Mexico - Contractual Savings Development Program Project

Document of THE WORLD BANK For Official Use Only Report No. P 7018 -ME REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN OF US$400 MILLION TO BANCO NACIONAL DE OBRAS Y SERVICIOS PUBLICOS, S.N.C. (BANOBRAS) WITH THE GUARANTEE OF THE UNITED MEXICAN STATES FOR A CONTRACTUAL SAVINGS DEVELOPMENT PROGRAM November 13, 1996 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currcncv l nit = New Peso (NP) US$It)= NP$7.5 (December 22, 1995) FISCAL YEAR January I - December 31 ABBREVIATIONS AND ACRONYMS AFP Administradoros de 1;ondos de Pensiones (Pension FLnd Administrator - Chile) AFORE Admnirnstradora de Fondos para el Retiro. (Pension Fund Administrator) BANOBRAS Banco Nacional de Ohras y Servicios ji blicos, S. X C. CNBV Comision iVacional Bancaria v de Valores. (National Banking and Securities Commission) CNSF Comision Nacional cle Seguros y Fianzas. (National Insurance and Bonding Commission) CONSAR Comision Nacional del Sistensa de Ahorro para el Retiro. (National Commission of the Retirement Savings System) FAMV Fondo de Apoyo al Mercado de Valores (Securities Market Support Fund) FOBAPROA Fondo Bancario de Proteccion al Ahorro (Bank Fund for Savings Protection) FOVI Fondo de Operacion y Financiamiento Bancarto a la Vivienda. (Housing Financing Trust Fund) FOVISSSTE Fondo para la Vzvienda de los Trabajadores del ISSSTE. (Government Workers' Housing Fund) FSRL Financial Sector Restructuring Loan. FSRP Financial Sector Restructuring Program. FTAL Financial Sector Technical Assistance Loan IMSS Inst7tuto Mexicano del Seguro Social. (Mexican Social Security Institute) INFONAVIT Instituto del Fondo Nacional de la Vivienda de los Trobajadores. (National Workers' Housing Fund Institute) ISSSTE Instutwo de Seguridad y Servicios Sociales de los Trabajadores del Estado. (Institute of Security and Social Services for Government Workers) IV Seguiro de Invalide-y Vida (Disability and Life Lnsurance) IVCM Invalidez, Yejez, Cesantia en Fdad Avanzada, y Muerte (Disability, Old age. Severance, and Death Insurance Coverages) RCV Seguro de Retiro. Cesantia en Edad Avonzada, y Vejez (Old Age and Severance) MPG Minimum Pension Guarantee NAFTA North American Free Trade Agreement PROCAPTE Programa de Capitalizacion Temporal (Temporarv Capitalization Program) SAR Sistema de Ahorro para el Retiro (Retirement Savings System) SHCP Secretaria de Haciendtay Credito Piiblico. (Ministry of Finance and Public Credit) SIEFORE Sociedad de Inversiones Especializadas de Fondos Para el Retiro (Specialized Pension Fund). Conversions in thn te bi rep rvnn rc sdon NP$, 5 US dollar. Vice President Shahid Javed Burki Director Olivier Lafourcade (LAMXC) Manager Sri-Ram Aiyer (Director, LATDR- Team Leader) IBRD team Join Stein and Gloria Grandolini (LASLG - Deputy Team Leaders), Mike Lubrano (LASLG), Tom Glaessner (EAICO), Richard Clifford (LAMIXI),; Zia Qureshi (LAMXC), R. van Puymbroeck (LEGLA); Ross Levine (PRDFP); Donald Mclsaac (FSD), and LUlpiano Ayala (Consultant). Jorge Serraino assisted in the processing of the report. IDB team Ezequiel Machado, Liliana Rojas, Stephen Weisbrod; Hans U. Schulz; Kim Staking; Esperanza Lasagabaster. Peer reviewers Estelle James (PRDPH). Dimitri Vittas (FSD), and Olivia Mitchell (outside peer reviewer The Wharton School. Univ. of Pennsylvania).  FOR OFFICLAL USE ONLY MEXICO CONTRACTUAL SAVINGS DEVELOPMENT PROGRAM TABLE OF CONTENTS Page No. LOAN AND PROGRAM SUMMARY ........................... iii I. MACROECONOMIC CONTEXT AND EXTERNAL FINANCING REQUIREMENTS .1 II. THE GOVERNMENT'S CONTRACTUAL SAVINGS DEVELOPMENT PROGRAM .3 A. The Current State of Mexico's Old Age Social Insurance System and the Need for Reform .3 Background .3 The Need for Reform .5 B. Old Age Insurance Reform: Timing, Objectives, and Principles of Reform .6 Timing of the Reform .6 Objectives of the Reform .8 Principles of Reform .8 C. The Key Features of the Reform and Comparison with Other Reforms .8 Old Age and Severance Reforms .9 Disability and Life Insurance Reforms .12 Occupational Risk Insurance .12 Comparison with Other Reforms .12 D. Issues and Government Strategy .14 Pension System Reform .15 Complementary Financial Market Reforms .26 lII. BANK ASSISTANCE STRATEGY .............................. 29 A. Overall Assistance Strategy .............................. 29 B. IFC .............................. 30 C. Coordination with the IMF .............................. 30 D. Coordination with the IDB .............................. 31 IV. THE PROPOSED LOAN .............................. 31 A. Origin .31 B. Loan Size and Proposed Tranche Conditionality .31 C. Technical Assistance .33 D. Disbursements .33 E. Accounts and Audit .33 F. Monitoring and Reporting .33 G. Benefits and Risks .33 H. Environmental Impact .36 V. RECOMMENDATION .36 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  -ii- ANNEXES I. Government Letter of Sector Policy for Contractual Savings Development II. Matrix of Policy Actions III. Matrix of Technical Assistance Needs IV. Pension Reform and its Impact on the Development of Mexican Financial Markets V. Estimated Fiscal Costs of Pension Reform VI. Current Pension System VII. INFONAVIT VIII. Economic Indicators IX. Balance of Payments X. External Capital and Debt XI. Status of Bank Group Operations in Mexico XII. Supplementary Data Sheet XIII. Mexico at a Glance Vice President Shahid Javed Burki Director Olivier Lafourcade Manager Sri-Ram Aiyer (Director, LAT, Team Leader) Staff Members John Stein, Gloria Grandolini (LASLG - Deputy Team Leaders) and Mike Lubrano (LASLG)  MEXICO CONTRACTUAL SAVINGS DEVELOPMENT PROGRAM PROPOSED LOAN AND PROGRAM SUMMARY BORROWER: Banco Nacional de Obras y Servicios Publicos, SNC (BANOBRAS). GUARANTOR: United Mexican States. AMOUNT: US$400 million TERMS: The loan is proposed to be a fixed rate single currency loan in US dollars, with a maturity of up to fifteen years. OBJECTIVES: The proposed loan would support the first phase of the Government's Contractual Savings Development Program (CSDP), which is designed to: (a) increase the equity, efficiency, and sustainability of the old age security system and gradually lead to greater effective coverage; (b) establish a financially viable pension system; (c) limit the fiscal impact of the current pension system; (d) raise the level of institutional savings and improve the allocative efficiency of domestic savings; and (e) enhance capital market development by stimulating greater private financial intermediation. DESCRIPTION: The first phase of the reform focused on the establishment of the legal, regulatory, and institutional framework for the reform of the country's old age security system. The second phase will concentrate on the actual implementation of the reformed pension system. Specifically, the first phase of the CSDP supported by the proposed loan, included: (a) introducing the legal and regulatory framework to establish the new pension system and tc regulate and supervise pension fund administrators; (b) designing and issuing the investment management regime; (c) assessing fiscal transition costs; (d) initiating improvements in INFONAVIT's performance; (e) individualizing accounts and strengthening IMSS capacity to manage the operational scheme of the new pension system; and (f) encouraging public confidence through education. In parallel, to ensure the success of the pension reform and recognizing its linkages with the rest of the financial sector, the Government implemented complementary financial market reforms, aimed at: (a) deepening financial sector reforms through continued bank restructuring; (b) modernizing the regulatory and supervisory framework for mutual funds and voluntary pension plans; and (c) deepening the insurance market for the provision of life and disability coverage and annuities. BENEFITS: Overall, the program will lay the basis for a marked increase in the volume of institutional savings and provide the institutional basis through which domestic savings can be channeled to productive investment. It will also lead to the creation of a new class of institutional investors and a new set of longer-term instruments. Pension and social security reform will move  -iv- the actuarially bankrupt defined-benefit system to a fully funded defined contribution scheme. Public confidence will be strengthened as workers will no longer view their contributions as a tax to provide benefits to current pensioners; instead, they will view these contributions as a means to build personal wealth. The separation of the pension and health sector schemes will result in pressure for greater efficiency in the delivery of public health benefits. Reforms in the insurance industry will create a larger class of insurance products such as annuities, life and disability and pre-paid medical insurance. Reforms to improve Mexico's legal framework for mutual funds, secured lending and asset backed securities will deepen the capital market over time and broaden the base for domestic savings. In addition, over the longer term, as pension funds increase their equity fund investments, they will become major catalysts for improved corporate governance. RISKS: The reform could lead to major fiscal risks if the savings generated from defined wage contributions do not earn an adequate real rate of return. These fiscal risks arise from the Government's continued guarantee of a minimum pension benefit to everyone participating in the social security system at the time of retirement. Without the housing fund component earning a positive real rate of return, these risks are high. Given the legal limitation on investment in foreign securities, the success of domestic capital market reforms are also crucial to the success of the pension reform especially because of the weakened state of the banking system, which is currently the only major private source of financial assets. Low real rates of return on the average pension fund's assets are also likely to increase the moral hazard associated with providing a minimum pension guarantee by encouraging contributor preference for high risk pension investments. To make success more likely, the Government gave itself a full year to prepare for the transition to the new pension scheme and during this time called on outside technical advisors to improve its supervisory institutions. The risks of political pressures to reverse fiscal management policies will always exist but are mitigated by both Mexico's growth potential over the medium term and the significant amount of time remaining in the term of the current administration which is strongly committed to these reforms. On the banking side, specific programs are in place to increase the capitalization of the banking system while the overall level of supervision has improved markedly. All the above factors will be important for improving the likelihood that pension funds will earn reasonable real rates of return, thus reducing moral hazard concerns. POVERTY CATEGORY: Not Applicable. ESTIMATED DISBURSEMENT: The proposed loan will be disbursed in a single tranche of US$400 million upon loan effectiveness (February 1997).  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO BANOBRAS WITH THE GUARANTEE OF THE UNITED MEXICAN STATES 1.1 I submit for your approval the following report and recommendation on a proposed Loan to the Banco Nacional de Obras y Servicios Pblicos, SNC (BANOBRAS) with the guarantee of the United Mexican States, in the amount of US$400 million to support the first phase of the Government's Contractual Savings Development Program which includes the establishment of the legal, regulatory, and institutional framework for the reform of the country's old age security system. The loan would be a fixed rate single currency loan in US dollars, with a maturity of up to 15 years, and would be disbursed in a single tranche of US$400 million. The Inter-American Development Bank (IDB) is supporting the program with a Sector Adjustment Loan of US$300 million, which would be disbursed in two equal tranches. I. MACROECONOMIC CONTEXT AND EXTERNAL FINANCING REQUIREMENTS 1.2 This section provides a summary assessment of recent economic developments in Mexico and of the economy's short to medium-term outlook. More details on key economic indicators, information on the balance of payments and financing requirements are given in Annexes VIII, IX and X. Further discussion of the economic outlook and country assistance strategy is provided in the Mexico CAS that was issued to the Executive Directors on October 15, 1996. 1.3 Progress on Adjustment. Mexico has responded with a strong adjustment program to deal with the financial crisis that erupted in December 1994. The Government's program has comprised: a substantial tightening of monetary and fiscal policies; a large exchange rate adjustment through moving to a floating exchange rate regime; steps to deal with the severe distress in the banking system; and initiation of further structural reforms--privatization, deregulation. The program includes measures to strengthen the social safety net. The Government's program has been supported by a large international financial package. 1.4 As a result of this effort, Mexico has achieved substantial progress in its adjustment objectives. The current account improved from a deficit of about 8 percent of GDP in 1994 to near balance in 1995, thanks to a 31 percent rise in exports (in dollar terms) fueled by the large peso depreciation. Inflation has been reduced from a peak of 8 percent a month in April to an average of around 1.5 percent in recent months. Helped by the external assistance package, Mexico has rebuilt its depleted reserves, improved its external debt profile, and regained a measure of access to international capital markets. 1.5 But the economy has also experienced a severe recession. GDP fell by 6.9 percent in 1995 and fixed domestic investment by about 30 percent. Also, while the progress on adjustment has helped investor confidence to recover, it remains fragile, as underscored by a new bout of financial market turbulence that emerged in the last quarter of 1995. The turbulence has since subsided, but the continuing fragility of market sentiment remains an important source of uncertainty for the short-term economic outlook.  2 PRESIDENT'SREPORT 1.6 Prospects. The central challenge that Mexico now faces is to foster a return to economic growth while consolidating the gains in macroeconomic stability and restoration of investor confidence. The current year represents an important period in that transition. An economic recovery is now underway. But growth initially will be moderate, with GDP likely to rise by about 3 percent in 1996. Much of this growth derives from the external sector based on the strength of exports. Inflation is projected to fall to around 27 percent in 1996, from 52 percent in 1995, allowing a further moderation of interest rates from the high levels seen in 1995. Provided Mexico perseveres with policies conducive to macroeconomic stability, and continues to deepen and extend structural reforms, it can lay the basis for stronger growth in 1997 and subsequent years. 1.7 If the competitive advantage conferred by the real depreciation of the peso is not allowed to be eroded, Mexico can maintain the new dynamism of its exports, with average real growth in exports of 9-10 percent annually. As growth recovers, so will imports, which contracted sharply in 1995. The rise in imports will tend to widen the current account deficit, but if the projected export growth is realized, the deficit should remain within limits consistent with a continued improvement in Mexico's external debt position. For the next few years, the current account deficit is likely to range from 1 to 2 percent of GDP. As investor confidence returns, private capital flows are expected to recover, but this will be a gradual process. With the retirement of a large part of its short-term debt in 1995, Mexico's external financing requirements will decline but Mexico will face an increase in debt service during 1988-99 on account of repayments due under the 1995 emergency financial assistance package. For a couple of years, before a fuller recovery in private flows occurs, some quick-disbursing official assistance would remain desirable, to support the reserve position as the current account deficit widens and the debt service remains high and to allow a further improvement in the debt profile. Given Mexico's recent experience, the still fragile state of investor confidence, and the economy's continuing vulnerability to a shift in market sentiment, maintaining a strong reserve position will be particularly important. 1.8 The foregoing outlook is subject to two important risks: the weakness in the banking system; and the vulnerability of the Government's macroeconomic program to social and political pressures arising from the deep recession. The various bank support schemes that the Government has put into operation have contained the scope of the banking system crisis. The economic recovery and reduction in interest rates would further help in alleviating banking system problems, and also help ease socio-political pressures. Nonetheless, the banking system remains fragile, and the costs associated with the Government's bank support schemes will be a source of pressure on the fiscal position over the next several years. An additional source of pressure on the fiscal position will be the transitional fiscal costs of social security reform (para. 2.36-2.45). The Government will need to continue to show firmness in resisting pressures for a premature relaxation of policies. 1.9 Restoring stronger growth in the economy in the medium term will require a recovery in investment from the plunge occurring in 1995. The bulk of the rise in investment will need to be supported by an increase in domestic saving, if Mexico is to avoid a reemergence of unsustainably large external deficits - an important underlying cause of the 1994 financial crisis. The rise in Mexico's current account deficit prior to the crisis reflected a large drop in its saving rate. Mexico's national saving rate fell from about 22 percent in the mid-1980s to 16 percent in 1994, and is low by international standards (Table 1).  MErco - CoN TRAcTuAL S4vlNGsDEJEopmENT PRoGRAV 3 | Country/Region 91 92 93 |MEXICO 20.3 19.0 19.0 CHILE 24.5 26.8 28.8 LACAVERAGE 19.0 20.0 20.1 EAST ASIA AND PACIFIC 33.8 33.1 34.7 AVERAGE DEV. COUNTRIES Middle Income Economies 26.7 25.6 24.2 WORLD 22.5 21.9 21.6 LAC VRAGE 19.0 20. 2. .A 2. .... ...- =9 o Source: The World Bank- World Tables 1995 1.10 Raising domestic saving and deploying them more efficiently will be a fundamental condition for Mexico to attain strong and sustainable growth. Reforming the pension system and developing the contractual savings industry is one of the most important changes the Government can implement to promote domestic savings and develop the financial and capital markets to make more effective use of these savings. II. THE GOVERNMENT'S CONTRACTUAL SAVINGS DEVELOPMENT PROGRAM 2.1 The Government of Mexico has embarked on a major and important reform of the old age security system which should prove beneficial both to individuals, through the opportunity to obtain increased retirement income, and to Mexico's economic growth prospects over the medium and long term. This reform will avoid the certain deleterious effects on public finances that would have inevitably occurred if the current public, defined-benefit scheme had been left in place. It will also lead to greater private intermediation of domestic savings and to the establishment of the institutions and instruments needed to absorb and allocate savings more efficiently in the future. 2.2 Section II of this report summarizes the current state of Mexico's old age security system and the need for reform of the contractual savings sector. It also describes the objectives and key features of the Government's reform program, and analyzes the main issues to be tackled and the Government's strategy for contractual savings development. A. The Current State of Mexico's Old Age Social Insurance System and the Need for Reform Background 2.3 Mexico's old age security system consists of three pillars. The first pillar is a publicly managed, pay-as-you-go (PAYG), defined-benefits plan. The second consists of individual retirement accounts set up through the commercial banking system, with deposited funds managed by the Central Bank. The third comprises voluntary occupational pension plans. 2.4 The First Pillar: Public PAYG Pension Plans. The Mexican social security system as it evolved for almost fifty years through 1992 consists essentially of two elements of old age support:  4 PRESIDN TSEPORT retirement, pensioners' health benefits, and disability pensions' based on payroll contributions of 8.5 percent of wages for formal private sector workers admninistered by the Mexican Social Security Institute (Instituto Mexicano del Seguro Social - IMSS) and 7 percent of wages for public sector workers administered by the Institute for Security and Social Services for Government Workers (Instituto de Seguridad y Servicios Sociales de los Trabajadores del Estado - ISSSTE); and * additional retirement income from contributions to two specialized housing funds based on an employer-paid contribution of 5 percent of wages for private sector employees administered by the National Workers Housing Fund Institute (Instituto del Fondo Nacional de la Vivienda de los Trabajadores - INFONAVIT) or 6 percent of wages for public sector workers administered by the Government Workers Housing Fund (Fondo para la Vivienda de los Trabajadores del ISSSTE - FOVISSSTE). 2.5 IMSS also provides private sector workers with health care coverage under its own hospital system based on a contribution of 12.5 percent of wages (9.5 percent of wages for public workers in ISSSTE). 2.6 The Second Pillar: The 1992 Reform and the Introduction of Individual Retirement Accounts (SAR). In a partial effort to address growing deficiencies in the pension system, the Government introduced the Retirement Savings System (SAR) in May 1992 which consisted of two sub-accounts: * a new mandatory 2 percent employer contribution to private and public sector employees channeled into individual retirement sub-accounts. These funds are collected by employers and channeled to the Central Bank through the commercial banking system. The Central Bank guarantees a real rate of return of 2 percent on these retirement sub-accounts which by end-1995 totaled NP$22.3 billion. Account registrations have become highly concentrated in the commercial banking system with the two largest banks (BANAMEX and BANCOMNER) handling more than seventy five percent of the total; and * a specialized housing sub-account managed by INFONAVIT. Although the contribution remained at 5 percent of wages, INFONAVIT's benefit provision was changed to accumulated balances (i.e., accumulated contributions plus a real return on these) as opposed to only nominal accumulated contributions. 2.7 The Third Pillar: Voluntary Occupational Pension Plans. By domestic financial market standards, voluntary occupational plans are quite large (about US$8 billion in total assets or 5 percent of GDP as of 1993) and cover about 20 percent of Mexico's labor force. While there are as many as 8,000 such voluntary plans, most of these funds are concentrated in 30 to 35 enterprises - foreign multinationals and the large parastatals - and combine a severance payment obligation (defined under Labor Law Article 165 as 90 days of minimum daily salary for each year of service) with either defined-benefit or defined-contribution schemes. Referred to in this report as IVCM (Invalidez, Vejez, Cesantia en Edad Avanzada, y Muerte), the Spanish acronym for disability, old age, severance, and life insurance.  MEaco - CoNTRAcTuAL SAVINGS DE-ELoPMENTPROGRAM 5 The Needfor Reform 2.8 The Zedillo administration has recognized that Mexico's current contractual savings system suffers from several weaknesses. These have significant economic consequences that limit the viability of the social insurance system, impede development of the country's financial sector, and limit prospects for sustainable economic growth. The three key weaknesses are: * Severe Financial Disequilibrium. Based on various measurement methods, the overall financial condition of the pension system to private sector workers provided by IMSS (representing about 80 percent of the total working population) will increasingly place a serious strain on public finances. In addition to IMSS' growing actuarial deficits - due in part to the rapidly increasing dependency ratio, as shown in Table 2 below, - the commingling of funds within IMSS for the different coverages which it provides has permitted the pension system's surpluses to be used to meet cash deficits in certain IMSS insurance programs, most notably health. According to Government calculations, IMSS' actuarial deficit (141 percent of 1994 GDP) is expected to result in a cash deficit by the year 2007, requiring either a trebling of contributions or an increase in Government contributions amounting to I percent of GDP in the year 2000 and 3.75 percent of GDP in the year 2030. * Low Population Coverage. The IMSS-managed retirement and disability system (IVCM) covers about 10 million contributors. Other publicly provided pension schemes cover 1.5 million public sector workers in ISSSTE, about 0.5 million workers in the state-owned petroleum company (Petr6leos Mexicanos - PEMEX), and 0.3 million military personnel, resulting in coverage of about 40 percent of Mexico's active labor force. The remaining 4.5 million self-employed workers, mostly agricultural, and 9.8 million underemployed or unemployed workers are not covered by the formal social security system. Table 2 Mexican Social Security Institute (IMSS) Pension Actuarial Balances as of 12/31/94 1994 NP$1000 million ASET LIABILIT:S.... ............ :: ::~~~~~S :.--:--.-: . -.... .. .... J W . : 9 ^ . .... fi - .- .- - -. - . - . . .. . ..... . ..... . . . .. . . . ......... . . .. Reserves 3.25 Present value of old pensions 96.93 Present value of future 683.67 Present value of future 2390.61 contributions liabilities Actual affiliates 179.74 This generation 1017.40 Future generations 503.93 Future generations 1373.21 TOTAL ASSETS 683.92 TOTAL LIABILITIES 2487.54 DEFICIT 1800.62 (141.5 % of GDP) Source: IMSS and Bank staff estimates. Figure 1 below shows the estimated trends of contributions and pensions of the current IVCM system without reform as Mexico's demographic structure moves towards that of the developed countries (see para. 2.9).  6 PREsIDEN TSREPORT NS2,500,000 - -- - N$2,000,000 N$1,500,000 .... Pensions N$1,000,000 3 XX -X- Contributions NS500,000- .... N v~ 00 - N 0 O+ I .. . . O| 0 0 0x - - - N m N N m m m MS - -l _N_ _ N Ns N es N N N N N N N NCe High Evasion. Evasion has been associated with two main factors: high inflation and short vesting periods. Past high inflation has reduced the real value of pensions. In most cases, this has reduced pensions to the guaranteed minimum benefit, which is equivalent to the minimum wage. In addition, given the short time period in which a worker becomes vested (10 years), nearly 80 percent of IMSS pensioners currently receive the guaranteed minimum wage benefit. Not surprisingly, workers have perceived the pension scheme as a payroll tax. This situation has created strong incentives for both employers and employees to avoid affiliation and under-report earnings to qualify, and over-report them to receive benefits. It has also acted as a deterrent to attract informal sector workers, who comprise mainly the poor. Without broader participation in the reformed pension system, extreme poverty in old age will be an increasing burden on society. B. Old Age Insurance Reform: Timing, Objectives, and Principles of Reform Timing of the Reform 2.9 Across a wide range of countries, both developed and developing, old age security systems are faltering primarily because current revenues are being used to pay for an ever- growing proportion of an aging population. Mexico, like many developing countries has the distinct advantage of initiating reform at a time when its demographic profile is relatively young, making reform more affordable. The timing of the Mexican reform is particularly advantageous given the following four demographic trends (Figure 2): * the majority of the Mexican population is still young - in 1990 only 6.4 percent of the population was above 65 (Figure 2a);  MExco - CONT2AC7UAL SAVINGS DEvELOPMENTPROGRAM 7 * rapid growth in aging as a result of lower fertility rates and improvements in life expectancy (Figure 2b) which will result in 10.4 percent of the population above 65 years of age by 2020; * a sharp increase in the dependency ratio: in 1960 there were four pensioners per one hundred contributors, by 1994 this ratio increased to 12.5 per one hundred pensioners (Figure 2c); and * Mexico's current demographic structure limits the fiscal costs of pension reform. In 1994 almost 50 percent of IMSS contributors were between 15 and 30 years old, while the peak of the average wage distribution is reached at around age 40 (Figure 2d); this implies that wages for the 15 to 30 year old population will increase in time enabling them to acquire a pension higher than the minimum. Age Age Rate per 1000 72 7 81 85 70 6 . -7 5 _ ! r..... 71 ....5.. 6165 -1990 68 66 .:0gX 1990 2000 2010 2020 203 190 4 : 1 5 3 5 5 5 7 51::: 64~~~~~~~~~~~~~~~~ 41 45 623 31 35 20 21 25 58 1 :.: S1:.:::.:.:11:.:.:.56 1970 1975 1980 1985 1990 1993 0% 2% 4% 6% 8% 10% 12% 14% 16% 18%/ ieEpcac FriiyRt -- -Mortality Rate U 160000 -- -16 ~D ttw 14 140000 --14 4-. ~120000 --12=, 3.5 8.10000 8.15 0 8 0000 7 8 ~~~~40000 *~~~~~~~~~~~~~~~~~~~~ 4 * 1~~~~~~~~~~~~~~.51 X ~~~~~~~~~~~~~~2.0~ ~ ~ ~ ~~~~~~~. 20000 2 0 5 0.5 0 0 ~~~~~~~~~~~~~~~~~0.0 0.0 1990 2000 2010 2020 230 15 25 35 45 55 65 75 85 Total Population Pop:ulation Over6 ~Elderly Dependency Ratio - Wage IMSS Distribution  8 PRESIDENT'SREPORT Objectives of the Reform 2.10 The reform of contractual savings and the complementary development of financial markets are two of the key goals contained in the Government's National Development Plan for 1995-2000. The Government's strategy aims at: * increasing the equity, efficiency, and sustainability of the old age security system and gradually lead to greater effective coverage; * establishing a financially viable pension system; limiting the fiscal impact of the current pension system and ensure transparency of the fiscal costs of transition; * enhancing financial market development and reducing volatility by stimulating greater private financial intermediation and increasing the array of financial instruments and contracts available; and * contributing to enhance the allocative efficiency of domestic and, in the longer-term, to raising aggregate savings. Principles of Reform 2.11 There are a number of important principles that must be embraced if a sound old age security system is to be put into place. Mexico, like several other Latin American countries, has taken up the challenge of moving towards a multi-pillar, fully funded, defined-contribution old age security system. In addition to ensuring an enabling macroeconomic environment, the key issues it will face are: * introducing the regulatory and supervisory framework to protect the pension rights of participants in the mandatory system; c recognizing, to the fullest extent possible, the fiscal costs of transition and identifying financing sources to turn its implicit social security debt into an explicit debt; * reforming the public pillar by shifting to individual retirement accounts and to private management of pension funds. Meeting these requirements entails reforming IMSS, ensuring real rates of return from the INFONAVIT sub-account, and developing the disability and life insurance market; * setting up the regulatory and institutional framework for personal savings and occupationalpension plans, providing additional protection on a voluntary basis; * building public support and confidence in the new pension system so as to attract informal workers and avoid evasion; and * implementing parallel financial sector reforms to ensure an adequate supply of quality financial assets available for pension fund investment. 2.12 To achieve these objectives, the Government has embarked upon a series of major policy initiatives that have been grouped together under the broad title of "Mexico - Contractual Savings Development Program (CSDP)." C. The Key Features of the Reform and Comparison with Other Reforms 2.13 In December 1995 the Mexican Congress approved legislation (the new Social Security Law - Ley del Seguro Social) to reform the existing social security system to restructure the  MA&co - CONT.ACTUALSAyNMSDEvLOPMENTPRoGRAm 9 pension system for workers in the formal private sector from the PAYG, defined-benefit system to a privately managed, defined-contribution system. Modeled on the system in place in Chile, the reformed pension system: eliminates the old PAYG scheme; provides current IMSS affiliates with a choice at retirement between the benefits under the old system or their accumulated balances under the new system; and provides a government-guaranteed minimum pension equal to the indexed minimum wage for those low-income workers whose savings are insufficient to provide a post retirement income at that level. A second legislative package on the implementation of the reforms (the Pension Systems Law - Ley de los Sistemas de Ahorro para el Retiro) was approved by Congress in April 1996. 2.14 The current IVCM system for private sector employees (para. 2.4) is separated under the reform into Old Age and Severance (RCV - Seguro de Retiro, Cesantia en Edad Avanzada, y Vejez) and Disability and Life Insurance (IV - Seguro de Invalidez y Vida), including provision of health benefits to pensioners. Annex VI provides a more detailed discussion of the existing IVCM system. Due to political constraints, the current reform did not contemplate changes to the ISSSTE, PEMEX, other parastatals, armed forces, and the state pension plans. Hence, the portability constraint across private and public sector workers' pension plans will remain for now an issue along with the financial disequilibrium to be faced in the future by these pension funds. However, the introduction of the defined contribution scheme for private sector employees, if successful, is likely to push all the unfunded state employee pension plans in the same direction. The reform is scheduled to be initiated on January 1, 1997, although the administration of pension funds by private managers will not become fully operational until mid-19972. The main legislative and administrative elements of the reform are described in the following sections. Table 3 summarizes the main differences between the old IVCM system and the new reformed system Old Age and Severance Reforms 2.15 The backbone of the new fully-funded pension system is constituted by individual retirement funds (SIEFORES - Sociedades de Inversi6n Especializadas en Fondos para el Retiro). The SIEFORES will be managed by investment management firms (AFORES - Administradores de Fondos de Ahorro para el Retiro) to be established by the private sector (domestic and foreign), IMSS, and trade unions. In addition to the option for IMSS to establish a single AFORE, it will continue to have a role as: (i) the legal enforcer of all contribution collections; (ii) the provider of benefits to all existing pensioners; (iii) the entity responsible for delivering benefits to those transition workers choosing the old PAYG system at retirement; and (iv) the provider of the minimum pension guarantee to all private sector workers. 2.16 Coverage and eligibility. Contributions to the new system will be compulsory for all private sector workers beginning on January 1, 1997. The retirement age remains at 65 years. 2 On October 28, 1996 the Mexican authorities presented draft legislation to Congress to delay the implementation of the social security reform from January 1, 1997 to July 1, 1997. Nevertheless, even though contributions to the SIEFOREs will begin on July 1, 1997, workers' affiliation will proceed as planned, beginning on January 1, 1997. AFOREs are expected to be already authorized and operating by then. The reform was postponed for two main reasons: (a) the GoveTnment was not fully ready with the unique identification system, which is essential to avoid evasion, ghosting etc; and (b) the Govermnent was not ready with systems for collection of contributions by IMSS and their transfer to the AFORES. The Mexican authorities decided that prior to the actual initiation of the reform it was necessary to install a more powerful system for individualization of accounts and to move towards a centralized and more reliable and accountable computer-oriented scheme for the payment of contributions. In terms of account individualization, it was decided to add to the IMSS number and the fiscal identification number (RFC) a more reliable identification number entitled Clave Unica de Registro de Poblacion (CURP). These actions will improve the overall design of the system.  |0 PRESIDENT SREPORT The years of contributions required for eligibility for the minimum pension guarantee (MPG) are raised from 10 to 25 years, defined as 12503 weeks. 2.17 Contributions. Beginning on January 1, 1997, each worker's individual retirement account will be composed of two compulsory sub-accounts, the RCV retirement sub-account managed by the AFORES, and the INFONAVIT sub-account. Workers can also open a third sub-account for voluntary contributions. Workers' contributions will be automatically passed on to the designated AFORES. 2.18 Under the reform, contributions to old age and severance in the AFORES' individual accounts will equal 6.5 percent of a worker's wage (the current 4.5 percent for old age and severance plus the current 2 percent contribution in the retirement sub-account in the Central Bank) and a Government contribution of NP$ 1 per day, known as the social quota (see Table 3). The social quota will equal between I and 5.5 percent of the worker's wage depending on the level of each workers' wage and will be indexed to the December 31, 1996 CPI. On average it will be equivalent to 2.2 percent of wages. It will be transferred to each worker's account to which active contributions are being made. Transition workers have the right to transfer their past retirement sub-account contributions (para. 2.6) made to the Central Bank between 1993 and 1996 into their new AFORES accounts. Contributions to the INFONAVIT sub-account, equal to 5 percent of a worker's salary, will continue to be invested in INFONAVIT housing. Total contributions for retirement, therefore, amount to between 12.5 and 17 percent of a worker's wage. 2.19 Benefits. Benefits under the new system fall into two groups: benefits to new workers and benefits to transition workers. New workers are defined as those beginning their contributions to the system after January 1, 1997. The first cohort of retirees fully under the new system is expected in approximately 25 years. Benefits will consist of the accumulated balances in their individual retirement accounts (AFORES plus INFONAVIT accounts) or the MPG under the new system. The MPG will be equal to the minimum wage in Mexico City as of December 31, 1996, indexed to the Consumer Price Index (CPI). At retirement, workers will choose between a gradual withdrawal option or buying an annuity from an insurance company. 2.20 Transition workers are defined as those currently contributing to the PAYG system. Although these workers will begin contributing to their new individual retirement accounts after January 1, 1997, they will retain the right to the benefits of the old system. A lifetime switch option allows transition generation workers to choose at retirement the higher of the acquired benefits under the current system and the accumulated balances in their individual retirement accounts under the new system. More specifically, transition workers' benefits under the old system would be: (i) benefits accrued under PAYG system equal to a percentage of the average of their last five years nominal wage or an MPG equal to the minimum wage in effect at the time of retirement, indexed to changes in the minimum wage; (ii) accumulated balances in the INFONAVIT sub-account (from 5/1992 onwards); and (iii) accumulated 5/1992-96 balances in the retirement sub-account (para. 2.6). These benefits would be compared to the accumulated balances in their individual retirement accounts (AFORES plus INFONAVIT accounts) plus accumulated 5/1992-96 balances in the retirement sub-account (Table 3). 3 One contribution week equals 7 contributing days.  MExco - CONTPACTuAL SA vNGS DEwPoMENTPROGRAm 11 Table 3: Mexico - Comparison of Current and Reformed Old Age Security Systems OldAge and Severance (RCV) IMSS * Contributions to chosen pension fund administrator (AFORE) l Benefits provided by AFORES if new system, or IMSS if old PAYG system ............................................................ chosen at retirem ent .... ........................ ...................................................... .............................. ................................................................................................... .chsna e Disability and Life Insurance (IV) 1MSS iMSS ... CONTRWUI'JONS ,% ~*w)~ 15.5 163-21.0............ is............. I6.S - 2L0 Old age and severance (RC') 12.5 - 170 (= L5 + NPSI per day) dli..f lrI#fff 4.0 Di~~~~~~~~~~ ........................i.,.f,,... ................................................ ........... Detailed breakdown: IVCM (to IMSS): 8.5 RCV Individual Accounts: Old age and severance 3.0 to AFORES: 6.5b+NP$1 Disability and death 3.0 Old age and severance 4.5 Reserves for pensioners' health 1.5 Retirement sub-account 2.0 Administration expenses 0.6 Social quota (per day) NP$1I Social Assistance 0.4 to INFONAVIT: 5.0 SAR-Retirement (to Central Bank): 2.0 IV to IMSS: 4.0 SAR Housing (to 1NFONAVIT): 5.0 Disability and life 2.5 Reserves for pensioners' health 1.5 ["C.'.Fw_'.'2' Er%ThILW l OldAge (minimum pension) 500 weeks (10 years) and 65 years old 1,250 weeks (25 years) and 65 years old Severance 150 weeks, inability to earn 50% of salary 250 weeks Disability Insurance 150 weeks 250 weeks Life Insurance . . . ... .-. ....... -............. ' "'"''..l Old Age: Amount of pension (i) benefits accrued under PAYG system New workers: accumulated balances in (a % of the average wage of last 5 years in individual accounts (AFORES + INFONAV1T) nominal terms plus a fraction for each year in since 1/1/1997; excess of 10, with a maximum of 10 minimum Transition workers: at retirement choose wages - Art. 167 old Social Security Law) + highest between: (i) current benefits (see (ii) accumulated INFONAVIT contributions previous column) and (ii) accumulated (iii) retirement sub-account balances 5/92-96 balances in individual accounts (AFORES + 11lNFONAVIT) since 1/1/1997 + retirement sub-account accumulated balances 5/92-96 (if ............................... ...........I................................................ ................................. | .................................... Old Age: Withdrawals d . * Gradual withdrawals from individual account; e or * Annuity bought from an insurance _ company Disability Insurance 50% of the average wage during last 150 35% of average wage for the last 500 weeks weeks of contribution of contributions ................... ................................................................ ................ ............................................ .............................. ................. ............................................... Life Insurance Widow: 90% of disability pensiow, Same as before Dependents: 20% of disability pension, or 30% if both parents deceased H Minimum Pension Guarantee (MPG) Equivalent to one Mexico City minimum Equivalent to one Mexico City minimum wage wage level indexed to actual minimum wage I on 12/31/96 indexed to the CPI f a. Under IVCM, contributions could not exceed 10 times the minimum wage and under the new system it is 25 times. b. Plus the accumulated balances in the retirement sub-account (from 1993 to 1996) if the worker so wishes. c. Government contribution of NP$1 per day is indexed to the consumer price level and estimated to be between I and 5.5 percent depending on worker's income. The maximum of 5.5 percent is for workers earning I minimum wage and the average is about 2.2 percent of wages. d. Lump withdrawal at retirement permitted only for balances in excess of 130 percent of MPG. e. Workers taking gradual withdrawals must take out annuity insurance to cover probability that they live longer than expected and outlast savings. f. Currently average wage for IMSS affiliates is 2.6 minimum wages, thus MPG is approximately 38 percent of average wage.  12 PRESIDENT'SREPORT 2.21 The MPG, to both transition and new workers, is provided by the Government in the event that the value of the worker's accumulated savings in all retirement accounts is inadequate to provide for the minimum pension. The Government contribution will only be equal to the difference between the MPG and funds available in the individual retirement accounts. For transition workers opting for benefits under the old IVCM system, IMSS will pay benefits first from the worker's accumulated balances in the individual retirement account, and when these funds are exhausted, from Government resources. Disability and Life Insurance Reforms. 2.22 The reform separates disability and life insurance coverages from the other lines of insurance which IMSS continues to manage. As a result, funds can no longer be commingled. Total contributions for disability and life insurance are 4 percent of wages since they include 1.5 percent for reserves for pensioners' health expenses. Eligibility requirements were increased from 150 weeks to 250 weeks and disability pensions were reduced from 50 percent of the average wage in the last 150 weeks to 35 percent of average wage for the last 500 weeks. IMSS will retain responsibility over the management of this line of insurance, but private insurance companies will provide benefits through annuities. Occupational Risk Insurance 2.23 Occupational risk insurance will also be separated from other lines of insurance which IMSS continues to manage. Premiums will become firm-specific in contrast to the current system where specific premiums are established for each economic sector. Hence, the reform will create greater incentives for firms to reduce work-related injuries and should result in a decline in the average work-related risk insurance premium. Benefits under this line of insurance, however, remain largely unchanged with the reform. For permanent disability injuries, pension benefits equivalent to 70 percent of the average wage of the last 5 years will continue to be provided. As in the case of life and disability insurance, private insurance companies will provide benefits through annuities. Comparison with Other Reforms 2.24 Table 4 below summarizes key comparisons between Mexico and three other countries in the region that have recently carried out pension reform. The reforms being carried out in Mexico, while broadly similar to those adopted in other Latin American countries, differ in several significant ways: * Eligibility requirements. The number of years of contributions to be eligible for the benefits of the new system are higher for Mexico (at 25 years) than in other recent reforms. In addition, Mexico has defined a week as equal to seven working days, which, in practice, extends the eligibility period. This high eligibility requirement reduces both the risk of evasion and the need for the Government minimum pension guarantee. * Demise of contributions to PAYG system and lifetime switch option. Unlike the new pension systems in Chile, Argentina and Colombia, the option to continue to contribute to a PAYG old age and severance insurance plan has been completely eliminated under the new Mexican system, even for transition workers. New workers, as in the case of Chile, will be totally integrated in the new system. Transition workers will have a choice on the benefit side at the time of retirement, but not on the contribution side. Thus, a larger volume of funds will be intermediated by the private sector than in the case of these other reforms. This is also an  MAxCO - CONMTACTUL SAVJNGSDEVELOPMENTPROGRAW 13 TABLE 4. PENSION REFORMS IN LATIN AMERICA .. e ,.M - -- -,, ,, ..~~~~~~~~.... . - l- ,:. . M . . ~~~~~. g' .,.. .. - ........ .. ..... .. a* . . Nature of the reform Public defined Public split into Public PAYG Public defined benefit benefit (PAYG) public PAYG and changed to changed to private changed to private private defined choice between defined contribution defined contribution public PAYG (for private sector contribution (all and private workers only) workers) defined contribution Transition arrangements Phased out Continues with Continues with Eliminated' What happens to old system? changes changes Is current labor force allowed to remain Yes Yes Yes Noa in old scheme? _ _ Is new system mandatory for new labor Yes No No Yes force entrants? Can workers switch back to public No No Yes, every Noa system after entering AFP? three years. Recognition bonds Yes Yesb Yes' Nod Profile of new pension scheme What role Minimum pension Flat and minimum Minimum Minimum for public pillar? guarantee pension pension pension guarantee Social assistance guarantee Social assistance Social _ assistance Total contribution rate for new system: available for old age annuity 10 8 10 6.5 + 5.0 + 2.2' disability/survivorsladministrative 3 3 3.5 4.0 public pillar and social assistance _General revenues 16 I General revenues Total contribution rate: before reform 19 27 8 15.5 after reform 13 27 13.5-14.5g 16.5 - 21.0 Maximum percentage of portfolio allowed in: Domestic equities 30 50 to be decided 0 Foreign securities 10 10 to be decided 0 Governnent bonds in 1994 45 50 50 100 (in 1997) a. Contributions to the old system cease on December 31, 1996. Transition workers can choose at retirement the higher of the benefits available under the old PAYG scheme or the new defined contribution plan. b. "Compensatory pension" is paid upon retirement, not as a bond. The value is based on years of contribution and last ten years' eamings. c. Workers with fewer than 15 0 weeks of contributions are not eligible for a recognition bond. d. Disclosure of expected current and fuiture fiscal costs would be made on an annual basis. e. This is paid by the employer. f. Government contribution ofNPS 1 per day is indexed to the consumer price level and estimated to be between I and 5.5 percent depending on worker's income and on average equivalent to 2.2 percent of wages. g. The rate shown is for 1996 and following years. The contribution rate will increase gradually between 1994 and 1996. Source: "Averting the Old Age Crisis" World Bank, 1994 (page 277) and World Bank intemal documents. improvement over the Colombian reform which allows continuous switching by new entrants between the two systems (every three years), raising administrative costs and increasing volatility in the privately-managed funds. Alternative to issuance of recognition bonds and implications for fiscal costs of transition. Mexico's pension reform also differs in that the Government will not issue recognition bonds (as in Chile) or compensatory pensions (as in Argentina) to explicitly value current workers'  14 PRESIDENT 'SREPORT past pension contributions. The Mexican Government could not issue recognition bonds or compensatory pensions because of the legal treatment of acquired rights. These acquired rights make it difficult to explicitly attach a value to a worker's acquired benefits under the old PAYG system up until the time of the reform. On the fiscal side, the Mexican plan is more risky because the Government's liability is uncertain. However, the Government's contribution of NP$1 per day partially recognizes the Government's potential liability. In addition, the magnitude of the fiscal obligation will depend on the real return on transition workers' post 1997 contributions. Its potential advantage is that it does not lock the Government into fixed fiscal costs. Should real returns be higher than expected, more transition workers will take their benefits under the new program, thereby reducing fiscal costs. In terms of choice to transition workers, Mexico's scheme offers an improvement over the Chilean system. In Chile, transition workers were asked to choose at the start whether to stay with the old system or accept a recognition bond and join the new system. Given that the system was new and the uncertainty of future returns, this was a difficult, if not an arbitrary choice to make. In the Mexico scheme, workers can compare the benefits of the two systems at retirement and choose the higher of the two. Moral hazard risks associated with the incentive for workers and AFORES to invest in high risk securities and to evade contributions given the expectation to retire with the old PAYG benefits are mitigated by two factors: (i) the majority of transition workers (65 percent) are under 32 years of age; and (b) workers will have their own individual retirement accounts as opposed to a hypothetical Government guarantee. M Minimum Pension Guarantee. In terms of the minimum pension guarantee, it is lower in Mexico than the other countries, equivalent at present to approximately 40 percent of average wage, a figure which is expected to decline to 25 percent of the average wage by the time the first cohort of new workers retires (about 2025) as real wages increase. Taking advantage of a historically low minimum wage in real terms and favorable demographics, Mexico's potential fiscal costs are likely to be significantly lower than those of other reforms in the region. In addition, from the incentive point of view, the lower the guarantee the less relevant it becomes and the greater the incentive workers and AFORES will have to earn a high rate of return. 2.25 The Mexican reform follows the Chilean model as well as adds some innovative elements. Like in Chile, all vestiges of the old PAYG system will disappear with the last cohort of transition workers around 2025. The authorities have worked closely with Chilean counterparts as well as authorities of the U.S. Securities and Exchange Commission since the AFORE systems builds on Chile's AFP experience and on the US mutual fund experience. The success of the reform and the minimization of fiscal costs will depend on careful implementation and strong supervision. The Government has allowed itself until the beginning of 1997 to put in place the necessary institutional infrastructure. Moreover, the Government will strengthen the role of the regulatory body both through new legislative and regulatory powers and through cooperative exchanges with Chile and the U.S. D. Issues and Government Strategy 2.26 Contractual savings reform in Mexico provides the first real opportunity to shift the old PAYG pension system to a fully-funded, defined-contribution model and expand and deepen  Kffxzco - CONTRACTUAL SA vwGGSDEvELOPmENTPROGRAM 15 domestic capital markets. Such reform encompasses both pension reform and complementary financial market actions. To achieve the objectives of the reform (para. 2.10), the Government needs to carry out a number of important actions, including: (a) designing and implementing the legal framework to regulate pension fund administrators and strengthening the monitoring and enforcement of the new scheme; (b) establishing and enforcing an adequate investment management regime; (c) evaluating and ensuring the funding of the fiscal transition costs; (d) improving the financial performance of the INFONAVIT-managed housing fund; (e) strengthening the IMSS in its ability to manage account individualization, the enforcement of billing and collection, and the provision of benefits; and (t) encouraging public confidence through education. In parallel, the Government will implement complementary financial market reforms to facilitate the continued development of the privately-managed pension system. To ensure the success of the pension reform, the Government will carry out these actions in two phases. The first phase focused on the establishment of the legal, regulatory, and institutional framework for the reform of the country's old age security system. The second phase will concentrate on the actual implementation of the reformed pension system. 2.27 Specifically, the first phase of the CSDP program, supported by the proposed loan, included: (a) introducing the legal and regulatory framework to establish the new pension system and to regulate and supervise pension fund administrators; (b) designing and issuing the investment management regime; (c) assessing fiscal transition costs; (d) improving the financial performance of INFONAVIT; (e) individualizing accounts and strengthening IMSS capacity to manage the operational scheme of the new pension system; and (f) encouraging public confidence through education. In parallel, the Government implemented complementary financial market reforms, aimed at: (a) deepening financial sector reforms through continued bank restructuring; (b) modernizing the regulatory and supervisory framework for mutual funds and voluntary pension plans; and (c) deepening the insurance market for the provision of life and disability coverage and annuities. The main issues raised by each of these actions and the Government's response are described below. Pension System Reform (a) Legal, Regulatory, and Supervisory Framework for Fund Administration 2.28 In December 1995, a new Social Security Law (Ley del Seguro Social) was enacted, modifying the current public pay-as-you-go, defined benefits scheme to establish a privately managed, mandatory, defined contributions scheme permitting private management [para. 4.5 (a)]. The new Social Security Law provided that the regulatory and supervisory regime governing the revised pension system would be the subject of subsequent detailed legislation. The Pension Systems Law (Ley de los Sistemas de Ahorro para el Retiro) approved by Congress on April 26, 1996 [para. 4.5 (b)] sets out the structure and powers of CONSAR and provides guiding principles for the establishment, operation and supervision of pension fund administrators (AFOREs) and specialized mutual funds for pensions (SIEFOREs). It also sets out more detailed rules governing conflicts of interest, market share limits, officer and director responsibility and investor protection. Since September 1996, CONSAR has finalized draft regulations covering authorization and capitalization of AFOREs and SIEFOREs, portfolio valuation, commissions and fees charged by AFOREs and promotion and marketing of AFOREs and SIEFOREs to the public [para. 4.5 (b)]. The Ministry of Finance and Public Credit has finalized rules governing the establishment of AFOREs controlled by foreign financial institutions [para. 4.5 (b)]. After discussions with Bank staff, CONSAR has also prepared draft rules governing the investment  16 PRESIDENT'SREPORT regime for SIEFOREs. These drafts are acceptable and are expected to be issued in final form in October/November 1996 [para. 4.6 (a) and (b)]. 2.29 The Pension Systems Law pointedly did not adopt the governance and supervisory framework applicable to Mexico's mutual fund industry. Legislators and the administration felt since a handful of financial groups control the bulk of the Mexican banking, securities and mutual funds industries, the legal/regulatory framework for a mandatory contribution system should impose stricter rules for independent decision-making and avoidance of conflicts of interest. A strong CONSAR with ample authority and human and other resources necessary to supervise and enforce compliance was also essential. 2.30 The law and regulations address these key areas of concern for regulation and supervision of AFOREs and SIEFOREs in the following manner: Nature and Control of AFOREs. Chapter III, Section II of the Pension Systems Law sets out the basic rules for ownership, organization, authorization, capital structure and corporate governance of AFOREs. AFOREs will be single-purpose business corporations with independent capitalization. CONSAR regulations require each AFORE to maintain a minimum paid-in capital of N$25 million and a special reserve (as required by Article 28 of the Pension Systems Law) equal to the greater of $25 million or 1% of the total assets of SIEFOREs under management. The paid in capital and special reserve are required to be invested in shares of the SIEFOREs managed by the AFORE. The capital of an AFORE that is a subsidiary of a financial group will not be available to meet the obligations of other subsidiaries of the group. As an additional safeguard, Article 22 of the Pension Systems Law provides that financial intermediaries (including banks) or financial groups that are not in full compliance with applicable capital standards may not be shareholders of an AFORE. The establishment of AFOREs requires the authorization of CONSAR, which may grant or deny authorization in its own discretion after examining the business plan, shareholding, systems, control and management of the firm. Article 54 of the Pension Systems Law empowers CONSAR to revoke the authorization of an AFORE or SIEFORE that fails to meet the standards set forth in law and regulations. CONSAR regulations require sponsors to provide it with detailed information about the business plan, management, source of capital and controlling shareholders. Under the Pension Systems Law, a shareholder that at any time wishes to acquire more than 10% of the capital stock of an AFORE is required to make detailed financial disclosures to the CONSAR revealing their sources of capital for the preceding five years. Foreign Ownership. Article 21 of the Pension Systems Law provided that the Ministry of Finance and Public Credit may issue, in accordance with international agreements, regulations permitting a class of AFOREs majority-controlled by foreign financial institutions (but not individuals or industrial concerns). In accordance with this provision, the Ministry of Finance and Public Credit has issued a regulation permitting financial institutions from NAFTA  MExco - CONTRhACTuAL S4AVYGSDELELOPmENTPROGR4AM 17 countries,4 Colombia, Costa Rica and Venezuela to establish majority-owned AFOREs. Up to 49% of the shares of such foreign-owned AFOREs may be held by other foreign or Mexican shareholders. Foreign-owned AFOREs will receive equal treatment with Mexican-owned AFOREs, will compete head-to-head with them and will not be subject to the types of market share limitations that Mexico enforces against foreign-owned banks and broker/dealers. * Commissions and fee structure. Article 37 of the Pension Systems Law permits AFOREs to charge management fees based on a percentage of assets under management, the flow of contributions, or a combination of both, in accordance with regulations issued by CONSAR. Consistent with Article 37, CONSAR has issued regulations which authorize each AFORE to freely set management fees based on a percentage of contributions (a front end fee), a percentage of assets under management, or some combination of the two. In evaluating the appropriateness of commission structures charged by the various AFOREs, regulators are aware that, from the affiliate's point of view, the most important factor is rate of return net of expenses. Accordingly, CONSAR will issue regulations requiring accurate disclosure of the net rate of return. * Conflicts of Interest. In recognition of the potential for abuse presented by Mexico's interconnected and highly concentrated financial system, Chapter III, Section V of the Pension Systems Law establishes strict limitations on permissible transactions between AFOREs and affiliated financial institutions and issuers. CONSAR recognizes that given that a large percentage of pension contributions may ultimately be managed by AFOREs which are subsidiaries of financial groups and/or affiliated with other financial institutions, strict supervision and enforcement of conflict of interest rules will be required to build public confidence in the system. The Pension Systems Law itself establishes that: * Employees, management and shareholders of an AFORE may not divulge or make personal use of material non-public information. . Employees with responsibility for making and executing investment decisions for AFOREs may not also serve as employees of an affiliated (or unaffiliated) financial institution. Overlap of decision-making personnel between an AFORE and affiliated financial institutions would dilute responsibility and in some cases create incentives to make investment decision that are not in the interests of the AFORE's contributors. * SIEFOREs may not purchase securities in a primary offering if such securities are issued by an affiliated financial or non-financial institution or underwritten by an affiliated financial institution. SIEFOREs may not effect deposits with affiliated financial institutions. * SIEFOREs may invest no more than 5% of their assets in securities issued or guaranteed by shareholders or those exercising management control. 4 U.S. and Canadian subsidiaries or branches of financial institutions from non-NAFTA countries are treated as U.S. or Canadian institutions. Accordingly, European and Japanese financial institutions can gain access to the Mexican market through their U.S. and Canadian Subsidiraries.  18 PRESIDENT'SREPORT * All contracts between an AFORE and affiliated companies must be approved by the compliance officer of the AFORE. CONSAR is empowered to issue regulations further clarifying the conflict of interest rules and establishing requirements for assuring continued compliance and supervision. The regulation governing the investment regime establishes that a SIEFORE may invest no more than 5% of its total assets in securities issued or guaranteed by entities that have a management or shareholding nexus with the SIEFORE. * Market Share Limits. In order to encourage greater competition in the provision of pension fund management, Article 26 of the Pension Systems Law sets a 20% limit on the system assets that may be managed by any single AFORE5. The Consultative and Supervisory Committee of the CONSAR is authorized to set a higher limit only if it determines that it will not prejudice the interests of workers. To assure that no AFORE receives an unfair competitive advantage, CONSAR intends to refrain from authorizing the first AFOREs until it is able to grant simultaneous authorizations to a significant number of competitors. * Responsibility of Officers and Directors. The drafters of the Pensions Systems Law and CONSAR have striven to establish clear rules of responsibility for directors and employees of AFOREs. The Pension Systems Law provides that members of the board of directors, the general director and the compliance officer of each AFORE must be approved by CONSAR on the basis of the moral integrity and technical and management capacity of the nominees.6 Article 52 of the Pension Systems Law authorizes CONSAR to remove any director, officer, compliance officer or other officer found to lack the moral integrity or technical or management capacity required for such position. * Publicity and Marketing. Article 53 of the Pension Systems Law requires that all advertising and marketing be conducted in accordance with regulations prescribed by CONSAR. Article 47 requires that SlEFOREs distribute prospectuses that fairly describe their portfolio and investment policies. All such prospectuses must be reviewed and approved by CONSAR. CONSAR has issued initial regulations covering promotion and marketing of AFOREs and SIEFOREs and is expected to issue more detailed guidelines on the required contents and presentation of prospectuses as practice in this area develops. 5 In addition, Transitory Article seventeen of the pension Systems law provides that for the first four years of operations of the new system, the maximum market share permitted each AFORE will be only 17%. 6 To avoid dilution of responsibility, Article 49 of the Pension Systems Law provides that the members of an AFORE's board of directors must also serve on the boards of each of the SIEFOREs managed by such AFORE. These directors must also be members of the investment committee of each SIEFORE. The board must be composed of at least five directors, and at least two-fifths of the members of the board must be independent directors. In order to qualify as an independent director, a director may not be closely related to or have any employment relationship with the shareholders or principal officers of the AFORE. Directors, including independent directors can be held responsible for any actions taken, or for knowledge of irregularities that may be contrary to the interests of the workers. Each AFORE is required to have a compliance officer responsible for overseeing compliance with the rules established by the Pensions Systems Law and CONSAR as well as internal rules and procedures. The compliance officer is appointed by and directly responsible to the shareholders of the AFORE and may not be removed by management. In addition to overseeing internal compliance and reporting to management and shareholders on the status of compliance, the compliance officer must report to CONSAR on a monthly basis or immediately in the event of the discovery of any irregularity in compliance. The Compliance Officer will be held responsible for failure to execute his responsibilities under the law and is subject to sanctions.  MEizco - CONTRACTuAL S4 vnGSDEvELOPmEIVTPROGRAM 19 Investor protection. Article 31 provides that each AFORE must establish a specialized unit to respond to questions and claims from workers and employers. Such unit must include an officer with authority to enter into agreements binding on the AFORE and must report to its board. More importantly for investor security, Articles 109 and I 0 of the Law provide for submission of claims of workers and employees that are not settled by such unit to a system of conciliation and arbitration overseen by CONSAR. . Supervision of the reformed system: strengthened CONSAR. From the outset, the Government has recognized the need for a strong regulatory authority for the pension system, with both the legal authority and the human and other resources required to assure compliance with law and regulations. The Pension Systems Law grants CONSAR broad powers to set and enforce rules and standards for all aspects of operations of the revised pension system. CONSAR has full supervisory authority over AFOREs and SIEFOREs, as well as supervisory authority over other participants in the pension system (such as banks and insurance companies) to the extent the activities of such entities involve the pension system. CONSAR is empowered to issue regulations, conduct examinations, impose fines and sanctions and recommend criminal prosecutions. In the event that irregularities are uncovered in the operations of any entity subject to CONSAR supervision (including AFOREs and SIEFOREs), CONSAR is authorized to effect an administrative or management intervention of such entity. As discussed above, CONSAR may revoke the authorization of any AFORE or SIEFORE found to be out of compliance with the Pension Systems Law or CONSAR regulations. CONSAR has prepared an institutional development plan ("Plan General de Restructuraci6n de CONSAR") to provide itself with resources commensurate with its new responsibilities. The annual budget of the CONSAR is expected to increase substantially by approximately 60%. Over the next eighteen months, the plan envisages the installation of a new computer system (and the hiring of outside contractors), a substantial increase in staff (from 162 to over 250), public education programs, the upgrading of key systems and training of personnel. Two-thirds of the new staff will be mid- and high-level personnel. A portion of the funds necessary for improving systems and developing the capacity of CONSAR staff will be provided through the on-going Bank - financed FTAL. The priorities of the plan in the areas of systems and personnel include: development of actuarial standards and methodologies of analysis; implementation of on-site and off-site supervision programs; drafting of examination manuals and training of examiners; implementation of systems and software to monitor trading activity and detect irregularities; development of methodologies for measuring risk and assessing the effectiveness of private securities ratings; installation of systems and preparation of staff to produce a regularly issued statistical bulletin providing key data on the performance of the pension system. (b) Investment Management Regime: Classes of Funds and Portfolio Composition 2.31 Article 43 of the Pension Systems Law authorizes CONSAR to establish and enforce rules of general application for the composition of the portfolios of SIEFOREs. In preparing these regulations, CONSAR has been especially sensitive to issues relating to: (i) the prudent balance between investing in government bonds, private equity and debt instruments and bank obligations; (ii) investor options among portfolios with different investment policies; and (iii) valuation of  20 PREzIDENT'sREPoRr portfolio securities. The draft investment management regime reviewed by Bank staff [para. 4.5 (b)] is expected to be issued before the end of 1996 [para. 4.6 (b)]. 2.32 Initially Single Class of SIEFOREs. Article 47 of Pension Systems Law authorizes CONSAR to permit each AFORE to manage and offer to its customers a variety of SIEFOREs with different portfolio compositions, provided that each AFORE offers at least one SIEFORE the portfolio of which is composed "fundamentally" of securities whose returns are indexed to the Mexican CPI. Mexican legislators felt that to assure public confidence in the system, participants need to be provided with the option of investing in instruments offering a real rate of return. 2.33 At the outset CONSAR will allow each AFORE to establish only a single SIEFORE, "fundamentally" invested in indexed instruments. CONSAR intends eventually (perhaps beginning in 1998) to permit each AFORE to offer customers a variety of equity and debt funds with distinct investment policies. This decision to restrict each AFORE to only a single debt fund at the outset reflects the government's desire to simplify supervision in the first year of pension fund operations, reduce potential confusion among the public and build public support by avoiding volatility. Article 4 of the draft investment regime regulations interprets the term "fundamentally" to require that at least 51% of the assets of the initial SIEFOREs be represented by debt instruments indexed to consumer inflation. 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