THE IMPACT OF PENSION REFORM ON CORPORATE GOVERNANCE

PRACTICES AND REGULATIONS: THE CASE OF CHILE *

Augusto Iglesias P.

PrimAmérica Consultores

September, 1999

Presented at the thirteenth Plenary Session of the Advisory Group on Privatisation, Organisation for Economic Co-operation and Development. Paris, France, 21-22 September, 1999.

*

I. Background information

Since the early eighties, pension funds have become important players in capital markets of many Latin American countries. This has been the consequences of radical reforms to their social security systems.

Corporate governance practices depend, among other variables, on the size of capital markets, the characteristics of their regulation, and the ownership structure of firms. All these dimensions are affected by the development of institutional investors.

Pension Reformin Latin American

(as of march 1999)

COUNTRY YEAR OF REFORM

AFFILIATES (number)

PENSION FUND

(MMUS$) CHILE 1981 5.984.508 32.663 PERU 1993 2.035.621 1.871 COLOMBIA 1994 3.770.349 2.459 ARGENTINA 1994 7.200.934 12.503 URUGUAY 1996 514.704 427 BOLIVIA 1997 448.927 395 MEXICO 1997 14.209.678 6.889 EL SALVADOR 1998 622.374 83 TOTAL 34.787.095 57.289

Fact N° 1:

In L.A., pension fund investments are strictly regulated. All countries apply quantitative restrictions that include a list of authorized assets; diversification rules; conflicts of interest regulation; valuation rules; etc.

...

To understand discussion on relationship between corporate governance and institutional investors in L.A. is necesary to know some basics facts regarding each one of this dimensions.

Investment rules for pension funds in Latin America

MAXIMUM OF PORTFOLIO IN EACH ASSET CLASS ARGENTINA CHILE COLOMBIA EL SALVADOR PERU URUGUAY

GOVERNMENT DEBT 50% 50% 50% 30% 40% 60%

TIME DEPOSITS 28% 50% 50% 40% 30% 30%

BONDS 28% 45% 20% 40% 49% 15%

STOCKS 35% 37% 30% 20% 35% 25%

MORTGAGE BONDS 28% 50% 30% 40% 40% 20%

FOREIGN INVESTMENT 10% 12% -- -- 10% --

CLOSE END INVESTMENT FUNDS 14% 5% 10% 20% 15% --

FUTURES AND EXCHANGE RISK COVERAGE 2% 9% -- -- 10% --

Fact N° 2:

Allthough, in general, investment rules do allow investment in stocks in some countries the stock market is non-existent or is too small. So, only the pension funds of few countries invest in stocks.

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Equity investments of pension funds in Latin America

(as of march 1999)

Country Pension Equity EquityFund Investment Investment

MMUS$ MMUS$ as a % of total

CHILE 32.663 5.203 15,9% PERU 1.871 644 34,4% COLOMBIA 2.459 79 3,2% ARGENTINA 12.503 2.301 18,4%

a Pension funds face important liquidity constraints. In many cases they can not sell their holdings of shares of one company without putting downward pressure on prices.

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Fact N° 3:

b Also, there is no “index investment” because trading by pension funds would “move the index”.

Because of these particular characteristics of the capital market, pensions funds have a “bias” in favor of an active role on corporate governance.

Fact N°4:

Pension funds that are part of the social security system are not “company plans”. Individuals select the pension fund manager they want. Also, regulation limits the investments of the fund in assets issued by firms related to the pension fund managers.

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Fact N°5:

The particular design that has been selected for the new pension fund systems in L.A. (private management and individual freedom to select pension fund manager), means that there is low risk of political interference on investment decisions (and so, on corporate governance).

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Fact N°: 6

In general, ownership is concentrated (“family ownership”). So, as pension funds invest in stocks of one company they become “partners” of few big shareholders. Maybe because of this reason, the main purpose of regulation seems to be the control of conflicts of interest between minority and majority shareholders, and not the control of conflicts of interest between shareholders and the management of the firm.

...

II. Impact of pension reform on corporate governance

The development of institutional investors has influenced corporate governance (in Chile) in three differents ways:

Pension funds and life insurance companies have an important presence in capital markets;

To protect social security funds, new regulations have been introduced to capital markets with impact on corporate governance practices;

Pension funds have appointed independent board numbers in many firms were they hold participation.

a. Pension funds, capital markets and corporate governance

Pension funds plus reserves of life insurance companies amounted more than US$40 billion in 1998 (55% of GNP). Social security savings are 14% of total savings and 3.4% of GNP.

Chile: pension funds and reserves of life insurance companies

(december of each year)

Year

Social Security Savings

(MMUS$) %GNP (MMUS$) %GNP (MMUS$) %GNP %GNP

1981 300 0,92 735 2,25 1.034 3,17 1,401982 606 3,73 544 3,18 1.150 6,91 1,861983 1.136 6,50 594 3,32 1.730 9,82 1,761984 1.244 8,51 623 4,15 1.867 12,66 1,871986 1.533 10,63 660 4,67 2.192 15,53 1,911986 2.117 12,69 838 5,26 2.954 17,95 2,081987 2.708 14,19 835 4,72 3.543 18,91 2,131988 3.584 15,06 1.078 4,87 4.662 21,08 2,501989 4.470 17,73 1.320 5,74 5.791 25,17 2,761990 6.658 24,27 1.885 7,49 8.544 31,76 3,131991 10.064 31,44 2.538 7,96 12.603 39,40 3,741992 12.395 30,61 3.339 8,54 15.735 39,15 3,441993 15.942 38,04 4.130 9,65 20.072 47,69 3,741994 22.296 42,06 5.896 10,87 28.192 52,93 3,881995 25.143 39,54 7.116 10,85 32.259 50,39 3,491996 27.198 40,88 8.039 11,97 35.237 52,48 3,001997 30.525 42,19 9.845 13,40 40.369 54,93 3,161998 30.716 43,34 N.D. N.D. N.D. N.D. 3,35

Pension FundsLife Insurance

Companies Total

a. Pension fund, capital markets and corporate governance

Pension funds plus reserves of life insurance companies amounted more than US$40 billion in 1998 (55% of GNP). Social security savings are 14% of total savings and 3.4% of GNP.

Pension funds hold more than 50% of the outstanding debt of the government; 16% of total time deposits and bonds issued by commercial banks; 50% of mortgage bonds; 53% of long term corporate debt; and 10% of the stock traded in the market.

Chile: share of pension funds in financial markets 1/

1/ Pension fund holdings of each asset class as a % of total assets in each class

ASSET CLASS 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

GOVERNMENT DEBT 31,9 40,7 39,5 38,0 39,9 46,3 52,6 52,7 55,3 50,9

TIME DEPOSITS AND 22,5 19,1 20,1 18,8 14,9 11,3 10,8 11,0 9,1 15,9BANK BONDS

MORTGAGE BONDS 53,0 52,1 57,7 58,6 60,8 57,3 57,4 55,7 55,4 50,0

CORPORATE BONDS 48,1 47,8 59,2 62,4 60,3 54,9 57,2 53,9 53,8 53,2

STOCKS 4,2 4,8 5,5 8,6 10,0 9,9 10,6 10,5 10,5 9,7

... Until 1986, pension funds only invested in debt. So, their

influence on corporate governance was only because their role as lenders of corporations who began to issue bonds as the market for long term debt developed:

Pension funds and life insurance companies helped to the development of the market for long term debt;

Corporation who wanted to issue debt were forced to have an independent risk rating;

Pension funds and life insurance companies did use their bargaining power to improve protections being offered to creditors.

In short, the cost of long term debt did decrease; the cost of monitoring corporations was reduced; and the quality of the information that firms provide to the market did improve.

... Since 1986, pension funds have been active investors in the stock

market.

As a proportion of the portfolio, investment in stocks did reach a maximum in 1994 (32,2%). Since then the proportion has decreased, mainly because international diversification of the portfolio.

Chile: Pension funds investment portfolio

a/ Include Debt issued by Financial Institutions

Year Central Treasury Time Mortgage Corporate Stocks Closed-end Foreign Pension

Bank Deposits Bonds Debt Investment Investment Fundsa/ Funds (MM US$)

1981 27,40 0,70 61,90 9,40 0,60 0,00 0,00 0,00 3001983 14,10 30,40 2,70 50,60 2,20 0,00 0,00 0,00 1.1361985 20,40 22,20 20,90 35,40 1,10 0,00 0,00 0,00 1.5331987 29,80 11,70 28,50 21,30 2,60 6,20 0,00 0,00 2.7081989 38,10 3,50 21,50 17,70 9,10 10,10 0,00 0,00 4.4701991 37,40 0,90 13,30 13,40 11,10 23,80 0,00 0,00 10.0641993 38,30 0,50 7,60 13,10 7,30 31,80 0,30 0,60 15.9421995 37,50 1,90 6,60 15,80 5,20 30,10 2,50 0,20 25.1431997 36,40 3,20 12,40 17,00 3,30 23,40 3,10 1,10 30.5251998 37,50 3,40 15,10 16,60 3,80 14,90 2,90 5,60 30.805

... Since 1986, pension funds have been active investors in the equity

market.

As a proportion of the portfolio, equity investment did reach a maximum in 1994 (32,2%). Since then the proportion has decreased, mainly because international diversification of the portfolio.

First, they did invest in state owned firms that were being privatized (most of them in the public utilities sector). Then they begin to invest in a broader range of firms.

Chile: Participation of pension funds in ownership of stocks

* 1997

Year % of Pension Funds % of stocks market in thein stocks portfolio of pension funds

1986 3,8% N.D.1989 10,1% 4,8%1992 24,2% 10,0%1995 32,1% 10,5%

1998 17,8% 9,7% *

Chile: Participation of pension funds in ownership of open public corporations

(december 1998)

Pension funds hold 10% of equity of open public corporations:

They participate in 99 firms (total number of firms traded in the market is 286).

In two firms participation is greater than 30% (but less than 35%).

In four firms, participation is between 20% and 30%. In seven firms participation is between 15% and 20% In twelve firms participation is between 10% and 20% In seventy four firms, participation is less than 10%

... The incorporation of pension funds and - to some extent - life

insurance companies to the stock market did help to increase its liquidity (at least for small investors, exit became an alternative in case of firms performing below expectations).

Also, pension funds did begin to produce regular and independent opinions on the performance of firms. Later, they became the main clients for investment banks doing the same job.

Because they are part of the mandatory social security system, pension funds are exposed to close public scrutiny. This also apply to firms were they invest.

Firms who want to go public and sell shares to pension funds, must meet certain minimum conditions (positive results in the last years; disclosure of relevant information; etc.).

b. Pension funds and capital market regulations

The development of pension funds has had an effect on the design of capital market regulation. In turn, this regulation has had an impact on the role of institutional investors in corporate governance.

Pension funds were created by law. They are part of a mandatory social security system. Therefore, there are some implicit - and explicit - state guarantees over results of the system. Capital market regulation was reformed with the purpose of reducing the cost of these guarantees. These changes in regulation have benefited not only pension funds, but also small investors and minority shareholders.

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The changes in capital market laws and regulations with direct influence on corporate governance practices are:

Mandatory risk rating

Control of conflicts of interest

Because of this, for shareholders and creditors, the conditions to participate in corporate governance have improved after pension reform.

c. Pension funds and monitoring of conflicts of interest

Because of regulation, pension funds are forced to participate in shareholders meetings and to vote in each one of the decisions (including the election of board members), that are presented to the shareholders (this is not only in Chile but also in other L.A. countries).

Latin America: regulation on the vote of pension funds in

shareholders meetings

NR: Not regulatedNA: Not available

Ch

ile

Arg

enti

na

Co

lom

bia

Per

ú

Bo

livia

1. Are pension funds allowed to participate in shareholders meetings? Yes Yes Yes Yes Yes

2. Are pension funds forced to participate in shareholders meetings? Yes Yes No No NA

3. Election of board members: NR NR

∙ Board of the pension fund must select the candidate to the board Yes Yes NA

∙ Pension funds must make their vote public Yes Yes NA

∙ Is it possible to vote for:- Candidates related to mayority shareholders? No No NA

- Candidates related to the pension fund management firm? Yes No NA

c. Pension funds and monitoring of conflicts of interest

Because of regulation, pension funds are forced to participate in shareholders meetings and to vote in each one of the decisions (including the election of board members), that are presented to the shareholders (this is not only in Chile but also in other L.A. countries).

Pension funds face liquidity constraints (they can not sell their holdings in a short period of time without depressing prices). So, for them voice and vote are the most important tools for monitoring performance of firms.

Then, because of regulations and market conditions, pension funds have been active in shareholders meetings and have elected independent board members.

Chile: Impact of pension funds on the election of board members

Board members(Total)

Board members

elected with votes

from at least one pension fund

Chapter XII 80 30 (37,5%)

Other 631 41 ( 6,5%)

Total 711 71 (10,0%)

Class offirm

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Independent board members are playing an important role as monitors of potential conflicts of interest between mayority and minority shareholders (foreign institutional investors are playing a similar role).

Because of the “demand” for independent board members by pension funds (an other institutional investors), a new “class” of professional board member is beginning to develop.

III. Some unsolved problems

In Latin America, there is some concern for the large relative size of pension funds in capital markets and the increasing concentration of this industry. Regulators fear that controllers of pension fund companies could control the firms in which the funds are invested, against the interest of the affiliates.

Latin America: concentration in pension fund industry

COUNTRY

% AFFILIATES % FUNDS % AFFILIATES % FUNDS

CHILE 8 77,9% 70,8% 92,8% 94,8% PERU 5 75,2% 76,2% 100,0% 100,0% COLOMBIA 8 62,3% 62,4% 85,2% 85,2% ARGENTINA 15 55,2% 52,4% 77,6% 76,6% URUGUAY 6 69,1% 76,8% 94,3% 93,8% BOLIVIA 2 100,0% 100,0% 100,0% 100,0% MEXICO 14 43,8% 50,4% 66,2% 68,2% EL SALVADOR 5 81,6% 83,6% 100,0% 100,0%

PARTICIPATION OF THREE MAYOR PENSION FUNDS

PARTICIPATION OF FIVE MAYOR PENSION FUNDS

PENSION FUND

MANAGERS (number)

III. Some unsolved problems

In Latin America, there is some concern for the large relative size of pension funds in capital markets and the increasing concentartion of the industry. Regulators fear that controllers of pension fund companies could control the firms in which the funds are invested, against the interest of the affiliates.

Regulators also understand that, effective participation of pension funds in corporate governance is important for the protection of minority shareholders.

a) Fist problem

A mix of regulations is being used to “balance” both objectives:

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Maximum investment limits as a % of the outstanding shares of the company;

Special (reduced) limits, when there is some interest of pension fund managers in the firms where they want to invest;

Mandatory and public voting of pension funds;

Limits to form coalitions with other pension funds;

Strong restrictions on voice.

In our opinion, the result of all these regulations is to weaken the potential influence of institutional investors on corporate governance (restrictions to voice and to form coalitions are the most questionable regulations).

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Some important institutions for corporate governance have not yet been developed:

Audit committes

Compensation committes

b) Second problem

III. Final Remarks

Corporate governance practices evolve as a result of both law and tradition. In Latin America, pension reform did force regulators to create, in a very short period of time, a new legal framework for capital markets and the banking sector with the purpose of reducing investment risk and the cost of government guarantees in the social security system. These changes in regulation have had a strong influence on corporate governance.

Regulations plus liquidity constraints have force pension funds to take an active role on corporate governance. However this situation could change as local capital markets develop and as pension funds begin to invest outside their domestic market.

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