Philippines - An agenda for the reform of the social security institutions

Report No. 13400-PH Philippines An Agenda for the Reform of the Social Security Institutions September 29,1995 CO'iintrv ()px,r,itiotis Division (CoullErv Depa)artmetlt I Eist Asia aind Pacifi( RegiOI Document of the World Bank  CURRENCY EQUIVALENTS Average 1994 - Pesos 27.5 (Jan-May) Average 1993 - Pesos 27. 1 Average 1992 - Pesos 25.5 Average 1991 - Pesos 27.5 Average 1990 - Pesos 24.3 Average 1989 - Pesos 21.7 Average 1988 - Pesos 21.1 Average 1987 - Pesos 20.6 ABBREVIATIONS AND ACRONYMS ADB - Asian Development Bank AFP - Armed Forces of the Philippines ASEAN - Association of Southeast Asian Natiorc BIR - Bureau of Internal Revenue BOI - Board of Investments BOO - Build-Operate-Own BOT - Build-Operate-Transfer BSP - Bangko Sentral ng Pilipinas BTO - Build-Transfer-Operate CBP - Central Bank of the Philippines COA - Commission on Audit COP - Committees on Privatization CPF - Central Provident Fund CPI - Consumer Price Index CSS - Contractual Savings Sector DBM - Department of Budget and Management DOF - Department of Finance ECC - Employee Compensation Commission EPF - Employees Provident Fund ERISA - Employment Retirement Security Act FERS - Federal Employment Retirement System FRN - Floating Rate Note FRTN - Floating Rate Treasury Note GDP - Gross Domestic Product GOP - Government of the Philippines GSD - Government Securities Department GSIS - Government Security Insurance System IMF - Interniational Monetary Fund IPO - Initial Public Offering MCC - Medical Care Commission NG - National Government NHFMC - National Home Mortgage Finance Corporation PFI - Participating Financial Institution SSC - Social Security Commission SSS - Social Security System  PHILIPPINES AN AGENDA FOR THE REFORM OF THE SOCIAL SECURITY INSTITUTIONS Table of Contents Page No. EXECUTIVE SUMMARY ................................ i I. INTRODUCTION ..................................... 1 A. Macroeconomic Background ........................... 1 B. Developments in the Capital Market ..................... 3 C. Objectives of the Study ............................. 5 D. Structure of the Study .............................. 6 II. THE CONTRACTUAL SAVINGS SECTOR .................... 7 A. Profile of the Contractual Savings Sector ................... 7 B. Savings Potential of the Social Security Institutions .... ......... 12 C. Role of Contractual Savings in Capital Market Development ... .... 13 D. Tax Status of the Contractual Savings Sector ................. 17 E. Regulatory Framework of the Contractual Savings Sector .... ..... 19 F. Conclusions and Recommendations ....................... 22 III. ORGANIZATION AND ADMINISTRATION ................... 24 A. Structure of the Social Security Sector in the Philippines .... ..... 24 B. Scope and Nature of Programs of SSS and GSIS .... .......... 26 C. History of SSS and GSIS ............................. 27 D. Organization ..................................... 29 E. Interface ........ ....... ............ .. 31 F. Compliance .33 G. Data Gathering and Management Information Systems .35 H. Legislative and Regulatory Framework .37 I. Conclusions and Recommendations .39 IV. SSS AND GSIS: OPERATIONAL AND FINANCIAL PERFORMANCE . 42 A. Operational Performance .42 B. Financial Performance .47 C. Asset Allocation and Fund Management .51 D. Conclusions and Recommendations .55 This report is based on the findings of a Bank mission which visited Philippines from April 25 to May 11, 1994, consisting of Messrs. Ismail Dalla (Task Manager), Asad Alam (Young Professional), Aldo Baietti (CFSPS), and Peter Kyle (LEGPS), and Anand Chandavarkar, Louis D. Enoff, and Subramanian Sundaresan (Consultants). Mmes. Hamideh Keyhani, Amalia Mendez, Mercedes Pendleton and Mr. Martin Edmonds (EA1IE) assisted in the preparation of this report.  V. ACTUARIAL ASSESSMENTS OF THE SSS AND THE GSIS ... ..... 56 A. Purpose and Scope ................................. 56 B. Summary and Findings .............................. 57 VI. OPTIONS FOR RESTRUCTURING .......... .. ............. 63 ANNEX A: ACTUARIAL CONCEPTS AND TERMINOLOGY ... ... 67 ANNEX B: RESULTS OF ACTUARIAL ASSESSMENT .... ....... 72 ANNEX C: SELECTED FINANCIAL DATA .................. 90 ANNEX D: MERGER OF SSS AND GSIS .................... 106 LIST OF TABLES IN TEXT 1.1 Philippines - Key Macroeconomic Indicators, 1989-93 .................. 1 2.1 Profile of the Contractual Savings Sector, 1993 ...................... 8 2.2 Assets of the Contractual Saving Sector . 2.3 Profile of the Life Insurance Industry .10 2.4 Additions to Reserves of SSS and GSIS, 1993 .13 2.5 Outstanding Public Sector Domestic Debt by Holder, 1986-93 ........... .. 15 2.6 Performance of SSS, GSIS, and EPF (Malaysia), 1990 .15 3.1 SSS - Breakdown of Active Participant Information .36 4.1 Division of Benefit Provisions................................. 42 4.2 Summary of Principal Pension Benefits ........................... 43 4.3 Summary of Current Contribution Requirements for Participants Earning Over Minimum Level .44 4.4 Current Trends in Contributions, Benefits and Expenses, 1989-93. 46 4.5 Sumimary of Financial Performance, 1989-93 .49 4.6 Asset Allocations as a Percentage of Total Portfolio, 1993 .52 4.7 Rate of Return on Investment Portfolio, 1989-93 .54 5.1 Main Results of Actuarial Assessment as of January 1, 1994 .58 LIST OF CHARTS IN TEXT 3.1 Current Structure of the Social Security Sector .25 3.2 SSS - Summary Organizational Chart .30 3.3 GSIS - Summary Organizational Chart .......................... . 32 4.1 SSS - Consolidated Operations, 1980-93. 45 4.2 GSIS - Consolidated Operations, 1989-93 .47 4.3 Rate of Return on Investment Portfolio, 1989-93 .54  LIST OF BOXES IN TEXT 3.1. What is Social Security? ..................................... 27 3.2. Proposed Amendments Affecting SSS and GSIS ...................... 40 6.1 A Decision Flow Chart for Redesigning and Old Age Pension System .66 LIST OF TABLES IN ANNEXES A. 1 Key Assumptions Used for Actuarial Assessment as of January 1, 1994 .71 B. 1 Summary of Current Contribution Requirements for Participants Earning Over Minimum Level .86 B.2 Summary of Principal Pension Benefits .87 B.3 Summary of Participant Information as of January 1, 1994 .88 B.4 Value of Assets Considered for Actuarial Assessment as of January 1, 1994 89 C. 1 Life Insurance Industry - Key Data, 1988-1992 .90 C.2 Survey Profile - Retirement Funds, 1993 .91 C.3 Executive Summary - Retirement Funds .92 C.4 SSS - Consolidated Income Statements, 1989-1993 .93 C.5 SSS - Consolidated Balance Sheets as of December 31st, 1989-1993 .94 C.6 SSS - Summary of Asset Allocation, 1989-1993 .95 C.7 SSS - Summary of Income Yields from Asset Categories, 1989-1993 .95 C.8 SSS - Distribution of Investments, 1992-1993 ....................... 96 C.9 GSIS - Consolidated Income Statements, 1989-1993 .97 C. 10 GSIS - Consolidated Balance Sheets as of December 31st, 1989-1993 .98 C.11 GSIS - Income From Loans and Investments, 1988-1993 .99 C.12 GSIS - Yield Rates, 1988-1993 .100 C. 13 GSIS - Outstanding Balances on Loans and Investments, 1988-1993 .... ...... 102 D. 1 Comparison of Social Security Replacement Rates at Retirement in Selected Countries .117 D.2 Privatization of GSIS Life Insurance Coverage .124 D.3 Compliance and Administration Under SSS .125 D.4 Design Issues Relating to Post-Merger SSS .126 D.5 Design of Post-Merger Supplementary GSIS ......................... 127 D.6 Post-Merger Benefits of Current GSIS Participants .................... 128 D.7 Medicare and Employees' Compensation Issues ...................... 129 LIST OF CHARTS IN ANNEXES B. 1 GSIS: Projected Net Income for Social Benefits Program .75 B.2 GSIS: Projected Level of Funding for Social Benefits Program .76 B.3 SSS: Projected Net Income for Social Benefits Program .77 B.4 SSS: Projected Level of Funding for Social Benefits Program .78 B.5 SSS: Impact on Projected Net Income for Social Benefits Program of Improved Compliance ..79 B.6 GSIS: Projected Net Income and Funding Levels Under Medicare Program .... 80 B.7 SSS: Projected Net Income and Funding Levels Under Medicare Program 81 B.8 GSIS: Projected Net Income and Funding Levels Under Employees' Compensation Program ..82 B.9 SSS: Projected Net Income and Funding Levels Under Employees' Compensation Program ..83 B. 10 Ageing of Philippine Population .............. .. ................ 84 B. 11 Current Age Structure: Non-retired GSIS and SSS Members ....... ....... 85 C. 1 SSS - Organizational Structure .102  C.2 GSIS - Organizational Structure ............. .. ................. 103 C.3 Guidelines on Social Security Coverage for Househelpers ....... ......... 105 D. 1 Recommended Structure for the Social Security Sector ...... .. .......... 109 D.2 Merged Social Benefits Program: Projected Net Income ................. 112 D.3 Merged Social Benefits Program: Impact of Improved Investment Return ... ... 113 D.4 Merged Social Benefits Program: Impact of Increased Contributions ... ..... 114 D.5 Merged Medicare Program: Projected Net Income ....... .. ........... 115 D.6 Merged Employees' Compensation Program: Projected Net Income .... ..... 115 D.7 Merged Social Benefits Program: Benefit Payments and Contributions as a Percentage of Payroll ...... .......... ................. 117  EXECUTIVE SUMMARY Introduction 1. In 1992, the World Bank conducted a study of the capital market in the Philippines.' The study highlighted the importance of the contractual savings secto.- (CSS) in capital market development, identified weaknesses and problems in the CSS, and made several recommendations for enhancing its efficiency. The study also recommended a comprehensive reform of the country's two social security institutions - the Social Security System (SSS) and the Government Service Insurance System (GSIS). The prospect of merging the two social security institutions was raised but not examined at that time, as it was beyond the scope of the study. 2. This current study of the CSS was undertaken in response to a subsequent request by the Government of the Philippines (GOP) in November 1993 for a detailed examination of the SSS and the GSIS (including the option of merging the two institutions). The study of the CSS continues Bank work on capital market development and focuses, in particular, on developing sources of institutional funds outside the stock market. In so doing, it complements other financial sector work carried out by the Bank over the last three years - starting with the reform of the banking system, the restructuring of the central bank2, and improvements in the government securities market. It also reinforces financial sector work undertaken by the Asian Development Bank (ADB) on the equity market, including the unification of the two stock exchanges, the strengthening of the Securities and Exchange Conmmission (SEC), and the improvement of the clearing and settlement system. 3. The study is based on the findings of a Bank mission which visited the Phiiippines in April- May, 1994 and the subsequent visit in February 1995 to discuss the Green Cover Report. It also builds on the findings and recommendations of the 1992 Capital Market Study. This study begins by describing the macroeconomic background, identifying recent developments in the capital market, and discussing the CSS in the Philippines. It then provides a detailed diagnosis of the problems of the social security institutions in terms of their actuarial soundness, administrative arrangements, and their operational and financial performance. Consideration of some options for restructuring or redesigning the programns are presented in Chapter 6. The merger of the SSS and GSIS and its rationale is discussed in an anmex followed by a specific plan to manage the transition. 4. Macroeconomic Background. The Philippine economy is now in the second year of an economic recovery following three years of stagnation. The increase in real output of 4.3 percent in 1994, and the maintenance of inflation at single digit levels, reflect the success of the stabilization efforts and the structural reforms undertaken by the GOP. These stabilization efforts have helped to reduce macroeconomic imbalances. The consolidated public sector deficit was reduced from 5.1 percent of GNP I Philippines: Capital Market Study, World Bank, Report No. 10053-PH, February 24, 1992. 2 Financial restructuring the CBP was completed in December 1993 in connection wit'r the second tranche release of the Financial Sector Adjustment Loan (Loan No. 3049-PH).  - 11 - in 1990 to 0.5 percent in 1994. Inflation has also declined from about 16 percent in 1990 to 9.0 percent in 1994. Gross official reserves, while still low, increased from US$2.0 billion in 1990 (equivalent to 1.5 months of imports) to US$7.0 billion in 1994 (equivalent to about 3 months of imports). The structural reforms enacted to date have spanned a wide range of policy areas, including trade, exchange rates, agriculture, privatization, and energy. 5. These stabilization efforts and structural reforms will contribute to modest economic growth in the near term. However, additional efforts will be required if an adequate level of growth is to be sustained. Savings remain low at less than 18 percent of GDP, substantially less than the historical level of 26 percent achieved during 1973-80 and comparably worse than neighboring countries. The savings rate is more than 30 percent of GDP in Indonesia, Malaysia, and Thailand, and more than 40 percent of GDP in Singapore. This low savings rate may reflect, in part, the low level of financial intermediation. A major cause of financial disintermediation in recent years has been the large operating losses of the Central Bank of the Philippines (CBP) and the financing of these losses through the banking system in the form of excessive reserve requirements (25 percent). 6. Recent Developments in the Capital Market. The growth of the capital market has been constrained in recent years by several factors, including political uncertainty, the power crisis, and the distortion caused by the insolvency of the central bank. During the 1980s, balance of payment difficulties and an overvalued exchange rate led to a decline in the holding of financial assets as measured by the ratio of M2 to GDP. Although this ratio rose from 34 percent in 1990 to 44 percent in 1994, it is still less than half the comparable figures for Malaysia and Thailand. With the election of President Ramos in December 1992, the restructuring of the CBP in December 1993, and the return to normal power supply conditions in late 1993, financial markets have rebounded on all fronts. The interest rate on government securities plummeted from a level of 24 percent in 1992 to around 13 percent in 1994. The Philippine stock market was one of the best performing in the world in 1993, evidenced by a rise in the ratio of stock market capitalization to GDP from 15.1 percent in 1990 to 69.6 percent in 1993. Foreign portfolio investment has increased sharply, and indications are that foreign direct investment almost doubled between 1993 and 1994. Although the Philippine capital market experienced remarkable growth in 1993 and 1994, it is still very small in relation to other ASEAN countries such as Thailand and Malaysia. Therefore, tremendous potential exists for the capital market to act as the engine of growth for the economy. The CSS has a major role to play in this respect. 7. The government securities market was profoundly affected by the passage of Republic Act No. 7653 on July 3, 1993, which created the new Bangko Sentral ng Pilipinas (BSP), later established on December 23, 1993. During the previous four years, monetary policy management had been rendered ineffective. Since the CBP did not have a portfolio of government securities to conduct open market operations, it had to rely on the GOP to raise resources through the issuance of Treasury bills to cover its operating losses and additional funds required to meet monetary targets. The excess amount raised through this action was deposited with the CBP for conducting open market operations. With the restructuring which took place in December 1993, the BSP acquired a large amount of T-Bills (P 280 billion) on its books which could then be used for open market operations. The BSP has performed very well since its restructuring and has provided a stable monetary policy frarmework for the financial markets. 8. Most government securities carry maturities of less than one year. In an effort to create a larger pool of long-term capital, the Government Securities Department began issuing Floating Rate Notes (FRNs) in 1991, and the program has been highly successful. As of May 31, 1995, the amount of the FRNs amounted to P 123 billion, or 31 percent of outstanding Treasury bills. Starting October 1994 the GOP began issuing fixed rate notes, starting with P 10 billion of two year notes and in June 1995  - Hii - issuing P 3 billion of five year notes. Given more stable macroeconomic conditions and financial markets, it is recommended that the GOP consider lengthening fixed interest long-term securities. However, to facilitate the success of this auction, the GOP should consider removing the stamp duty, clarifying the tax on income and capital gains from fixed interest rate long-term securities, improving the clearing and settlement systems, and providing information to market participants cn a timely basis. These measures are discussed in the Capital Market Study3. The CSS, especially the two social security institutions, can play an important role in contributing to the growth of a robust government securities market (Chapter 2). 9. Among the notable recent developments relating to the stock market were the unification of the Manila and Makati Stock Exchanges at the end of March 1994 and the ratification by the Senate of the Stock Transactions Tax Bill on April 28, 1994. The latter provides for a graduated three-tiered tax on initial public offerings (IPOs) that aims to encourage greater public ownership of closely held firms. The equity market continues to experience rapid growth and market capitalization increased from US$13.7 billion in 1992 to US$40.3 billion in 1993 and US$55.5 billion in 1994. Tlhe turnover ratio also increased during the same period. At the end of 1994, the Philippine constituents comprised about 3.9 percent of the total investable market capitalization of the 10 Asian markets followed by the IFC. Daily trading value averaged US$60 million in 1994, a sharp increase from the past, but still modest compared with a daily trading volume of US$500 million in Thailand. The buoyancy of the market is also borne out by the rise in the number of listed companies from 153 (1990) to 180 (1994). The Contractual Savings Sector 10. Profile. The CSS consists of the two social security institutions (SSS and GSIS), the occupational pension funds, and the insurance industry, both life and non-life. At the end of 1993, total assets of the sector were estimated at P 256 billion (US$9.4 billion). This represents a sizable pool of long-term resources, equal to more than one-quarter of the market capitalization of the listed issues on the two stock exchanges, 27 percent of the assets of the banking system, or 17.4 percent of the GDP. 11. The two social security institutions account for 60.2 percent of the total assets of the CSS. At the end of 1993, the total assets of these two institutions totaled P 154 billion, 11 percent of GDP. The total assets for the SSS amounted to P 103.8 billion in 1993, compared with e 50.3 billion for the GSIS. 12. The occupational pension funds consist of private pension funds, the Armed Forces of the Philippines Retirement and Separation Benefits System (AFP), the Home Development Mutual Fund (Pag- ibig), and several multi-employer plans. These occupational pension funds are voluntary and consist largely of single employer occupational schemes (pag.-ibig) was made mandatory in i995). They are supplementary to the social security system. However, data on their actual number and the size of their total assets is not fully known. It is estimated that the total value of the assets of all the occupational pension plans in 1993 was about P 40 billion.4 3 For details please see the study on the Asian Bond Market. Dalla. June 19, 1995. 4 The Wyatt Company's annual survey of 168 pension funds in the Philippines reveals that the assets of these funds have doubled between 1990 and 1993. This growth rate of 100 per cent was used as a proxy for the growth rate of the aggregated assets of occupational pension plans. The 1993 estimate was obtained by applying this rate of growth to the l 20 bn value that was estimated by the 1992 Capital Market Study.  - iv - 13. The size of CSS assets is substantial, and asset growth has been significant. CSS assets increased at an average annual rate of 18.1 percent during the period 1980-1993. As a percentage of GDP, the share of the CSS rose from 10.7 percent in 1985 to 17.6 percent in 1993. 14. Savings Potential of the Social Security Institutions. The CSS has generated substantial savings. Contributions to savings by the constituent social security institutions can be measured by their annual additions to reserves - the excess of current revenues from contributions and i;nvestment income over current expenditures on benefit payments and operating expenses. In 1993, the additions to reserves of the SSS and the GSIS were close to P 21 billion, equivalent to 1.4 percent of the GDP and 7.8 percent of gross domestic savings. A better sense of the magnitude of these savings can be gauged by comparing the additions to reserves with the value of IPOs in the stock market. The aggregate addition to reserves was 1.6 times larger than the total value of IPOs in 1993; those of the SSS alone almost equalled the IPOs that year.5 Although the level of savings mobilized is substantial, the social security institutions have not yet realized their full potential. As discussed in Chapters 3 and 4, the SSS suffers from low compliance with contribution payments while the GSIS has large overdues. There are also indications that present resources may not be able to fully cover the generous increases in benefits approved during the last four years. There is a clear need to improve asset management functions at both institutions to increase the risk adjusted returns so that future obligations could be met without recourse to the GOP. These inefficiencies on the revenue side have constrained the ability of these institutions to generate additional surpluses. 15. Role of CSS in Capital Market Development. The CSS is an ideal source for term financing, and potentially a substantial one, owing to its assured cash inflows and long-term liabilities. Even if aggregate savings are unaffected, contractual savings will cause a shift in favor of long-term finance used to promote the equity and bond market. A major gap in the capital market in the Philippines is the shortage of long-term finance: and the contractual savings sector, as the most sizeable-and dynamic source of non-inflationary long-term capital, is best suited to fill it, if proper corrective measures are taken in a timely manner. 16. Given the nature of their liabilities, both the SSS and the GSIS should be investing in long- term assets. Instead, they have chosen to invest mainly in short-term government securities and in below market member loans (GSIS). Their asset structure is in part explained by the fact that there are currently no long-term fixed income debt instruments in the Philippines and further by constraints in their charters on making equity investments. The SSS and the GSIS could play a much more active role in developing the domestic capital market by lengthening the maturity structure of government securities and by promoting the equity market through appropriate policy changes (para. 45). A more diversified investment portfolio and prudent investment policy would also enable both institutions to earn a higher risk adjusted return without compromising their fiduciary obligations or disrupting financial rnarkets. 17. The present asset and maturity mismatch between long-term liabilities and predominantly short-term assets could be redressed through an integrated reform and policy package which should include: (i) reducing below market member loans (salary, policy and housing); (ii) issuing !ong-term fixed rate government securities on a competitive basis; and (iii) providing for full or par,ial privatization of fund management. The mission's findings suggest that there is an adequate fund management expertise in the private sector available at competitive rates, a fact borne out by the experience of private pension funds. 5 Lack of disaggregated data for the occupational pension plans precludes estimation of their contribution to savings.  - v - 18. Tax Status of the CSS. Although both the SSS and the GSIS are tax exempt by law, there are some tax practices which need to be addressed to facilitate the growth of an active secondary market in government securities. Currently, the SSS and the GSIS are required to pay a withholding tax of 25 percent at source. This tax is expected to be refunded to the respective institution; however, the process takes up to one year or more, and the refunds are given in the form of tax credits which have no value for tax exempt organizations. This increases the carrying cost of government securities and creates disincentives for both institutions to participate in the secondary markets. Therefore, it is recommended that the present practice of withholding at source for both institutions be imrnediately discontinued. 19. The insurance industry is heavily taxed. The taxes on the industry include: (i) the tax of five percent on all premium income; (ii) the normal corporate tax on net income; (iii) the 25 percent withholding tax on interest income; (iv) the stamp tax on life policies; (v) examination and license fees; and (vi) municipal taxes on insurance premiums which vary with individual municipal jurisdic.ions. The total tax burden on the industry represents a tax rate of about 36 percent. The high taxes imposed on the insurance industry put it at a disadvantage relative to competing sectors such as the Pre-need, trust and private pension fund industries. It is recommended that the GOP consider rectifying this anomaly, especially the five percent tax on premium income. 20. The tax status of private pensions discriminates against self-employed or other inuividuals who do not participate in a qualified plan, limits the portability of benefits and constrains the mobility of labor. While the incentives for employers are adequate and generally in line with those offered in other countries, the contributions of plan participants are not tax-deductible and pre-retirement benefits cannot be rolled into a personal account to maintain its tax-exempt status. Such deductions should be viewed as part of an integrated tax incentive structure for saving. Social Security Sector 21. Current Structure of the Social Security Sector. The current social security sector is essentially two-tiered; the first tier provides mandatory basic universal coverage while the second rier provides voluntary supplementary coverage. The first tier consists of the SSS, the GSIS, and a specia! retirement benefit scheme for government employees which is administered by the Department of Budget Management (DBM). The second tier comprises the occupational pension plans, the Pag-ibig and the housing fund. 22. Nature of the Programs. All the social security programs in the Philippines are of the defined benefit type (i.e., benefits are provided at a stated level, based on pay and contributory service, and contribution levels are set to provide adequate income to provide for these benefits and administrative expenses.) These two plans have been in place for more than 40 years. Though statutory provisions call for eventual universal coverage, these 2 programs currently cover about 60% of the work force. The Government has assumed responsibility for maintaining the solvency of these funds and for guaranteeing the benefit levels prescribed. Because of the inflationary climate, there is a strong tendency to raise benefit levels annually in order to offset, at least partly, any diminution in the real value of the benefits. Because of demographics there is an increasing % of retirees in relation to the number of workers. 23. There are several anomalies in the current structure which make a strong case for restructuring or rationalization. First, the actuarial assessment shows the need for revision to the programs to maintain actuarial soundness. There is an artificial dichotomy between public and private sector employees in the first tier. The SSS administers the program for persons working in the private sector while the GSIS administers the programs for persons employed by all levels of government (except the armed forces and the judiciary) and those in government corporations. Second, there is duplicate  - vi - coverage of some government employees. The GSIS also provides insurance, both life and non-life. While there may have been a justified rationale for GSIS' participation in the insurance business in the past due to the lack of a viable private insurance industry, this is no longer the case. The captive nature of its market is a source of distortion in the market, particularly in view of its tax-exernpt status. Finally, the structure is characterized by a lack of portability between institutions. 24. Operational Performance of SSS. In March 1994, the SSS was serving over 14.6 million members and about 500,000 pensioners. The SSS provides three types of benefits: (i) social benefits; (ii) medicare benefits; and (iii) employee compensation benefits. A list of benefits is given in Table 4.1 in Chapter IV. In 1993, the SSS collected total contributions of P 13.4 billion and paid out P 14.0 billion in benefits, leaving a gap of P 0.6 billion to be covered by investment inconmc. A breakdown of total benefits payments shows that 84.9 percent were for social benefits (retirement and ielated), followed by Medicare (12.33 percent) and employee compensation (2.8 percent). 25. The amount of benefits paid for 1993 amounted to an increase of 34.7 percent over 1992, and an increase of 223.7 percent since 1989. In terms of the number of claims for 1992, the increase was about 2.5 percent for a total of 1,944,715 claims processed. About 59 percent of the claims are for social security (SS) benefits while 37 percent were for medical compensation (MC) and 3 percent for employees compensation (EC). Within the SS claims for sickness payments were by tar tiie largest volume (over 550,000), but retirement benefits continue to be the maior share of expenditures. Processing times for benefit claims have continued to show a significant improvement. Data from the first quarter of 1994 show processing pension claims down from 44 days to 2 days, MC from 20 days to 15 days, and Sickness/Maternity down from 30 to 19 days. Overall, the operating cost for SSS in 1993 was P 1.0 billion, 3.8 percent of the total revenue and 1 percent of total assets, which is reasonable. 26. One of the disturbing features of SSS operation is the rapidiy rising level of benefit payments. During 1980-86, contribution income increased at a compound annual rate of 6.4 percent, benefit payments by 18 percent p.a., and operating expenses by 13. 1 percent p.a. Despite this pattern, the SSS was able to accumulate substantial reserves, since contributions were still higher than total benefit payments and operating expenses. Therefore, all earnings from investments were being added to reserves. However, during 1987-93, benefit payments increased at a much higher rate of 34 percent p.a., compared with 30 percent p.a. for contribution income and 27 percent for operating expenses. The combination of benefit payments and operating expenses exceeded income from contributions in 1992, and benefit payments alone exceeded contribution income by over P 500 million in 1993. Consequently, the SSS has had to use investment income to cover current expenses over the last two years. 27. This development represents a serious concern when viewed in the context of anticipated demographic developments in the Philippines (see Chapter 5, para. 5.14 and 5.15 and Annex B, Charts B. 10 and B. I 1). Chart B. 10 in Annex B illustrates how the age distribution of the Philippine population is expected to evolve over the next 50 years. It shows a very young workforce which will age significantly over the next 50 years. In just over 25 years, by the year 2020, the percentage of persons age 60 and over will increase from 5.3 percent to over 10 percent. The ratio of the population between age 25 and 60 to the population above age 60 is an indicator of the number of potential workers to retirees. This ratio is currently close to six and is expected to stay level for another 15 years and then drop to close to three by the year 2040. As more employees reach retirement, the cost oif pension and related benefits will be expected to increase, especially under a partially funded system such as the Philippines. This expected demographic change calls for a closer analysis of the various individual programs (retirements, disability, etc.) which are driving the benefits increases. At a minimum, it would  - vii - be prudent for the GOP to exercise restraint in legislating annual benefit increases across the board. The continued rapid increase in SSS disability claims is also cause for further analysis. 28. Levels of benefits have increased at a rapid rate because of generous increases in SSS benefits granted by legislators, who perceive that the SSS has a very large pool of funds which have to be utilized to increase the benefits for the members. The GSIS provides a pension at retiremetit of close to 80 percent of final salary for those with a full career of 35 years for those within the wage base ceiling. The SSS also provides a very generous pension, aiming at a salary replacement rate at retirement of close to 70 percent for a full career of 35 years, with higher wage base ceilings. The dependent's pension, in this case, is at the level of 100 percent of the member's pension. There seems to be less appreciation of the fact that these obligations are on longer terms and the level of benefiLs have to be kept at a realistic level so that the system will remain solvent. 29. The other possible contributing factor for this mismatch is the low level of compliance and possible abuse in medical claims. There is a need to review the claims process to correct the abuses. As far as compliance is concerned, it is recommended that the SSS consider crediting service on the basis of contributions made rather than years of participation. This will act as a deterrent to the contributors who are contributing solely to meet the minimum eligibility criteria. 30. Operational Performance of GSIS. In 1993, the GSIS was providing service to over 1.4 million members. A total of 691,560 persons received benefits of some sort from its Social Insurance Fund. This is by far the largest GSIS fund, with expenditures over 5 times more than the amnount paid in the second highest category, Medicare. Payments for Employee Compensation claims ranlked third in monetary value, but were just about one-half as much as Medicare payments. Property Replacement, General Insurance, Optional Life Insurance, and Barrio Officials Insurance round out the benefit categories administered through GSIS. 31. During 1989-93, member contributions rose from P 4.85 billion to P 10.85 billion, an average annual increase of 22.3 percent. Benefit payments rose at an annual rate of 25.8 percent, with the sharpest increase in medical expenses which rose fourfold during the period. While these numbers may indicate the financial performance of the GSIS is superior to the SSS, a further analysis of the situation paints a different picture. DBM still covers pension payments for some pre-1977 government employees. While GSIS benefits have been historically low, they are expected to double in the future, and its policy holders are aging (see Chapter 5). Furthermore, the return on investment has been subpar. Finally, its operating expenses are higher than those of the SSS. In 1993, total operating costs for the GSIS were P 886 million or 5.6 percent of the total revenue and 1.5 percent of total assets, compared with the ratio of 3.8 percent and 1.0 percent, respectively, for the SSS. Compliance 32. Compliance refers to the accuracy and timeliness of contributions made to the svstem in accordance with statutory mandates. Contributions can come completely from einployers when they withhold an employee's share of contributions through payroll deductions or when there is no employee contribution. In some cases, employees or the self-employed may contribute directly. In tihe Philippines, the employer is responsible for deducting the employee contribution from payroll and is therefore liable for submitting both the employer and employee contributions to the proper institution. The issue of employer compliance with reporting and contribution requirements is a concern in many social security systems, especially when coverage of groups of workers is expanding. This is a rmatter of particular concern because of the low rate of compliance experienced in the Philippines. While it is not possible to arrive at an exact figure, estimates of employer compliance with SSS contribution requirements range  - viii - about 35-55 percent. This is a very low rate. While not out of line with other countries in similar coverage situations, it is a cause for concerted attention. It rewards non-compliant companies by givinig them a competitive advantage over companies making regular contributions, and reduces beaefits for many - usually those at the lowest end of the earnings scale. These effects combine to gcnerate an overall lack of faith in the viability of the social security system. 33. The SSS has recognized the seriousness of this problem and has devised an ambitious program to increase compliance. This program calls for an increase in the number of SSS inspectors and greater cooperation with Department of Labor and Employment inspectors, as well as the more aggressive prosecution of employers in the courts. It is recommnended that SSS accelerate the implemen.ation of these measures. 34. There are currently over 500,000 employers in the Philippines and the number is growing. At current staffing levels, each SSS inspector is responsible for over 1,500 employers. Redeployment of staff and close cooperation with labor inspectors who are visiting many of these same employers will alert them to when compliance is a priority. The litigation strategy employed by the SSS in the past has been to prosecute employers only under the civil code for failure to comply with reporting and contribution requirements of the SSS. Under their new campaign, SSS lawyers are attempting not only to prosecute more cases but also to invoke criminal penalties for lack of compliance. 35. In addition to these efforts, it is recommended that five additional measures should be considered. First, a single person with a high level of authority should be designated at SSS headquarters to coordinate the compliance strategies. This person could also be a communications poiPt for disseminating information about particular successes being achieved by the different branch offices in their compliance efforts, thereby spreading word of "best practices". Second, awareness of compliance lapses should be increased through data exchanges with other entities. Third, a review of the soundness of the present formula should be a matter of priority since employees receive credit for a full year of work after making contributions for only six months - providing a disincentive to contribute each month. Fourth, an aggressive public relations campaign should be undertaken to inform workers of the benefits that they may be losing due to the lack of reporting. Finally and most critically, there must be some firmer statutory base to assist SSS in collection of contributions. It is recommended that municipalities be required to verify compliance with SSS prior to renewing licenses for business establishments. This is particularly useful, because there is no tax compliance data base for SSS to rely on. We would propose that SS devise an automatic process for the municipalities to use so that this verification would take no longer than 2 or 3 weeks. 36. Compliance is not a problem for the GSIS since the Government as employer withholds employee contributions from payroll deductions and can submit full contributions to GSIS. While there are no compliance problems, there is a dispute about how to deal with payment of contributions by DBM for those employees who opt to retire under R.A. 1616. See Chapter 5 for a full discussion of this issuje. It is recommended that NG settle its outstanding overdues with GSIS as soon as possible. 37. Fraud Potential. Because of the disproportionate growth of claims and benefit payments in the disability and Medicare programs, a thorough analysis needs to be made to uncover the cause and status of any potentially fraudulent activities. Appropriate prevention and detection measures should be developed.  - ix - Financial Performance 38. As mentioned both social security institutions in the Philippines are defined benefit plans. The provision for defined benefit coverage impacts upon financial operations in two ways. First, it requires the institutions to meet contractual obligations in the future. This means that existing assets and future contributions less benefit payments have to be managed in such a way that contractual obligations are met in full. The soundness of the plans is normally assessed periodically thiough actuarial assessments (see Chapter 5). Second, it is common practice for social security institutions not to record future liabilities as contingent liabilities on their published accounts but to reflect them in separate actuarial assessment reports. 39. The financial performance of the two institutions is discussed in Chapter 4 and summarized here. Both funds have grown substantially during the 1989-1993 period. GSIS reserves more than doubled, while the SSS fund in 1993 was slightly less than twice the 1989 total. The combined assets of the two funds in 1993 were P 163.1 billion (US$6 billion). Both the SSS and the GSIS have been able to generate net income and accumulate relatively large reserves during each of the last five years. Although the share of contributions in total income for the SSS has been declining, the SSS added more than P 57 billion to reserves since 1989 due to investment income. It would have been able to add substantially more reserves had it followed a different asset allocation strategy (para. 46). During the same period, the GSIS was able to add almost P 33 billion, mainly because its contribution levels were higher and exceeded benefit payments, and due to partial coverage of pension payments for some government employees by the DBM (para. 35). The reserve level of the GSIS would have been substantially higher if it did not have a large carrying cost because of non-payrment by DBM of the government contributions to GSIS funds (about P 4.6 billion), and had it followed a more prudent investment policy. Asset Management 40. The two social security institutions generate large amounts of long-term funds that need to be managed effectively to obtain the highest risk adjusted return so that the income plus capital gains will be adequate to meet future obligations. Recent trends in financial indicators of both institutions make a strong case for strengthening their asset management capabilities. 41. Asset Allocation and Fund Management. The investment of reserve funds is a critical function of both the SSS and the GSIS. Both institutions have a fiduciary responsibiHity to ensure that funds are managed prudently and invested in a diversified portfolio which will geneIate the highest risk adjusted returns, enabling them to meet future obligations in full. 42. Investment Policy and Guidelines - SSS. SSS investment policies are set forth in RA 6111, as amended. Specifically, the institution is required to accumulate all funds in excess of its administrative and operating expenses and benefit obligations in an Investment Reserve Fund, with fund investments mandated to earn at least 9 percent. The law allows the SSS to invest in a wide array of instruments, including a variety of types of loans to members, real estate loans, government securities and private listed equity and marketable securities. It also specifies ceilings for each investment category, most of which may not exceed 10 percent of the Reserve Fund. Investments in direct housing loans, however, may account for up to 30 percent of the Reserve Fund and no ceilings are mandated for government securities. Beyond these legal provisions, the SSS has issued written guidelines governing its fund management decisions. These guidelines provide overriding principles and objectives for investing, stressing sound criteria for maximizing returns consistent with maintaining the safety of principal and liquidity. The SSS stresses prudence and sound business/financial principles as well as the  importance of benefiting as many members as possible and supporting the social and economic development programs of the GOP. Although these guidelines are quite sound, they are now less appropriate for a pension fund such as the SSS. Given the nature of its obligations, SSS has a long-term investment horizon and should be allowed to engage in more equity investments. Worries that government ownership of equities might lead to greater government interference in private activities could be met by restraints on ownership in particular companies and sectors and on voting rights as well as keeping asset management at arms length from government. Capital gains are tax exempt in the Philippines. The investment limits which are prescribed in the law will need to be replaced by general principles such as prudent man rules, diversification, and risk adiusted returns. Policies regarding asset allocation (i.e.. ceilings for each class of asset and investment limits on individual issues) should be left to the Trustees. A revised investment policy should be prepared with the assistance of a well-recognized investment advisor. Such a policy should be constructed with adequate safeguards to ensure sound management of the assets. 43. Investment Policy and Guidelines - GSIS. The Charter of the GSIS provides managers with some investment guidelines, but to a much lesser extent than the SSS. In PD 1146. the law grants full authority to the Board in determining fund allocation among different instruments. There appears to be little else issued formally in terms of specific guidelines governing asset allocation and investment policies. There is a clear need for the GSIS to devise a written policy with external assistance along the lines suggested for the SSS (para. 42). 44. Asset Mix and Portfolio. Both the SSS and the GSIS have a somewhat different portfolio composition from either the private pension funds or the AFP. The maior differences lie in the greater allocations to government securities and member loans by both the SSS and the GSIS, and the lesser emphasis on marketable securities. The other major features of their portfolios are: (i) large member loans at below market rates; (ii) large exposure in housing loans through the NMHFC, which is reportedly in financial distress; (iii) poor accounting of portfolio quality. The accounting standards uised for reporting SSS and GSIS portfolios are not in accordance with generally accepted accounting principles; and (iv) underallocation to equity investments. 45. As of the end of 1993, the SSS and the GSIS combined had allocated mc,re than P 25.8 billion (US$956 million) to NHMFC's housing program. While these investments are collateralized by mortgages and guaranteed to an extent by the NG, they have a high carrying cost and potential for loss because of the NHMFC's poor financial condition. Given the NG's commitment to the unified housing program, the SSS and the GSIS have been asked to allocate an additional P 10 billion to the program in 1994. However, these measures can only erode further the capital of these institutions if structural remedies are not made with the program. Financing housing is a viable activity if it is done correctly. Given that the Philippines has a vibrant banking system and the established pattern of wholesale financing through government financial institutions, it is recommended that the SSS and GSIS create wholesale lending facilities for housing to be made available to eligible participating financial institutions at market rates. The participating financial institutions (PFIs) would be responsible for the credit risk. In the meantime, an independent assessment of the NHMFC will need to be carried out. 46. The historical experience of most countries has confirmed that equity investments generate much higher risk adjusted returns over time than other classes of assets, although such investments are more volatile in the short-term. Because of these experiences, most pension funds should allocate between 40-70 percent of their assets in equity investments with internal diversification. The present limit of 10 percent was appropriate in the past because of the very small size of the domestic equity market. However, the domestic market is now much larger, making a strong case for revising this limit upward. This would be consistent with maximizing the risk-adjusted return on the portfolio. As discussed earlier,  - xi - asset allocation ranges should not be prescribed in law, but should be decided upon by the 1'rustees. The increased allocation in equity investment will also foster the development of the domestic capital market as it will increase the pool of funds for equity investment. 47. Investment Performance. During 1989-93. both institutions realized returns less than the Treasury bill rates. The SSS fund outperformed the T-Bill yields in only two years and barely kept pace with inflation, while the GSIS fund never did. The GSIS performance was particularly poor since its investments yielded an average return of only 11.8 percent, and the annual yield on total assets was only 8 percent - below the inflation rate during the same period. When adjusted for inflation over the period, the real rate of return for the SSS portfolio was only 5.0 percent, and the return for the GSIS was actually negative, with a -0.6 percent real rate of return. Low yields result from asset allocation decisions under which the majority of assets are allocated to those programs which offer below market returns with potential credit risks and a lower allocation is made to those programs providing higher risk adjusted returns. There is clearly room for further improvement through a better mix of assets arnd improved asset management. It is, therefore, recommended that the institutions consider appointing private fund mangers to manage a major part of their assets starting with a pilot project. In the meantime, in-house asset allocation capability should be strengthened to improve returns and enhance ability to monitor performance of fund managers. Actuarial Assessments of the SSS and the GSIS 48. Given the long-term nature and complexity of many of the commitments undertaken to provide for benefits to contributing members, a comprehensive detailed actuaria5 assessment is essential. The internal actuarial departments of both the GSIS and the SSS carry out actuarial studies of their various funds, annually in the case of the GSIS and once every five years in the case of the SSS (the last one having being performed as of January 1, 1990). These investigations have some limitations for the following reasons. The available figures do not fully reflect the current situation. In the case of the SSS, much has happened since the last valuation some four years ago by way of pension increases, changes in wage base ceilings, general increases in benefits, and changes in compliance. For the GSIS, the internal valuations are limited by the data that are made available to them and no adjustments are made to reflect the inadequacies. The actuarial methodology used differs for the two systems, thus making comparisons of limited value. The method of valuation used by the GSIS does not call for the long-term projection of benefits and contributions. The valuations are carried out for internal purposes and do not make explicit allowance in the assumptions for certain important elements of the programs which are crucial to the current study. 49. Funding Method Used by the SSS. For its main social security benefits, the SSS has adopted a system known as the scaled premium method. This method of funding is recommended for developing countries by the ILO. It involves a long-term projection of cash flows. items of income (contributions and investment earnings) are compared year-by-year with iterns of expenditure (expected benefit payments and expenses). The current level of contributions would be considered to be satisfactory if, for a sufficiently long period in the future, income is expected to exceed expenditures. 50. Funding Method Used by the GSIS. For its Social Insurance Fund, the GSIS has adopted a method which would appear to be one that aims towards full funding, in common with many private occupational plans. Instead of evaluating future cash flow projections, past service liabilities (i.e., the present value of benefits that have accrued with respect to past service rendered) are determined and compared with the value of assets as of the measurement date. This follows a more traditional accounting style of presentation which employs an actuarial balance sheet. In determining past service liabilities, assumptions are made for future pay increases.  - xii - 51. It should be noted, however, that the membership data used by the GSIS for its valuations do not reflect updated salary information and no adjustments are made on account of this. Salary data, in most cases, are several years out-of-date. Moreover, no future pension increases are anticipated and the wage base ceiling is assumed to remain at current levels. The liabilities calculated by the GSIS are therefore significantly understated. Thus, although the GSIS uses what at first glance appears to be a full funding method (assets held by the GSIS are approximately equal to the liabilities calclilated by the GSIS), the method as it is applied results in the accumulation of assets that more closely resembles a partially funded program. 52. The scaled premium method was used by the actuary which carried out the independent assessment for this study. The SSS funding method involves the projection of fuitire cast flows, and an analysis of long-term cash flow trends is essential to a proper understanding of the actuarial status of these funds. 53. In connection with this study, an independent actuarial assessment was carried out for the social benefit programs by a well-known actuarial firm in the USA. Chapter 5 discusses Lhe findings and additional information is provided in Annex B. Main points are highlighted beiow. 54. GSIS. The actuarial assessment shows that the GSIS's reserves will be fully depleted by the year 2015 (Chart B.2, Annex B) unless corrective measures such as higher contribution rates, improvements in returns, or a reduction in benefits or a combination of these measures are taken in time. Two main conclusions can be drawn with relation to the GSIS Social Benefit programs. First, the current level of funding of the GSIS (after removal of the assets needed to cover the life insurance liabilities) is very inadequate; assets are only some 10 percent of the projected past service liabilities with allowances for future pay increases. This inadequacy, despite the substantial contributions made in past years, is the result of the low returns on invested funds. The internal appraisal of the GSIS as of Januarv 1, 1994, reveals a close balance between assets and liabilities only because of the overly optimistic assumptions and the use of out-of-date data which led to an understatement of liabilities. Second, again, despite substantial contributions, the net cash flow and the funding level both display an unsatisfactory trend over future years. 55. SSS. The actuarial assessment shows that the SSS's reserves will run out by year 2021 unless corrective measures are taken in time. Regarding the Social Benefit programs of SSS, both the current level of funding and the trends in future net cash flow and funding leveis indicate the adverse financial position of this system. With respect to funding levels, the rapid increases which have occurred recently in the wage compensation base have led to significant increases in liabilities without comparable increases in available funds. Although there is no internal valuation current enough to provide a basis for valid comparisons, the valuation of four years ago appears to suggest that the scaled premium structure would be adequate in the intermediate future only through the use of an exceptionally optimistic set of valuation assumptions. The present assessment shows a rapidly worsening cash flow situation and an imperative need to adiust the scaled premiums within the next few years. Objectives of the Reform 56. Recognizing that a study of the social security sector could focus very narrowly on just the effect on capital markets or might be so broad as to challenge the basic objectives of the programs, the mission team developed objectives for framing the study. The following four objectives guided the formulation of the recommendations for the study:  - xiii - * Assisting the Social Security Institutions in Achieving their Objectives. The objectives of the social security institutions have been developed over a long period of time and are consonant with well-established social objectives in the country. However, some ot these objectives like universal coverage and long-term financial security for all workers and their dependents will not be achievable without substantial action. * Enhancing the Role of the Social Security Institutions in Capital Market Developmnent. As noted in Chapter 2, the social security institutions are the single largest mobilizer of long-term funds in the country. However, the short-term nature of their current investments, in many instances at below market rates, has constrained the development of the capital market. * Helping the Govermnent Improve the Efficiency of the Social SecuritV Sector. Inefficient program administration contributes to the lack of public confidence in any program. Improving the efficiency of the SSS and the GSIS will not only improve public confidence, but also lead to better service and financial savings. * Improving the Legal and Regulatory Framework. The myriad laws and amendments to the laws that govern the SSS and GSIS inhibit public understanding, obscure transparency. and expose the institutions to potential misuse and mismanagement. 57. In light of these objectives, a diagnosis of the problems affecting these two institutions suggests a package of reforms which include a restructuring of the social security sector. Although some reforms in the existing structural arrangements of each of the institutions can address some of the problems identified, it is our view that a thorough review of both programs should be undertaken. 58. Financial viability of both institutions can be immediately enhanced thrcugh better asset management and adjustment of the contribution rates. However, a thorough analysis of the effect of these actions on the currently separate SSS and GSIS programs was not done in this study. We did projec2t the effect of increased asset returns and increased contributions on a merged fund. The results are summarized in para. 61 below. If these increases were to be applied to the separate SSS and GSIS programs several variations should be explored to determine the best and most acceptable increases. Suggestions for this type of review are contained in Chapter 6. It is recommended that this GCP proceed with actuarial analysis of each of the two programs. 59. Merged Social Benefits Program. We examined several options for merging the SSS and GSIS. Annex D describes the options considered and a recomnmended course for mergzr. A transition plan is also included. 60. In addition, Annex D discusses the actuarial assessment of a merged system. The assessment shows that, by including current and future government employees in the SSS contribution and benefit structure, net income of the fund will become negative by year 2007, or about seven years earlier than the projected level of SSS without the merger. Similarly, the merged fund would be fully depleted by 2014, about seven years ahead of SSS. The reason for this is that SSS will have to bear the burden of the GSIS funds which will run out earlier. 61. An analysis demonstrates that the financial soundness of a merged social benefits program can be strengthened considerably by improving the investment performance and increasing the current rate of contribution. By achieving investment returns that are three percent higher on average than what is assumed under the base scenario, and by raising the contribution rate from 8.4 percent to 11.4 perzent  - xiv - of covered salary, the life of the merged fund would be extended to 2026. an increase of 12 years. Other measures such as raising retirement ages or reducing replacement rates could also be used to further strengthen the position of each institution or the merged institution. For a discussion of some considerations for revising the social benefits system see Chapter 6. 62. The Social Benefit Fund of the GSIS is projected to plateau by 1996 and to actually begin decreasing between 2007 and 2010. The SSS Social Benefit Fund on the other hand will continue to increase until at least 2007 (see Table 5.1). By merging the SSS and the GSIS Social Benefit Funds the decrease in fund build-up would not begin until around the year 2000 (see Chart 6.2). If immediate measures are taken to improve investment return this timeframe could be extended another 6 to 10 years (see Chart 6.3). This would enable basic policy changes in the programs to be analyzed and debated and even phased in beginning in the 1996-1998 timeframe. All of this could be accomplished in time to prevent the assets of the funds from beginning an irreversible decline. 63. Since both the SSS and the GSIS are expected to face increasing financial pressures in the coming years, it will be advisable to begin appropriate actions now. Aside from policy changes in the design of the overall system, the contribution structure of each will need to be reappraised, and it will be easier to do this for one system than for two, assuming equity in treatment of workers is a desirable goal. Moreover, the demographic situation is still favorable, with heavy infusions of young workers to support future benefits; it would be preferable to begin the reform as soon as possible since, as the covered population matures, the costs associated with system change will increase.  CHAPTER 1 INTRODUCTION A. Macroeconomic Background 1.1 The Philippine economy is now beginning to experience an economic recovery after two years of recession. Table 1. 1 presents some of the key economic indicators for the country over the last five years. The increase in real output by 4.3 percent in 1994, and the maintenance of inflation at single digit levels, reflect the success of the stabilization efforts and structural reforms undertaken by the Government. Table 1.1: Philippines - Key Macroeconomic Indicators, 1990-94 1990 1991 _ 192 I 1993 199* Growth Rates (%) Real GNP 4.5 0.7 1.4 2.6 5.1 Real GDP 2.7 -0.2 0.3 2.1 4.3 Key Prices Nominal Exchange Rate' 24.3 27.5 25.5 27.1 26.4 Real Effective Exchange Rate 100.0 98.8 109.6 106.9 114.1 Inflation Rate (CPI) 16.2 13.1 8.1 8.4 9.0 Interest Rate, Deposits 19.5 18.8 14.3 9.6 10.5 Interest Rate, 91-day T-Bills 23.7 21.5 16.0 12.4 12.7 Macro Aggregates (% of GNP) Gross Domestic Investment 24.0 19.9 20.8 23.8 24.4 Gross National Savings 18.6 17.7 19.0 17.9 19.8 Current Account Balance -6.1 -2.2 -1.8 -5.9 -4.6 Consolidated Public Sector Deficit -5.1 -2.1 -2.0 -2.1 -0.5 Domestic Public Debt 27.3 26.2 37.6 43.6 35.7 Total External Debt 64.5 65.2 57.0 61.2 58.8 Money and Credit (% of GNP) M2` 33.9 34.0 36.3 A0.9 44.1 Reserve Money 10.4 10.7 11.1 12.0 10.4 Net Domestic Credit 23.1 19.3 20.7 43.6 45.1 Of which: Private Sector Credit 19.2 17.6 20.1 25.6 28.1 Notes: a/ peso/US$, period average. b/ equals sum of currency outside banks, and demand, time, savings, and foreign currency deposits of resident sectors other than the central government (IFS lines 34 +35). Sources: IMF, IFS, Central Bank.  - 2 - 1.2 The stabilization effort has helped in reducing macroeconomic imbalances. The consolidated public sector deficit was reduced from 5.1 percent of GNP in 1990 to 0.5 percent of GNP in 1994. The inflation rate has declined to 9.0 percent in 1994 from about 16 percent in 1990. Gross official reserves, while still low, have increased from US$2.0 billion (equivalent to 1.5 months of imports) to US$7.0 billion in 1994 (equivalent to about 3 months of imports). 1.3 Structural reform has spanned a wide range of policy areas. Trade policy has been significantly liberalized with a reduction in tariffs and quantitative restrictions. Restrictiorns on foreign ownership have been loosened and approval procedures have been simplified in an attempt to attract foreign direct investment. Exchange controls have been almost completely relaxed with virtual convertibility on the current account, including full repatriation of profits, dividends and capital on registered foreign investments. Marketing monopolies in the agricultural sector were abolished and most controls on producer prices were eliminated. A comprehensive agricultural reform program for acquiring and redistributing land was been introduced. An ambitious privatization program has also been underway with 301 public corporations targeted for divestment. Over 80 companies have already been privatized so far, including the national airline. Finally, in response to the severe electricity shortages which plagued the country in 1991-92, the Government opened up the power sector to private participation. The resultant surge of private investment effectively eliminated the shortages. 1.4 These stabilization efforts and structural reforms will contribute to modest economic growth in the near term. However, additional efforts will be required if an adequate level of growth is to be sustained. Savings remain low at less than 20 percent of GNP, substantially less than the historical level of 26 percent achieved during 1973-80 and comparably worse than neighboring countries. The savings rate is more than 30 percent of GDP in Indonesia, Malaysia, and Thailand, and more than 40 percent of GDP in Singapore. This low savings rate may reflect, in part, the low level of financial internediation. The ratio of M2 to GNP at 44 percent is about half that of Malaysia and Thailand, and around 40 percent of that in Singapore. A major cause of financial disintermediation in the early 1990s was the large operating losses of the Central Bank of the Philippines (CBP) and the financing of these losses through the banking system in the form of excessive reserve requirements (25 percent). 1.5 Domestic savings are also depressed by the high level of consolidated public debt which keeps real interest rates very high. The interest rate on 91-day Treasury bills was close to 24 percent in 1990. Measures such as the major financial restructuring of the CBP in December 1993 in connection with the Financial Sector Adjustment Loan (para. 1.7) have contributed to the sharp dcc1ine in the T-bill rate to average 12.7 percent for 1994. The absence of continuous borrowing by the CBP to meet its cash flow requirements and monetary targets have also provided a more stable environment for financial markets in general and the banking system in particular. One of the major sources of long-term savings in the Philippines is the Contractual Savings Sector (CSS), which has only partly invested in productive investments.  B. Developments in the Capital Market Overview 1.6 The growth of the capital market has been constrained in recent years by several factors, including political uncertainty, the power crisis, and the distortion caused by the insolvency of the central bank. During the 1980s, balance of payment difficulties and an overvalued exchange rate led to a decline in the holding of financial assets as measured by the ratio of M2 to GDP. Although this ratio rose from 33 percent in 1989 to 44 percent in 1994, it is still only half the comparable figures for Malaysia and Thailand. With the election of President Ramos in December 1992, the restructuring of the CBP in December 1993, and the return to normal power supply conditions in late 1993, financial markets have rebounded on all fronts. The interest rate on government securities plummeted below 13 percent for 1994. The Philippine stock market was one of the best performing in the world in 1993, evidenced by a rise in the ratio of stock market capitalization to GDP from 15.1 percent in 1990 to 69.6 percent in 1993. Foreign portfolio investment has increased sharply, and foreign direct investment almost doubled in 1994. Although the Philippine capital market experienced remarkable growth in 1993 and 1994, it is still very small in relation to other ASEAN countries such as Thailand and Malaysia. Therefore, tremendous potential exists for the capital market to act as the engine of growth for the ecopomy. This report argues that the CSS has a major role to play in this respect. Government Securities Market 1.7 The government securities market was profoundly affected by the passage of Republic Act No. 7653 on July 3, 1993, which created the new Bangko Sentral ng Pilipinas (BSP), later established on December 23, 1993. During the previous four years, monetary policy management had been rendered ineffective. Since the CBP did not have a portfolio of government securities to conduct open rnarket operations, it had to rely on the GOP to raise resources through the issuance of Treasury bills to cover its operating losses and additional funds required to meet monetary targets. The excess amount raised through this action was deposited with the CBP for conducting open market operations. With the restructuring which took place in December 1993, the BSP (the new central bank) acquired a large amount of T-Bills (P 280 billion) on its books which could then be used for open market operations. 1.8 The volume and magnitude of BSP-administered issuances and transactions continued to expand and total government securities issued through the BSP increased by about l 140.7 billion (or 27 percent) in 1993 to l 655.3 billion, with a reduced weighted average rate of 15.0 percent as against 16.6 percent in 1992. The surge in the primary market was also reflected in secondary market sales and the consolidated sales and purchases of Treasury bills and floating rate treasury notes (Fi'TNs) within the dealer network was reported at P 2.04 billion. The issuance of the T-bills is carried out through a book-entry system, which accounted for about 96 percent of the gross issues. The scope of coverage by the book-entry system was expanded to include BSP Bills aside from T-Bills (auctioned, top, GOCC/Special Series) and FRTN issues. Likewise, the range of institutional partLicipanr,s was broadened to cover all thrift-banks, nonbanks with quasi-banking licenses and special trust accounts. The custodianship facility, established in conjunction with the book-entry system, held about P 39.9 billion in securities. 1.9 To keep pace with the growing volume and complexity of the market, it is vitally important to ensure the continuous efficient administration of the market and its smooth transfer of the fiscal agency  - 4 - function to the DOF. To this end, a prime pre-requisite is to develop high-grade and weli-motivated GSD staff with the professional expertise to keep abreast of market developments. At the samte timne, high priority should be accorded to the full computerization of GSD operations, both hard and software systems. 1.10 Most government securities carry maturities of less than one year. In an effort to create a larger pool of long-term capital, the GSD began issuing Floating Rate Notes (FRNs) in 1991, and the program has been highly successful. As of May 31, 1995, the amount of the FRNs amounted to P 123 billion, or 31 percent of outstanding Treasury bills. Since October 1994, the NG has been issuing two year fixed rate notes, and in June 1995 issued five years fixed rate notes, thereby providing a benchmark for pricing long-term corporate securities. Given more stable macroeconomic conditvons and financial markets, it is recommended that the GOP consider auctioning additional fixed interest long-term securities. To facilitate the success of these notes, the GOP should consider removing the stamp duty, clarifying the taxation regulations both on interest income and capital gains from fixed interest rate long- term securities, improving the clearing and settlement systems, and providing information to market participants on a timely basis. These measures are discussed in the Capital Market Study. The CSS, especially the two social securities institutions, can play an important role in contributing to the growtl; of a robust government securities market (Chapter 2). The Stock Market 1.11 There have a been a number of notable developments recently affecting the stock market. The first was the unification of the Manila and Makati Stock Exchanges at the end of March 1994, and their consequent functioning under a one-price system. Another major development was the unanimous ratification by the Senate on April 28, 1994, of the Stock Transactions Tax Bill, which provides for a graduated three-tiered tax on initial public offerings (IPOs) and aims to encourage broader public ownership of closely held firms. A "closely held" corporation is defined as one in which at least 50 percent of the outstanding capital stock or at least 50 percent of the total combined voting power of all classes of stock entitled to vote is owned directly or individually by 20 individuals. 1.12 Tax rates will be based on the proportion of the stock sold, bartered or exchanged or disposed, to the total outstanding shares of stock after the listing on the stock exchange. 'rhe tax will be paid by the issuing firm in the case of primary offerings or by the seller in the secoind offering. This year, more than a dozen firms have reportedly lined-up P 30 billion worth of IPOs. The same Bill increases to one-half of one percent the prevailing one-fourth of one percent transfer tax on the gross selling price of publicly-listed shares. Given the modest increase in the tax rate, it is unlikely to have a major impact on the volume of public issues or stock exchange activity. The equity market continues to experience rapid growth and market capitalization increased from US$13.7 billion in 1992 to US$40.3 billion in 1993. The turnover ratio also increased during the same period. At the end of February 1994, the Philippine constituents comprised about 5.6 percent of the total investable market capitalization ot the 10 Asian markets followed by the IFC. Daily trading value averaged US$40 million in February 1994, a sharp increase from the past, but still modest compared with a daily trading volume of US$500 million in Thailand. The buoyancy of the market is also borne out by the rise in the number of listed issues from 254 (1990) to 284 (1993). 1.13 A final noteworthy development concerns Congressional ratification (April 29) of the amendment to the Build-Operate-Transfer (BOT) Law, sections of RA No. 6957 ("An Act Authorizing the Financing, Construction, Operation, and Maintenance of Infrastructure Projects by the Private Sector,  - 5 - And For Other Purposes") which, among other provisions, permits negotiations instead of bidding for award of contracts for infrastructure projects. The amendment would also allow companies conducting pre-feasibility and feasibility studies on major infrastructure projects a first "crack" at securing the contract. The amendments are aimed at speeding up execution of infrastructure projects. Reportedly, five Malaysian conglomerates (Penang Group, Malaysian Airlines, Diversified Resources, Country Heights, and the Landmark Group) are awaiting Presidential approval of the amended law. The prospective BOT projects include toll roads, housing projects, resorts, and airports. C. Objectives of the Study 1.14 In 1992, the World Bank conducted a study of the capital market in the Philippines.' The study highlighted the importance of the contractual savings sector (CSS) in capital market development, identified weaknesses and problems in the CSS, and made several recommendations for enhancing its efficiency. The study also recommended a comprehensive reform of the country's two social security institutions - the Social Security System (SSS) and the Government Service Insurance System (GSIS). The prospect of merging the two social security institutions was raised but not examined at that time, as it was beyond the scope of the study. Subsequently, in early 1994, the GOP formally requested the Bank to study this major institutional issue, which led to a Bank mission visiting the Philippines in April-May 1994. 1.15 The paucity of long-term domestic funds in the Philippines brought this issue to the forefront. The CSS and the fast growing stock market are the only major sources of sach funds. The CSS is a particularly appropriate source of long-term funds because of its assured cash flows and long- term liabilities. To the extent that the assets of the social security institutions comprise more than 60 percent of the assets of the CSS (see Chapter 2), they are the primary players in the CSS. In principle, by mobilizing these long-term savings, the social security institutions can make non-inflationary Jong-term finance available to those who can use it most efficiently. The long-term maturity structure of their liabilities also creates a demand for matching financial assets, in the nature of equities and fixed income securities. This is particularly relevant as the size of the resources available to them, and tc the CSS in general, can provide an effective primary and secondary market for government and private securities, expand the capital market, and generate demand for professional investment and fund managers which will help establish a funds management industry. 1.16 The social security institutions, in particular, have thus far played only a limited role in capital market development. This has been due to several reasons. Regulatory constraints have meant that both the SSS and the GSIS have allocated only limited amounts of their assets to long-term securities such as equity. The lending policies of these institutions have also favored consumption loans to members at subsidized interest rates. The weaknesses in the operational performance and in the institutional structures of the social security systems have also undermined their potential importance to the CSS, In addition, the continuing volatility of interest rates has made even the private pension system and the insurance sector fairly myopic in the conduct of their investments. 1.17 The need for a comprehensive package of reforms for the social security institutions is, therefore, clear. Such a strategy would also complement other financial sector work carried out by the I Philippines: Capital Market Study, World Bank, Report No. 10053-PH, February 24, 1992.  - 6 - Bank over the last three years - starting with the reform of the banking system, the restructuring of the central bank, and improvements in the government securities market. It would aiso reinforce financial sector work undertaken by the Asian Development Bank on the equity market, including unifying the two stock exchanges, strengthening of the Securities and Exchange Commission (SEC), and improving the clearing and settlement system. D. Structure of the Study 1.18 The study is based on the findings of a Bank mission which visited the I'hilippines in April- May 1994. It also builds on the findings and recommendations of the 1992 Capital Market Study. Following this Introduction, Chapter 2 discusses the contractual savings sector in the context of examining the social security institutions. Chapter 3 examines the current status of the sociai security sector and the organization and administration of the SSS and the GSIS. Chapter 4 discusses the operational and financial performance of the SSS and the GSIS. Chapter 5 provides an actuarial assessinent of the Ewo institutions. Chapter 6 presents the various options to be considered when restrl]cturing the social security sector. The annexes contain various actuarial and statistical notes and a plan for merger of the two social security institutions.  - 7 - CHAPTER 2 THE CONTRACTUAL SAVINGS SECTOR 2.1 Contractual savings refer to any transaction whereby economic agents enter into a birding arrangement with institutions, whether public or private, to trade current consumption for future income. The prospective future income could be in many forms - for instance, as lump sum payments, annuities, or medical benefits. The nature of these contractual arrangements can be compulsory (e.g., social security schemes, provident funds) or voluntary (e.g., private life insurance and pension funds). In some countries in East Asia, such as Singapore and Malaysia, there is a pronounced policy towards compulsory or 'forced' savings, and national provident funds constitute the only major source of contractual savings.2 In some others, like Indonesia and Thailand, compulsory contractual savings schemes are rudimentary and the major sources of contractual savings continue to be voluntary in nature. 2.2 This chapter presents a profile of the CSS in the Philippines, discusses its potential for generating savings, identifies key linkages with capital market development, examines the tax status of the sector, and concludes with a discussion of the legal and regulatory framework of the CSS. A. Profile of the Contractual Savings Sector An Overview 2.3 Table 2.1 presents the profile of the CSS in the Philippines as of 1993. The CSS consists of the two social security institutions (SSS and GSIS), the occupational pension funds, and the insurance industry, both life and non-life. At the end of 1993, the total assets of the sector were estimated at e 256 billion. This represented a sizable pool of long-term resources, equal to more than one-quarter of the market capitalization of the listed issues on the two stock exchanges, 27 percent of the assets of the banking system, or 17.4 percent of the GDP. 2.4 The two social security institutions (SSS and GSIS) account for 60.2 percent of the assets of the CSS. At the end of 1993, the total assets of the social security programs were P 154 billion, 11 per cent of GDP. An accurate assessment of the asset size of these schemes depends on several factors, the most important of which are the age of the fund, its funding method, its level of contributions and benefits, its coverage, the demographic characteristics of its members, and the efficiency of investment of its surplus funds. 2.5 The occupational pension funds consist of private pension funds, the Armed Forces of the Philippines Retirement and Separation Benefits System (AFP), the Home Development Mutual Fund (Pag- ibig), and several multi-employer plans. These occupational pension funds are voluntary and consist largely of single employer occupational schemes. They are supplementary to the social security system. 2 In Singapore, the total assets of the Central Provident Fund alone were 72 per cent of GDP in 1987. Adding the assets of life insurance companies raises the ratio to 78 percent. In Malaysia, the corresponding figures were 41 per cent and 48 per cent, respectively. For more details, see D. Vittas and M. Skully (1991), "Overview of Contractual Savings Institutions," Working Paper Series No. 605, The World Bank.  - 8 - However, neither their actual number nor the size of their total assets is fully known. The AFP is not yet paying benefits. The Government provides for the benefits directly from the budget. The fund is currently used as an investment vehicle, but current plans will have it assume the payment of benefits at the point in time when the annual income from contributions and earnings on investments become sufficient to sustain ongoing operations. In 1993, the total assets of the AFP were close to P 7 billion. As the assets of the AFP grow, they will provide a growing source of long-term funds. The Pag-ibig offers supplementary schemes for both public and private sector employees and is now compulsory. Bank staff estimates put the total value of the assets of all the occupational pension plans at about P 40 billion in 1993.3 Table 2.1: Prorile of the Contractual Savings Sector, 1993 Social Security Occupational Insurance" | Total Pensions' : Total Assets (1 bn) 154.1 40.0 62.0 256.1 As % of CSS 60.2 15.6 24.2 100.0 As % of GDP 10.5 2.7 4.2 17.4 Assets of the Banking System' 957.5 Assets of the Financial Systemd 1,859.6 Stock Market Capitalization 1,009.1 Notes: a/ estimate. b/ estimate, assuming a growth rate of 10% in 1993. c/ data for September 1993; covers all banks - commercial, thrift, rural, and specialized government. d/ data for September 1993; sum of the assets of the banking system, central bank, and non-bank financial institutions. Sources: SSS, GSIS, Commission of Insurance, Central Bank, Philippine Stock Exchange, and staff estimates. 2.6 As of December 31, 1993, the total assets of the insurance industry, both life and non-life, amounted to P 62 billion. Much of it is in the private sector, but there are public corporations which also provide insurance. The most important public agent in this field is the GSIS, whose insurance business was worth P 9 billion in 1993.4 Other public institutions provide specialized insurance, including the Philippine Deposit Insurance Corporation, The Home Insurance and Guaranty Corporation, and the Philippine Crop Insurance Corporation. While the role of the Government in providing 3 The Wyatt Company's annual survey of 168 pension funds in the Philippines reveals that the assets of these funds have doubled between 1990 and 1993. This growth rate of 100 per cent was used as a proxy for the growth rate of the aggregated assets of occupational pension plans. The 1993 estimate was obtained by applying this rate of growth to the P 20 billion value that was estimated by the 1992 Capital Market Study. 4 This is the sum of the total assets of the General Insurance Fund, the Optional Life Insurance Fund, and the property Replacement Fund.  - 9 - specialized insurance can be justified, the commercial insurance provided by the GSIS should clearly be in the private domain and it is recommended that the NG consider divesting this business to the private sector as a part of the overall restructuring of the two social security institutions (para. 2. 11). 2.7 The size of CSS assets is substantial, and asset growth has been significant. CSS assets increased at an average annual rate of 18.1 percent during the period 1980-1993. This growth is largely attributable to the surge in SSS assets, which grew at an average annual rate of 20.5 percent during the same period. The GSIS grew at a slower rate of 14.0 percent, as did the insurance industry. Table 2.2 shows the growth rate of the CSS and its various components over this period. Table 2.2: Assets of the Contractual Savings Sector (in billions of pesos) Average 1980 1985 1990 1993 Annual Growth ._______ Rate (%) Social Security 18.4 43.1 98.6 154.1 17.8 SSS (9.2) (26.3) (62.5) (103.8) (20.5) GSIS (9.2) (16.8) (36.1) (50.3) (14.0) Occupational Pensions n.a. n.a. 20.0 40.0 n .a. Insurance 11.1 18.1 45.5 62.0 14.1 TOTAL CSS 29.5 61.2 164.0 256.1 18.1 GDP (Peso billion) 243.7 571.9 1,073.1 1,456.6 14.7 CSS/GDP 12.1% 10.7% 15.3% 17.6% Sources: SSS, GSIS, Commission of Insurance, staff estimates, and IMP. 2.8 While a detailed study of the social security institutions is presented in Chapters 3 and 4, the following two sections provide a brief description and analysis of the life insurance industry and the private pension funds, which are the other significant components of the CSS. The Life Insurance Industry 2.9 The life insurance industry comprises almost two-thirds of the assets of the insurance industry. It is principally owned and operated by the private sector, except for the GSIS which offers contpulsory and optional life insurance for government employees. The bulk of the total assets of the industry (about 84 percent) are held by domestic insurers. 2.10 The growth of the life insurance industry during the last decade has been impressive and has kept pace with domestic inflation and with the growth of the Philippine financial sector as a whole. (Tables 2.3 and Annex Table C. 1). This is all the more remarkable considering that the industry operates on an uneven playing field because of constraints such as higher discriminatory taxation relative to other segments of the financial  - 10 - sector. In fact, the growth of the life insurance sector has been faster than indicated by the published data, which exclude the so-called Pre-need sector in the Philippines. The Pre-need industry. which provides for specific benefits relating to education, cremation and internment, and pension fund accumulation, is essentially a form of insurance, and is recognized as such in other countries and offered by insurance companies. The Pre-need industry in the Philippines, which is a recent development, has been growing fast, with assets already estimated to be about e 1 billion. Its rapid growth is principally attributable to tax concessions which are not granted to the life insurance industry and to the differential standards of regulation imposed by the Securities and Exchange Commission. The Insurance Commission has no jurisdiction over the Pre-need industry. Table 2.3: Profile of the Life Insurance Industry _______________________________________ _ : V 1988 1989 199i 1991 1992 Life Insurance 23 23 23 22 23 Domestic Philippine National 19 19 19 18 19 Domestic Non-Philippine National 2 2 2 2 2 Foreign 2 2 2 2 2 Per Capita Exp. on Insurance) 126.55 146.93 164.79 15.29 210.92 Life Sum insured as % of GNP 21.16% 21.93% 21.55% 20.82% 24.60% Premiums (life and non-life including 0.94% 0.96% 0.94% 0.94% 0.99% professional reinsures) as % of GNP Composite (Life & Non-Life) 2 2 2 2 2 Memo: Number of Authorized Insurance Companies (Life 131 128 130 127 127 & Non-Life) __ __ _ Source: Key Data, Insurance Industry 1989-1992, Insurance Commission, Department of Finance, Department of Finance, Republic of the Philippines. 2.11 The growth and profitability of the insurance industry, however, has been afifected adversely by (i) the very high commission rates relative to elsewhere in the world; (ii) onerous discriminatory taxation (discussed later); (iii) overly conservative investment policies; and (iv) a failure to develop attractive new product lines. The industry, while financially sound, has played a marginal role in capital market development. Given the strong growth and the proven capabilities of the private iife insurance industry, and the need for reform and rationalization of the GSIS, there is a strong case for early divestiture of its life insurance business. 2.12 The asset mix of the industry shows a relatively high proportion of 3hort-term government securities (about 35 to 37 percent), which is explained in part by the very high yields on short-term Treasury bills. Stocks and property represent only about 20 percent of the assets. The prevailing composition of insurance industry investments results in a mismatch between the maturities of its assets (mostly short-term) and its liabilities (long-term), with a concomitant over-emphasis on short-term cash income rather than accumulation of capital and reserves.  - 11 - 2.13 If the industry is to maximize its contribution to capital market development, it will need to adopt an agenda to act concurrently in four areas: regulatory environment, institutional development, taxation, and the Insurance Commission. The recommendations relatiDg to the regulatory and developmental aspects as well as the reorganization of the scope and structure of the Insurance Commission have been set out in detail in the Philippines Capital Market Study.5 The Private Pension System 2.14 The private pension system in the Philippines is comprised primarily of voluntary single- employer occupational pension plans. This sector, while still relatively young, is an important source of retirement benefits for Philippine workers and one of the very few sources of long-term capital. Most of these employer sponsored formal retirement plans have tailored their benefit scliemes to satisfy the minimum requirements established by the labor code (i.e., a specific multiple of salaiy per year of service with the company). The average benefit is roughly 1.5 times the member's final monthly salary times years of service, and is typically paid as a lump sum at separation. 2.15 Comprehensive data are not available on the total size or growthi of pension fund assets, but a useful sample survey of 168 pension funds by The Wyatt Company gives representative orders of magnitude (Annex Table C.2). The median fund size as of end-year 1993 was P 26.2 billion. The portfolio composition of the average fund was about 50 percent in corporate loans, 24 percent in fixed interest investments, about 12 percent in stock, with barely 3 percent in real estate or direct equity participation, and the remainder largely in Treasury bills. The focus seems to 1e mostly on short-term gains in fixed income securities (1-3 years) with equities being traded more as speculative issues. Surprisingly, few investments are allocated to the stock market, despite its higher rate of returm over the long-run. Nevertheless, the private pension system is contributing to the development of the capital market through the involvement of financial intermediaries and external fund managers. 2.16 However, while occupational pension schemes are becoming more importanr in terms of the total assets invested in the various segments of the capital market, there is no agency to supe;vise and safeguard the quality and value of the investment portfolios. The Bureau of Internal Revenue is at present the principal government agency overseeing the registration and performance of employer sponsored retirement plans, but its perspective is purely oriented towards the tax aspects. Further steps are recommended along the lines indicated in the previous report on the Philippines Capital Market Study.6 These are, broadly, as follows: (a) There is a pressing case for the early creation of a regulatory unit within the Ministry of Labor to enforce current regulations for financial disclosure and compliance with generally accepted accounting principles to perform pension fund audits. (b) The Bureau of Internal Revenue should improve compliance with the tax code and develop the expertise to evaluate actuarial studies and contribution plans. Report No. 10053-PH, February 24, 1992, Vol. 11, Annex 2, pp. 139-143. 6 Ibid, Annex 3, p. 149.  - 12 - (c) Formulation of investment guidelines to diversify investments, provide incentives for greater participation in the equities market, reduce related party transactions, and restrict investments in the employer stock and related transactions to a ceiling of 10 percent of the total portfolio. (d) Representatives of employees on the board of trustees should be appropriately trained and oriented in pension fund management issues. (e) Individuals and the self-employed should be allowed to set up personal penision accounts with the same tax status as that accorded to occupational pension sectors. B. Savings Potential of the Social Security Institutions 2.17 The CSS has generated substantial savings. Contributions to savings by the constituent social security institutions can be measured by their annual additions to reserves - the excess of current revenues from contributions and investment income over current expenditures on benefit payments and operating expenses. In 1993, the additions to reserves of the SSS and the GSIS were close to P 21 billion, equivalent to 1.4 percent of the GDP and 7.8 percent of gross doniestic savings (Table 2.4). A better sense of the magnitude of these savings can be gauged by compariun the additions to reserves with the value of IPOs in the stock market. The aggregate addition to reserves was 1.6 times larger than the total value of IPOs in 1993: those of the SSS alone almost equalled the IPOs that year.' Although the level of savings mobilized is substantial, the social security institutions have not yet realized their full potential. As discussed in Chapters 3 and 4, the SSS suffers from low compliance with contribution payments while the GSIS has large overdues. There are also indications that present resources may not be able to fully cover the generous increases in benefits approved during the last four years. There is further a need to improve asset management functions at both institutions to increase the risk adjusted returns so that future obligations could be met without recourse to the NG. These inefficiencies on the revenue side have constrained the ability of these institutions to generate additional suirpluses. 7 Lack of disaggregated data for the occupational pension plans precludes estimation of their contribution tv savings.  - 13 - Table 2.4: Additions to Reserves of SSS and GSIS, 1993 SSS GSIS 'I'OTAL Additions to Reserves (P bn) 13.0 7.8 20.8 As % of GDP' 0.9 0.5 1.4 As % of Gross Domestic 4.9 2.9 7.5 Savingsb As % of Initial Public 99.5 59.7 160.2 Offerings I I a/ In 1993, nominal GDP = i 1,501 billion. b/ In 1993, gross domestic savings = 17.7% of GDP or P 265.7 billion. Source: SSS; GSS; IMF; the mission's estimates. 2.18 The empirical evidence on the effect of social security on aggregate savings is not conclusive. However, there are two general points which can be made about the CSS. First, the fact that voluntary private pension schemes have shown rapid growth along with the compulsory schemes administered by the SSS seems to suggest that the effect on aggregate private savings may well be salutary. Second, contractual savings, whether compulsory or voluntary, generate sigaificant positive externalities from their potential use for term finance.8 C. Role of Contractual Savings in Capital Market Development 2.19 The CSS is an ideal source for term financing, and potentially a substantial orne as well, owing to its assured cash inflows and long-term liabilities, which can be reasonably estimated through actuarial methods. Even if aggregate savings are unaffected, contractual savings will cause a shift in favor of long-term finance used to promote capital market development.9 A major gap in the capital market in the Philippines is the shortage of long-term finance, and the CSS is in a position to a play a major role in filling this gap without compromising its fiduciary responsibilities. 2.20 Although the liabilities of both the SSS and the GSIS are predominantly long-term, their assets are largely short-term (see Chapter 4). This stems from several factors, the primary ones being the high short-term rates on Treasury bills (between 15 to 28 percent during the nineties) and the very small size of the equity market (due to the crowding out of the private sector by thie NG and lack of political stability). The skewed pattern of interest rates and the high real sbort-term rates (over 10 percent in recent years) inhibit the development of the market for long-term capital. As mentioned earlier, these high real rates were caused by very large consolidated budget deficits anLd operating losses A. Chandavarkar, (1993), "Saving Behaviour in the Asian-Pacific Region," Asian-Pacific Economic Literature, Vol.7, No. 1. 9 Dimitri Vittas, "Economic and Regulatory Issues of Contractual Savings Institutions," 1990, World Bank, CECFP, Processed, p. 11; "Overview of Contractual Savings Institutions," 1991, World Bank, WPS. 605, March, pp. 50-56.  - 14 - of the CBP (para. 1.5). As a result, there have been no long-term instruments available to local investors. Furthermore, both the SSS and the GSIS have played a very limited role in secondary market trading due to a withholding tax of 25 percent at source imposed on both these institutions - despite their tax-exempt status. Technically, they are entitled to receive a tax refund from the BIR. However, the claim period is too long (over a year) and the refund is generally given in the form of tax credits, which are meaningless to tax exempt institutions. 2.21 Given appropriate fiscal and monetary policies, the SSS and the GSIS could play a much more active role in developing a long-term government securities market in the Philippines and, in so doing, lengthen the maturity structure of government securities. Moreover, investing in long-term government securities by the SSS and the GSIS would further benefit the members of these institutions, since such investments hold out the promise of higher rates of returns. (Both the SSS and the GSIS have been providing loans at below market rates to members for consumer and housing loans in recent years.) Table 2.5 shows the distribution of holders of government securities in recent years. The holdings of government securities by semi-government entities, which include contractual savings institutions such as the SSS and the GSIS, have increased steadily, from 12.1 percent of the total outstanding in 1986 to 27.7 percent in 1992, while the holdings of private investors have declined from 51.8 percent to 39.4 percent during the same period. Although considerable progress is noticeable, much remains to be done to enhance the role of the SSS and the GSIS in fostering the development of a long-ierm government securities market. 2.22 In this respect, it is instructive to draw upon the Malaysian experience. Table 2.6 compares the performance of the SSS and the GSIS in the Philippines with the Employees Provident Fund (EPF) in Malaysia. Two lessons can be learned from this comparison. First, with high contributions from both employers (11 percent) and employees (9 percent), the total resources of the EPF available for investment have been much larger than those of the SSS and the GSIS. Second, lMalaysian law requires that 75 percent of the EPF's resources be invested in government securities; consequently, government securities constitute the main component of EPF investments. In 1990, for instance, government securities accounted for 73 percent of EPF investments, while they accounted for about 50 percent and 28 percent of SSS and GSIS investments, respectively. Likewise, the government securities held by EPF accounted for 52 percent of total government domestic debt outstanding, wiiile the SSS anid the GSIS held substantially less (17 percent).  - 15 - Table 2.5: Outstanding Public Sector Domestic Debt by Holder, 1986-93 (percent) 1986 1987 1988 199 199 1991 1992 1991 (As a percentage of total outstanding) 100.0 100.0 100.0 100.0 100.0 100.6 100.0 na. Central Bank 8.9 6.1 3.7 4.6 3.4 3.0 8.9 n.a. Commercial banks 19.4 12.9 16.1 23.4 23.2 24.2 17.0 n.a. Thrift banks 1.5 1.2 1.5 1.4 0.9 0.9 1.5 n.a. Trust funds 6.3 6.6 5.8 4.4 3.2 3.1 5.5 n.a. Semi-Government entities /a 12.1 13.6 13.1 11.9 22.7 25.2 27.) n.a. Other private sector 51.8 59.7 59.8 54.3 46.7 43.5 39.4 n.a. a/ includes SSS and GSIS. Sources: Govermment Securities Department, BSP; World Bank, The Philippines: Capital Market Study, 1992; and mission's estimates. Table 2.6: Performance of SSS, GSIS, and EPF (Malaysia), 1990 (percent) Philippines Malaysia SSS GSIS EPF Total assets as percent of GDP 5.5 3.2 41.0 Portfolio structure (as % of total) 100.0 100.0 100.0 Loans 21.7 51.0 0.0 Government securities 50.9 28.0 73.6 Other 27.4 21.0 26.4 Holding of government securities 13.0 ..5 51.8 (as a % of government domestic debt) . - Sources: Malaysia, Employees Provident Fund, 1991 Annual Report; World Bank, Philippines: Capital Market Study, 1992. 2.23 There have been some notable developments in the lending programs of the SSS arud the GSIS, such as the e 4 billion fund for power loans (GSIS), the Stock Investrment Loani Program (SSS), and the Stock Purchase Financing Program (GSIS). The latter is no doubt devised to promote equity participation by small investors, but this may not necessarily be the most feasible channel, considering the lack of expertise in such groups, who may be better served by entities like mutual funds.  - 16 - 2.24 The present asset and maturity mismatch between long-term liabilities and predominantly short-term assets could be redressed through an integrated reform and policy package designed with the following features: (a) A reduction in subsidized member loans (salary, policy and housing) while pricing them more nearly to market levels, coupled with a phased divestiture of the insurance business of the GSIS. These steps would together release more resources for long-term assets as well as higher-yielding bonds and equities. Such loans currently account for a disproportionate share (about 32 percent) of the SSS portfolio. The SSS is also the largest source for low-cost housing funds, but the provision of housing finance is better suited for a specialized agency. This is a subject which merits a separate study. (b) Partial linkage of contributions and benefits which would make the public more conscious of the long-term nature of social security. To this end, the benefit formulas should be rationalized and made more transparent. (c) A well-orchestrated public relations campaign to inform opinion makers and the public about how the viability and adequacy of social security arrangements depends critically on the ability of the SSS and the GSIS to effectively discharge their fiduciary responsibilities. (d) The SSS and the GSIS could create a window for longer-term government securities, provided the NG introduces such securities on a competitive basis. (e) Provide for full or partial privatization of fund management. The mission's findings suggest that there is an adequate pool of fund management expertise in the private sector available at competitive rates, which is also borne out by the experience of private pensions. This would also facilitate larger equity investments (currently about 11 percent) and provide valuable support to the privatization program. Should the CSS Sector Invest Abroad or in Foreign Currency Denominated Assets? 2.25 Although Section 26 of its Charter does not prohibit the SSS from investing abroad, it also does not expressly provide for such investments. This, however, is a complex conflict-of-interest issue (between members and overall public policy) which merits careful consideration in the event that the SSS and the GSIS find it more remunerative to invest abroad. The GSIS was recently barred from investing in higher yielding foreign securities which would have been in keeping with their fliduciary responsibility for maximizing returns on their investment portfolio. This prohibition was probably prompted by the desire to prevent the export of domestic savings and to forestall public criticism of starving the domestic capital market for sectoral interests. It is not unusual for national contractuai savings institutions to be permitted to invest abroad to overcome the constraints of the domestic capital market, e.g., as in the case of the Central Provident Fund (CPF) of Singapore or in Chile, where a 1990 authorizatioii permits investment in foreign assets with a ceiling increasing from 1 percent to 10 percent from 1991-l996.'0 Carnelo Mesa-Lago, Changing Social Security in Latin America, Lynne Rienner Publishers, Boulder, Colorado, 1994, p. 126. In Singapore, "due to budgetary surpluses of the government, CPF balances are largely invested abroad, but the probably higher real rate on those investments is not channelled back to the CPF members", Mukul G. Asher, "Some Aspects of the Role of State in Singapore," The Economic and Political Weekly, April 2, 1994, p. 802.  - 17 - This measure in Chile was announced despite the opposition from somne quarters over the export of workers' savings abroad.1' There is no reason why the CSS in the Philippines should not be permitted to invest abroad or in foreign currency instruments such as Philippine Brady bonds, as long as such investments are consistent with their fiduciary obligations and are subject to specified limits and prudential regulation. However, this would require a much higher level of investment expertise than is currently available in-house at either the SSS or the GSIS, and provides added incentive for privatizing the fund management activities of these institutions. The SSS is expected to have liabilities in foreign currencies in the future as reciprocal agreements with various countries become effective and since foreign currency denominated assets would diversify risk and offer some protection against a depreciating peso. It would further be consistent with the philosophy of liberalizing the capital account which would operate as a two way street, permitting outflows as well as inflows of capital. D. Tax Status of the Contractual Savings Sector 2.26 Currently, both the SSS and the GSIS are exempt by law from any taxes, fees, or charges on: (i) all contributions; (ii) all benefits paid; (iii) income from investments; (iv) all supplies, equipment, papers or documents needed to operate the systems; and (v) assets and properties. Moreover, the benefits they pay are not liable to attachment, levy or seizure, unless the obligation is either to the SSS or to the GSIS. Under prevailing law, the tax exemptions are not to be affected by any subsequent legislation to the contrary. 2.27 During the Martial Law regime, the SSS was taxed for a time, but it is not clear whether a P 191.2 million tax refund pending from the BIR, mentioned in the "Operating Highlights for the Year 1992" of the SSS, refers to this period or whether it was part of the pending refunds normally due on account of the withholding tax of 20 percent at source for all financial instruments. 2.28 Many countries exempt contractual savings from taxes to provide an incentive for savings. For instance, in Malaysia and Singapore, all contributions to and benefits froni the provident funds are exempt from taxes, as are accumulated interest and any capital gains from permissible withdrawals for purchase of real estate and stocks. There are, however, some anomalies irn tde ctrrent tax s.atus of contractual savings in the Philippines which merit amendment and reform, as these impair the cash flows and investment capabilities of the SSS and the GSIS, and the savings incentives for private contractual savings. The first of these is the levy of the withholding tax of 25 percent on interest income at source on both the SSS and the GSIS which is inconsistent with the tax-exempt status of both these institutions. On the other hand, the presumptive exemption of these institutions from the amended VAT is not justifiable. Much more onerous is the continued levy of the five percent tax on life insurance premiums, which, in conjunction with the varied municipal taxes on such premiums, puts private insurance at a serious disadvantage and undermines the concept of a level playing field. These issues merit close examination with a view to speedy reform. 2.29 The current withholding tax of 25 percent at source also poses problems for both the SSS and the GSIS since this tax is embedded in the price of the financial instruments which are bought by these institutions. Although this tax is refunded to the respective institution, the refund process is International Labor Office, Report of the Director-General, (Appendix on the Experiences of a Number of Countries in the Area of Social Security), Geneva, 1992, p. 22.  - 18 - excessively prolonged - as long as one year or more. This adversely affects their cash flows and investment potential, all the more so should the SSS and the GSIS increase their bill and note trading activities. There are two possible solutions to this problem. One is to allow "netting" of withholding tax payables and receivables by the two institutions as suggested by the Capital Market Study.'2 But it would be administratively simpler and more in keeping with the tax-exempt status of the SSS and the GSIS to instead exempt both these entities from the withholding tax. Such a step would greatly enhance their cash flow and investment potential and contribute to the enlargement of the capital market generally. 2.30 The insurance industry is heavily taxed. The taxes on the industry include: (i) the tax of five percent on all premium income; (ii) the normal corporate tax on net income; (iii) the 25 percent withholding tax on interest income; (iv) the stamp tax on life policies; (v) examination and license fees; and (vi) municipal taxes on insurance premiums which vary with individual municipal jurisdictions. The total tax burden on the industry represents a tax rate of about 36 percent on the sum of net income plus capital gains (staff estimate for 1988). The high taxes imposed on the insurance industry put it at a disadvantage relative to competing sectors such as the Pre-need, trust and private pension fhild industries. The tax status of the private life insurance sector raises some important issues for policy and fiscal equity. Albeit, the main burden is the five percent tax levied on all premium income, which is effectively a direct tax on long-term planned savings as it is the premium paid by the policy holder which is taxed (and not the income from those savings). 2.31 Consistent with the recommendation of the 1992 Capital Market Study, the present mission recommends the following: (a) The premium tax should be replaced with a structured investment tax on insurance policies which would also apply to Pre-need and trust investments. This will ensure that savings, on which tax is already collected as original income tax, are not taxed again. (b) Concurrently, tax rates on Pre-need and Trust investment should be brought directly into line with life insurance in order to ensure that the overall changes are revenue neutral. (c) Premiums on life insurance policies should be allowed as income tax deductions, up to a limit of, say, f 2,000 p.a. (d) Deductions should also apply to the Pre-need and trust industries to ensure a level playing field within an overall ceiling covering all voluntary contractual savings. 2.32 The tax status of private pensions discriminates against self -trnployed or other individuals who do not participate in a qualified plan, limits the portability of benefits, and constrains the mobility of labor. While the incentives for employers are adequate and generally in line with those offered in other countries, the contributions of plan participants are not tax-deductible and pre-retirement benefits cannot be rolled into a personal account to maintain its tax-exempt status. Such deductions should be viewed as part of an integrated tax incentive structure for saving, and should also incorporate deductions for interest on housing loans, subject to an overall ceiling of, say, 15 to 20 percent of gross income (under Section 28 (g) of the Internal Revenue Code) to cover deductions on account of voluntary contractual savings. 12 Ibid., Vol. 11, Annex 1, Section, 3.14.  - 19 - E. Regulatory Framework of Contractual Savings Sector SSS and GSIS 2.33 The legal and regulatory arrangements relating to the public sector (SSS, GSIS and Employees' Compensation (EC) and Medical Care (MC)) and the private sector (pension and retirement funds) have to be evaluated in terms of the relevant objectives and criteria of regulation, which broadly comprise the following: (a) Providing a requisite degree of operational and financial autonomy to fulfill fiduciary responsibilities to members. (b) Ensuring adequate oversight, surveillance, accountability and transparency. (c) Minimizing the moral hazard inherent in government guarantee of benefits to members (SSS and GSIS). (d) Providing prudential safeguards for private funds to minimize risk of loss to participants in private pension plans. 2.34 The legal and regulatory arrangements must serve and reconcile the interests of: (a) The participants, staff and management. (b) The Office of the President, whose interest is to ensure maximum possible support for the economic, social and political priorities of the administration. (c) The Department of Finance and the BSP, whose interest lies in efficient management of the public debt. (d) Macroeconomic objectives such as the development of the capital market consistent with the fiduciary responsibilities of the social security institutions. 2.35 The SSS and the GSIS are governed by their respective Charters, which can be amended by Congress. Oversight of the SSS Commission and GSIS Board of Trustees is exercised by the Executive Secretary to the President but, in practice, the two institutions have enjoyed a great deal of operational autonomy since the regime of President Aquino. The Commission on Audit (COA) has auditing jurisdiction over the two institutions. 2.36 While the present regulatory arrangements have worked reasonably well, there are specific areas of improvement which merit attention and action, particularly the following: * The need for professional appointments to the various Commissions and the Board of Trustees, together with greater accountability and transparency, and coupled with due safeguards against the politicization of the SSS and the GSIS or any attempts to impair their authority and independence. Individual members of Congress may be tempted to pressure  - 20 - the SSS and the GSIS in accordance with the economic priorities of their constituents and to suit their political objectives. * Through public dissemination of the annual reports of the COA, of which the annual reports of the SSS and the GSIS are an integral part. In line with SSS practice, the GSIS annual report, which is forwarded to the Executive Secretary to the President and members of Congress, should also be made publicly available. * There should be periodic independent actuarial evaluations of both the SSS and the GSIS, encompassing both financial and economic aspects, and such evaluations should be published. This task should be assigned to an independent office along the lines of the Public Actuary in Australia, but with the provision for contracting- out actuarial services. * There is a need to strengthen the regulations concerning employer r-egistration for the SSS and for the reporting of earnings of the self-employed by making the emrployer's consent on SS Form R-l obligatory, whereupon he would be assigned an identification number.'3 * The use of the social security identification number for various purposes such as paying taxes, opening a bank account, and applying for passports and labor permits, would greatly increase compliance and heighten public awareness of the social security system. Private Pension Systems 2.37 In most countries, the responsibility for regulating the private pension sector is typically divided between the labor organizations and the pension sector. Although the focus of regulation and supervision is on several aspects of pension fund administration and management, it is principally on the appropriations and legitimacy of financing, contributions, administration expenses and the management of the fund's investment portfolio. In the Philippines, there is no unified formal regulatory framework. The BIR is virtually the only institution involved in regulating the sector, but its focus is confined to tax related aspects and. even in that sphere, its role and performance fall short of cormparable international standards. There is no single agency that monitors possible conflicts of interest in the management and administration of pension funds and oversees the system as a whole. 2.38 The major areas of weakness in the BIR's oversight of pension sysiems include: * Inadequate enforcement of compliance with tax code; it only verifies deduction claims. * A lack of actuarial expertise to evaluate pension funds prior to approval and when they are periodically updated, for which there is no legal requirement. * A lack of guidelines to ensure adequate security for plan participants and for the investment of funds. '3 D. Zoeliner, Report of a Preliminary Advisory Mission to the Philippines, Geneva, ILO Social Security Department, 1988.  - 21 - 2.39 In the absence of a formal regulatory system, the actuarial firms, the find man2gers and, to some extent, the auditing and accounting firms have created a self-policing mechanism, which is also buttressed by employee representatives on a fund's board of trustees. While these efforts are welcome and laudable, they are no substitute for an effective formal system for collecting information, receiving complaints, and generally supervising the prudential aspects, which can serve to protect participants in the event of mismanagement or loss. 2.40 The regulatory framework of private pensions could be developed and strengthened by suitably adapting the framework prevalent in the U.S. and other developed countries as foilows: * Creating a central bureau to act as a registering, regulatory and statistical agency. * Enacting a comprehensive law to regulate private pension funds; ensuring payment of pensions to employees in the event of employer bankruptcies along the lines of the U.S. Employee Retirement Security Act (1974) (ERISA), and providing prudential investment guidelines, reporting and disclosure provisions. * Creating a Pension Benefit Guarantee Corporation to insure retirement benefits. 2.41 Life Insurance Industry. The growth and development of life insurance in the Philippines has outstripped the capacity of its governing regulations embodied in the Insurance Code (1978) and administered by the Office of the Insurance Commission, which falls under the DOF. While the regulatory focus has been quite rightly on prudential aspects, this has meant control of specific processes and transactions with a rather conservative and narrow application of the regulations rather than the direction and health of the industry as a whole. Private insurers also feel that the playing field is not equal relative to the treatment accorded the GSIS. 2.42 The Insurance Code should be revised to provide for: (a) Clear guidelines for prudential as well as a developmental role for the Insurance Commission. (b) Flexibility in regulatory controls to keep pace with changing market conditions, although their emphasis should be on prudential surveillance rather than on direct control of activity. 2.43 The Commission should continue its process of industry consultation to acidress all current issues, including the level of commission charges to agents, which are reportedly higher than comparable international levels. This is, however, a somewhat complex and thorny issue since it raises the auestion of whether any attempt to guide and regulate market-determined commission charges would be consistent with the process and philosophy of financial deregulation and liberalization. In any evetnt, the Commission should ensure a level playing field between private life insurance and the GSIS pending divestiture of the latter's life insurance business.  - 22 - F. Conclusions and Recommendations 2.44 The CSS is the most sizeable source of long-term resources (about P 256 billion in 1993), equal to almost one-seventh of the total assets of the financial system and more than one-sixth of GDP. The sector has grown rapidly, averaging 18 percent annually during 1980 to 1993. Growth in the SSS (about 20 percent p.a.) and the GSIS (about 14 percent p.a.) has also been accompanicd by the steady growth of both private life insurance and private pensions. Although the CSS has generated substantial flows of savings (about 7.8 percent of gross domestic savings or about 1.4 percent of GDP in 1993), the social security institutions have not yet realized their savings potential due to low compliance (SSS), large receivables from the national government (GSIS), relatively low risk adjusted returns on its assets caused by the investment policy constraints, and poor asset allocation decisions. Although the liabilities of the CSS are predominantly long-term, their assets are largely short-term, reflecting high average Treasury bill rates (15 to 25 percent during the nineties). Their role in the government securities market, especially the secondary market, has been constrained due to the withholding tax of 20 percent, despite their tax-exempt status. 2.45 The enhancement of the role and efficacy of the CSS in capital market development would require an integrated reform and policy package designed along the following lines: (a) Changing the asset management strategy which would entail an increase in allocation to equity, a reduction in below market member loans (salary, policy and housing), and coupled with divestiture of the life insurance business of the GSIS. (b) Creating a trading window for long-term government securities in the SSS and the GSIS. (c) Fully or partially privatizing asset management, with provision for investing abroad, other things being equal, if it is remunerative and prudent. (d) Exempting the SSS and the GSIS from the withholding tax with appropriate implementation. (e) Abolishing the five percent premium taxes on the life insurance industry and allowing tax deductions for contributions to private pensions, subject to an overall ceiling. 2.46 While present regulatory arrangements have worked reasonably well, the following considerations should also be considered to improve the regulatory framework: (a) The need for appointing qualified professionals to the various commissions and Boards of Trustees along with greater transparency and accountability. (b) Periodic independent actuarial evaluations. (c) Strengthening the regulations concerning employer registration for the SSS. (d) Use of the Social Security identification number for various other purposes (e.g., taxes, bank accounts, issue of labor permits).  - 23 - (e) Creation of a Central Bureau to act as a registration, regulatory, and statistical agency to regulate private pensions, enactment of a comprehensive law to regulate private pensions on the lines of the U.S. Employee Retirement Security Act (1974); creation of a Pension Benefit Guarantee Corporation to insure retirement benefits. (f) The Insurance Code should be revised to provide a level playing field, clear prudential and developmental guidelines for the Insurance Commission, and flexible regulatory controls focused more on prudential surveillance than on direct control of activity. (g) Feasibility of reducing high commission charges to insurance agents.   - 24 - CHAPTER 3 ORGANIZATION AND ADMINISTRATION 3.1 This chapter discusses the organization and administration ol the SSS and the GSIS. It begins with an overview and analysis of the current structure of the social security sector. This is followed by an examination of the different aspects of the SSS and the GSIS -- tde scene and nature of these programs, their objectives, organization, interfaces, operations, data gatherirng and maniagement, legislative and regulatory framework - and, finally, conclusions and recommendationts. A. Structure of the Social Security Sector in the Philippines 3.2 Chart 3.1 presents the current structure of the social security sector. The sec.or is essentially two-tiered; the first tier provides mandatory basic universal coverage while the second tier provides voluntary supplementary coverage. The first tier consists of the SSS, the GSIS, and a special retirement benefit scheme for government employees which is administered by the DBM'4 (herein referred to as the DBM). The second tier comprises the occupational pension plans and the Pag-ibig. 3.3 There are several anomalies in the current structure which make a strong case for restructuring or rationalization. First, there is an artificial dichotomy between public and private sector employees in the first tier. The SSS administers programs for persons working in the private sector, while the GSIS administers programs for persons employed by all levels of government (except the arnied forces and the judiciary) and those in government corporations. Armed forces personnel (including the police) are covered by AFP, which is administered separately. Judges and constitutionally designated positions are also covered by a separate retirement system. These separate systems are smaiil and tailored to unique sections of government employees and, therefore, will not be further awqilyzed in this study. 3.4 Second, there is duplicate coverage of some government employees. The DBM provides lump sum gratuity benefits to public sector employees hired before May 1977. Since these enmployees are also covered by the GSIS, they may opt for either benefit at retirement. 3.5 Third, there are a multitude of public bodies providing similar first tier bene.fits and, in some cases, not fully capable of performing this function. For instance, as has been noted in Chapter 2, the AFP does not yet provide any benefits, although it collects mandatory contributions trom members. 3.6 Fourth, there is an asymmetry in the arrangements governing the SSS and the GSIS, the two primary institutions in the sector. The social security programs of the SSS and the GSIS are governed by the Social Security Commission (SSC) and the Board of Trustees, respectively, while the Employ-