The Global Surge in Latin America Pension Funds

by Moises Vidal, Director, Treasury Sales Manager, Latin America Financial Institutions, Bank of America Merrill Lynch, and Tom Avazian, Managing Director, Global Banking and Markets Product Executive, Bank of America Merrill Lynch

The Latin America pension fund sector has experienced dramatic development in recent decades. Forward thinking decisions by many governments across the region during the 1990s and 2000s led to the establishment of mandatory participation for employees in many countries. At the same time, modest population growth, high levels of urbanisation and positive demographic trends – unlike many countries, Latin America has a growing working age population – have prompted significant growth in pension assets.

Today, assets under management (AUM) in Latin America exceed $900bn, and are doubling in size every five to six years in Brazil, Mexico, Chile, Peru, and Colombia [1]. However, the scale of the region’s pension market varies widely depending on population size and market maturity. Chile has the most mature market, having established a regulatory framework for private pension providers, including a robust regulator, over 20 years ago: today AUM total more than $167bn [2]. In contrast, Peru had AUM of $37bn in 2013 (although they have grown five-fold in the previous decade) [3].

While pension fund markets and rules differ significantly across Latin America, countries in the region have one important similarity: pensions are based on contributions to individual accounts in pension funds that are invested in financial markets and are managed by private companies. The principle of individual accounts managed by private sector firms (rather than public sector provision) has been an important factor in the growth and development of the pension fund sector for a number of reasons.

Private pension fund management companies have been able to innovate in terms of the types of investments they offer their investors. Moreover, they have often been active in lobbying governments in their countries to review restrictions on how funds can be invested. Two decades ago many countries required funds to invest almost entirely in the domestic market (and frequently specified investment in domestic government securities, in effect providing a captive source of public sector funding).

However, over time many countries have loosened their limits on the level of investment permitted in international markets, although levels vary widely by country. Today, Brazil, not coincidently the country in the region where the public sector plays the largest role in pension provision, has one of the lowest limits (at 10%), with Colombia and Mexico at 20%, Peru at 42% and Chile at 80% [1],[4]. It is widely expected that over time countries in the region will continue to increase the level of assets that can be invested overseas.

Increased breadth requires more sophisticated services

As Latin American funds have increasingly diversified the types of assets and range of geographies that they invest in – the US, Europe and Japan have been the main recipients of investment, although there is strong emerging market investment by Chilean funds – their need for services associated with investment and operational efficiency has increased. Historically, the securities services industry in many Latin American countries has had limited choice in terms of the service providers they work with; as a result the quality of services has sometimes failed to match international standards.

However, as Latin American pension funds venture overseas, they have an opportunity to put in place best-in-class solutions for principally custody, liquidity management (including short-term investment), settlement and foreign exchange. Funds from the region often have limited experience of operating across different time zones, different types of securities or in different currencies. It is therefore critical that they receive support to ensure their needs are met.

Moreover, Latin American pension funds are expanding internationally at a challenging time. The historically low interest rate environment in many countries around the world, unprecedented policy action (such as quantitative easing) and increased regulations (such as Basel III and money market fund reform) mean that it is crucial for pension funds to operate efficiently. Additionally, they must have sound risk management and access to resources to enable them to achieve their objectives.[[[PAGE]]]

Choosing the right provider

“Pension funds that are becoming more active in international markets are faced with an enormous choice of service providers, so what should they be looking for?” asks Tom Avazian, managing director, global custody and agency services, Latin America at Bank of America Merrill Lynch. “Ideally, they need a provider that not only has the global capabilities and knowledge they require but also understands their business strategy and the dynamic of their home market.”

Banks, or other providers offering settlement services, should be able to provide Latin American pension funds with reliable, proven settlement capabilities in multiple markets. They should be able to accommodate single, multiple and/or external investment managers and accept instructions electronically in multiple formats to optimise flexibility and convenience.

For custody services, pension fund managers need to be confident that their assets are being received, managed and disbursed efficiently, while limiting risk – especially when operating in multiple international markets. Service providers should be able to offer access to a wide variety of markets and asset types and provide direct access to major depositories and sub-custodians where appropriate. Providers should also be members of relevant entities, such as the Depository Trust & Clearing Corporation, the Federal Reserve and Euroclear.

Foreign exchange (FX) is a crucial part of international fund management. Fund managers need cost-effective access to a wide range of currencies through an efficient, streamlined and transparent multicurrency platform that is integrated with payment capabilities and securities settlement. As Latin America pension fund management companies grow in other emerging markets, it will become increasingly important to be able to access non-G10 currencies. More generally, an FX provider must be able to offer continuous linked settlement services to eliminate settlement risk for FX payment instructions.

Finally, pension fund managers require short-term investment and liquidity solutions. Traditionally, many fund managers have simply kept surplus cash in demand deposit accounts. However, the combined impact of regulations under Basel III – which seek to strengthen the global financial system – are expected to increase costs of high quality liquid assets required to be held for certain deposits under the liquidity coverage ratio (LCR). Consequently, pension fund managers now need access to a comprehensive range of offshore investment solutions, including Treasuries and Certificates of Deposit, in order to utilise products that balance their requirements for security, liquidity and yield. Given that short-term investment is a new area for many Latin America pension funds, it is important that providers offer extensive support on liquidity management and investment options.

“What is perhaps most important in today’s markets is that these services – custody, settlement, FX, short-term investment and others – are not only best-in-class but are fully integrated,” says Avazian. “By harmonising and integrating the various treasury and financial solutions pension fund firms use in international markets, there is an opportunity to optimise efficiency, reduce costs and enhance risk management.”

Banks with cross-product relationship teams can use their expertise to provide value-added products such as structured notes and FX swaps. As importantly, they are able to use their expertise to offer a consultative approach to help Latin American pension fund managers meet their objectives. “By working with a bank that offers a one-stop shop across multiple areas – and potentially in multiple regions – counterparty risk can be minimised and standardisation, consistency and other efficiencies maximised,” notes Avazian.

Notes

1. Latin America Distribution Dynamics: Closed Markets Begin to Mature and Open Report – written by Cerulli Associates
2. Business insight in Latin America - BNamericas
3. Latin American Pension Funds Shift to Real Estate, Gradually – written by Jamestown Latin America
4. The Guide to Latin America Pension Funds – written by Campollo Consulting