarity of objectives • Independence from political interference • Accountability to insured persons • Professional Management • Low operating costs • Prudence in investments

32. 12 Principles Edward Tamagno’s México’s recommended • Clarity of objectives • Independence from political interference • Transparence & accountability to • insured persons • Professional Management • Low operating costs • Prudence in investments • Program Efficacy (yield goals) • Systemic efficiency (market • competitiveness) • Alignment of interests and incentives • Integral process (“big picture” & • assets and liabilities management) • Supervision and regulation • competence • Solid corporate governance

33. Asset – liability management • Problem defined as “ability of assets to match or pay • liabilities”, not just investment of assets • how much asset needs to grow • Ultimate surplus = assets remaining once liabilities paid • 3 dimensions, market value, surplus, variance of surplus • ensure positive mean of surplus and a “reasonable” probability that it will be positive • computer simulation (many scenarios) • limit number of asset classes -> optimize strategic allocation (individual asset through traditional techniques)

34. 12 Principles Edward Tamagno’s México’s recommended • Clarity of objectives • Independence from political interference • Transparence & accountability to • insured persons • Professional Management • Low operating costs • Prudence in investments • Program Efficacy (yield goals) • Systemic efficiency (market • competitiveness) • Alignment of interests and incentives • Integral process (“big picture” & • assets and liabilities management) • Supervision and regulation • competence • Solid corporate governance

35. Mobility & competition (transfered accounts between AFORES, as of March 2002) % of real returns % of salary % of balance

36. Flexibility to compete

37. 12 Principles Edward Tamagno’s México’s recommended • Clarity of objectives • Independence from political interference • Transparence & accountability to • insured persons • Professional Management • Low operating costs • Prudence in investments • Program Efficacy (yield goals) • Systemic efficiency (market • competitiveness) • Alignment of interests and incentives • Integral process (“big picture” & • assets and liabilities management) • Supervision and regulation • competence • Solid corporate governance

38. Commission structure % of real returns % of salary % of balance

39. 12 Principles Edward Tamagno’s México’s recommended • Clarity of objectives • Independence from political interference • Transparence & accountability to • insured persons • Professional Management • Low operating costs • Prudence in investments • Program Efficacy (yield goals) • Systemic efficiency (market • competitiveness) • Alignment of interests and incentives • Integral process (“big picture” & • assets and liabilities management) • Supervision and regulation • competence • Solid corporate governance (Enron, • Worldcom, Capital Hedge Fund)

40. Players • The pension system also involved a new improved fiscal and data collection process (based on a central processing agency, PROCESAR) • 17 AFORES were originally set up, 12 remain after initial consolidation, all AFORES reported a net profit in 2001 • Assets have grown to $27 bn. USD, equivalent to 4% of the 2001 GDP equivalent to 60% of international reserves • Annuity insurance companies were also created and now manage $6 bn. USD in assets • AFORES are regulated by an independent supervisory body (CONSAR)

41. 12 Principles Edward Tamagno’s México’s recommended • Clarity of objectives • Independence from political interference • Transparence & accountability to • insured persons • Professional Management • Low operating costs • Prudence in investments • Program Efficacy (yield goals) • Systemic efficiency (market • competitiveness) • Alignment of interests and incentives • Integral process (“big picture” & • assets and liabilities management) • Supervision and regulation • competence • Solid corporate governance(Enron, • Worldcom, Capital Hedge Fund)

42. 12 Principles Edward Tamagno’s México’s recommended • Clarity of objectives • Independence from political interference • Transparence & accountability to • insured persons • Professional Management • Low operating costs • Prudence in investments • Program Efficacy (yield goals) • Systemic efficiency (market • competitiveness) • Alignment of interests and incentives • Integral process (“big picture” & • assets and liabilities management) • Supervision and regulation • competence • Solid corporate governance (Enron, • Worldcom, Capital Hedge Fund)

43. Conclusions

44. In risk management and regulation of defined contribution schemes There are many approaches, diverse techniques and management frameworks However ….

45. Risk matrix Risk types, i.e. legal, credit, operational, market, etc. Appetite Identification Monitoring processes Control Reporting Audit Models Methodology Organizational structure Regulation Governance

46. low probability low severity low probability medium severity medium probability medium severity high probability medium severity organization threatening high probability high severity Priority approach Yes, understand severity and probability but consider first risk appetite

47. Risk Identification Monitoring Control Reporting Measuring Step approach • Strategic objectives (derived from business plan) Determine risk apetite • Initiate risk management process • Risk management infrastructure People Data Models Procedures IT

48. Big, Big Picture

49. “Big, big picture” or risk management cartography 12 Principles (Tamagno’s 6 + Mexico’s 6) Ed Tamagno’s 6 Principles BASEL COMMITTEE (CONSAR regulations 15-5 and CNBV 1423) Efficacy Risktypes Sound corporate governance Clarity of objectives Contingency planning market regulatory legal systemic Prudence in investments Risk Committee Basic Risk Management Process Risk Manual Models Sensitivity Analysis Independence from political interference Competence in supervision and regulation Systemic efficiency (competitiveness) Stress Testing Segregation of Duties Low operating costs liquidity credit operational Models and Measuring Systems Risk Management Unit Transparence & accountability to insured persons Professional Management Alignment of interest and incentives Complete view (asset-liability)

50. “Big, big picture” or risk management cartography 12 Principles (Tamagno’s 6 + Mexico’s 6) Ed Tamagno’s 6 Principles BASEL COMMITTEE (CONSAR regulations 15-5 and CNBV 1423) Efficacy Risktypes Sound corporate governance Clarity of objectives Contingency planning market regulatory legal systemic Prudence in investments Risk Committee Basic Risk Management Process Risk Manual Models Sensitivity Analysis Independence from political interference Competence in supervision and regulation Systemic efficiency (competitiveness) Stress Testing Segregation of Duties Low operating costs liquidity credit operational Models and Measuring Systems Risk Management Unit Transparence & accountability to insured persons Professional Management Alignment of interest and incentives Complete view (asset-liability)