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Investment of Mandatory Funded Pension Schemes

E Philip Davis


The steadily-worsening financing difficulties of pay-as-you-go social security
pension systems in both developing and OECD countries is leading to renewed
interest in advance funding of pensions as a complement or even a substitute
for pay-as-you-go. Given the belief that individuals may not voluntarily save for
old age, and in order to durably reduce future government liabilities, mandatory
schemes are often favoured. A crucial issue in this regard is the investment of
assets by mandatory funded schemes. If investment provides an inadequate
rate of return, pensions may be insufficient to ensure satisfactory living
standards for retirees. Such inadequate rates of return may arise if investment
is in low yielding assets, or if there are excessive administrative costs.
Meanwhile, if investments are excessively risky, pensioners risk poverty if they
retire in unfavourable market circumstances, even if the mean rate of return is
high. Such excessive risks may arise notably if assets are inadequately
diversified. A poorly-designed funded scheme may indeed be worse than the
pay-as-you-go scheme that it replaces or supplements.

In this context, this article seeks to set out principles and issues for the appropriate
investment of assets by mandatory funded pension schemes, drawing on relevant
country experience as well as theory. It makes particular, but not exclusive reference
to the situation of developing countries, and notably to the "Latin American model" of
pension funding which was pioneered by Chile. It does not address the equally
important issue of how to deal with an existing - dysfunctional - pay-as-you-go
scheme during a switch to funding. Not the least important aspect of this is to
lower the contribution rate sufficiently to leave room for contributions to a funded

ISSN 1367-580x.