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P. S. Srinivas

ARGENTINA'S experience with private pensions offers a sobering lesson. Four years of recession and its worst financial crisis in history have brought Argentina, the world's sixth richest country in 1902, to its knees a hundred years on.

A quarter of the Argentine population is unemployed. Over half the population is now officially below the poverty line. Rioters loot supermarkets. A people, once proud of eating the best beef in the world, now fight over carcasses of cows when cattle-trucks overturn. The exchange rate has gone from one peso to one US dollar — fixed for over a decade under the convertibility law — to over three pesos to the dollar: Argentines' savings have been cut by two-thirds in five months. The government has defaulted on its $150-billion debt. Bank deposits have been frozen since December and the government now proposes to give depositors long-term peso-denominated government bonds in lieu of their US dollar deposits.

Cash has disappeared since only limited withdrawals are allowed. The stories of interest on radio stations are those that involve ATMs that still have cash. Barter is rampant in private transactions. The entire banking system, shut down several times in the past four months, is now bankrupt. And what has all this done to Argentina's much acclaimed private pension system? In 1994, Argentina replaced its government-run public pension system with a private one in which each individual worker had his/her own individual retirement account (IRA) managed by private pension fund managers. Before 1994, working Argentines paid a tax from their wages to finance pensions paid by the government to retirees. In the 1980s, this public pension system faced a financial crisis as liabilities outstripped assets. Politicians bestowed generous benefits on pensioners — often the full wage at retirement indexed to wage growth in the economy. The system suffered from extensive evasion and low retirement ages. Poor record-keeping meant multiple pensions for some workers. Despite inflows from taxes and generous government transfers from its general budget, pension liabilities could not be covered. In addition, birth rates were slowing, which meant fewer workers paying taxes; death rates were slowing, which meant more retirees getting pensions; and life spans were increasing, which meant each retiree got a pension for longer.

There were only three ways out — cut benefits, increase taxes, or `reform' the system. Argentina tried to change the benefit formula, but the courts overruled it. Further increases in already high wage taxes on a shrinking tax base were politically unacceptable. So the Argentine system was reformed in 1994. Every worker paid 11 per cent of his salary into IRAs. Private fund managers invested these assets. The industry was competitive: Contributors chose their fund manager. The accumulated funds would be available on retirement to pay a pension to the contributor. And, best of all, since the government was out of the pension system, the political risk was minimised. Politicians could not raid pension funds for pet projects. They could not bestow largesse on their favourite vote bank. Privately managed funds would give the rights of ownership to contributors.

But there was a catch. Pensions involved long-term social and financial contracts with the entire Argentine workforce. The new private system was prone to mismanagement and risk-taking by fund managers. The average Argentine was not financially sophisticated and could not make educated financial investment decisions. So, it was imperative that the pension system be well regulated. The Argentine regulator was, as all good regulators everywhere are, a part of the government. Things began well. Diversification was encouraged. The regulator decreed that, at most, half of all investments should be in Argentine federal government bonds, with a separate limit on bonds issued by the states. Equity investments were allowed. Pension funds should contribute to national development, therefore only a small fraction of the investments could be outside Argentina. An individual pension fund's performance was evaluated on how close its performance was to the industry average, so no single pension fund could take large risks. Within these constraints, the pension fund managers did their own bit to safeguard contributors' assets.

They did not need much encouragement to buy government bonds — the government's insatiable appetite for borrowing kept interest rates so high that bonds were often the most attractive financial instruments. Since equity markets were shallow and risky, much of the other investments was in bank deposits. The rate of return on bank deposits was higher than on equities and the banking system was highly rated internationally.

The results were obvious. By June 2001, Argentina's pension funds assets were worth $22 billion. All pension funds held almost identical portfolios — no individual fund wanted to take the risk of being different. Over half the assets were in federal and state government bonds — few managers considered them risky, or even if they did, there were few alternatives within the regulations. A fifth of the assets were held in bank deposits, and the banks, in turn, bought government bonds with the money — returns on such a treasury operation were higher than on credit-risk-based lending. In effect, therefore, over two-thirds of pension assets were in government bonds. The remaining assets were in domestic equities and mutual funds. Just 3 per cent of the assets were invested abroad.

Then came the crisis. In mid-2001, Mr Domingo Cavallo, Minister of Economy, announced a "voluntary" restructuring of close to half of all Argentine government debt in which debt coming up for repayment in the near future would be replaced by 10-30-year government bonds yielding a higher rate of interest than the existing debt. The vast majority of the takers for this "swap" were domestic pension funds and banks that ostensibly did so "voluntarily". Wall Street — to which the swap was originally targeted — respectfully declined the offer. The regulator then increased the upper limit on federal government securities and the pension funds, "voluntarily" lending the government more money through bond purchases. Either the Argentines rated their government a much higher quality credit than international investors or no one asked pension fund contributors for their views on the matter.

In December 2001, Mr Cavallo decided to dispense with the niceties of voluntarism. He simply took $3.5 billion of the pension fund cash lying in domestic banks to service Argentina's debt to international creditors. He replaced this cash with government bonds at below market rates of interest and called this a "patriotic" investment by the pension funds. And early this year, the government defaulted on all of its debt. It also "pesofied" the economy: Dollar assets of domestic investors were converted to pesos. Now the Argentine pension funds are stuffed full with defaulted government bonds, carrying below-market rates of interest, two-thirds of whose face value has been wiped out by the devaluation. The small amount of domestic equity holdings will soon be worthless as the crisis bankrupts much of the corporate sector, which, assuming a fixed one-for-one exchange rate, had borrowed dollars against peso earnings. The one bright spot — capital gains in peso terms on miniscule foreign assets. These, unfortunately, will not make up for catastrophic losses on other investments. And as the famous song goes, `I cry for you, Argentina'.

That pension funds, private or public, are subject to political risk is, unfortunately, not unique to Argentina. It is true globally and Argentina's experience has lessons for many other countries considering pension reform, India included. Privatisation does not remove government from the system, it just appears in a different form.

Privatisation does not necessarily mean democratisation of the decision-making process of pension fund managers. International investments are often the only high quality insurance for retirement assets against macroeconomic volatility in developing countries. Good governance is as critical in a private pension system as it is in a public one.

(The author, formerly with the World Bank and the Asian Development Bank, is Associate Professor of Finance, Indian School of Business, Hyderabad.)

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