Speech at GAMF 2022
Daniel J. Houston
Today, I want to discuss the role of pension systems in financing national development. At Principal, we've provided financial and retirement security for over 140 years. Over the course of our history, we've grown our business from insurance and retirement in the United States, to global asset management, serving more than 49 million customers in 80 plus markets around the world, including China where we serve nearly 25 million customers. During this time, we've developed a specialized expertise and knowledge in managing pension funds in emerging markets.
Today, Principal is one of the Top 3 retirement providers in the U.S., one of the largest pension fund managers in Latin America, and we have substantial pension and long term savings operations across Asia. In China, we've operated an asset management business for nearly two decades, working closely with our joint venture partner, China Construction Bank, to provide secure long term savings options for customers across China.
Accessible, secure, and dependable long term savings vehicles are what form effective pension systems. In turn, effective pension systems can provide people and their families with lifetime financial security; it can build capital markets that invest in public goods for the benefit of society; and it can provide governments with additional fiscal space to make choices about public spending.
China has embarked on a course to significantly improve the country's multi-pillar pension system, strengthening the first pillar social pension scheme across all provinces and working to expand second and third pillar savings. These changes are not only pragmatic, they are also poised to mobilize unprecedented amounts of domestic capital that will offer protection against the costs of an aging society, generate lifelong financial security for millions of citizens, and create capital markets capable of financing the real economy for generations to come.
A couple of proof points. First, global pension assets have grown at an accelerated rate over the past 10 plus years. In 2010, global pension assets under management were valued at $30 trillion. And by 2020, that figure nearly doubled, to $56 trillion USD. Second, the U.S. pension market itself accounts for $35 trillion of the global total. At Principal, we view this as evidence that public policies that support the development of fully funded, multi-pillar retirement systems are worth the investment and create great value for individuals' retirement security.
As economists have turned their attention to the challenges of aging and increasing longevity, they have warned that governments are not acting quickly enough to secure retirement finance for the long term. However, the good news is that where governments, like China, have deployed funded systems, societal benefits have developed as quickly as savings have accumulated. This is the path that China is pursuing, and if history is the guide, the changes sought by Chinese policymakers are exceptionally promising.
I'll share with you a couple examples from two other economies that began this journey earlier.
Starting with Mexico. Mexico created its individual, mandatory, funded pension system, the AFORE system, in 1997. In about a generation's time, with Mexican workers saving only 6.5% of their wages in the mandatory scheme, the total assets under management (AUM) in the AFORE system have grown to $246 billion, which is roughly 21% of Mexico's gross domestic product.
The AFORE pension fund managers, constituted by a group of Mexican and global pension fund firms, have averaged annual returns of 5.38%, or 1.12% of GDP. These returns plus the contributions are annually invested in both the Mexican public and private sectors. A smaller portion is also invested in foreign assets. The capital market backed by AFORE assets is one of the most significant sources for business and industrial finance in Mexico, investing some $75 billion in Mexican equities, corporate bonds, local Mexican REITS and other instruments critical to growth. The remaining $171 billion assets in the system are diversified among Mexican public sector instruments, local private assets, and foreign assets.
In 2020, the Mexican Congress passed landmark reforms of the AFORE system that will substantially increase financial security for Mexican workers while expanding this vital capital market. Beginning in 2023, Mexico will add a mandatory employer contribution to a system that has relied solely on individual worker savings since its inception. By 2030, the new employer contribution will more than double the savings rate for workers, rising gradually from 6.5% of wages to 15% of wages over 8 years. These reforms will mean an increase in retirement income replacement rates on average from 28% today, to 53% for Mexican workers, after the employer contribution stream is fully phased in 2030. Meaning that Mexico's working and middle classes will be much more prepared for retirement in the future than they are today.
It's important to note that these reforms to the pension system received political support across a spectrum of stakeholders in Mexico, including labor unions, the country's largest industry associations, as well as economists and the Mexican Congress. These constituencies, including most importantly Mexico's largest employers, recognized the value not only of increased pension savings as a hedge against rapid aging, but the shared prosperity provided to the country as a whole.
The other example I'll share with you is one that any pension expert in the audience will know well. Chile was a pioneer in the promotion of directly funded pension systems, in the early 1980's replacing an unsustainable pay-as-you-go system with the AFP pension system. The capital market backed by the pension assets of Chilean workers has become Latin America's deepest reservoir of national finance. As of December 2021, total assets under management in the AFP system were $192 billion, roughly 76% of Chile's GDP. Average annual real returns on assets managed by the private companies that administer the AFP system, between June 1981 and December 2020 were 8%.
The capital market backed by AFP assets is one of the most significant sources for business and industrial finance in Chile, investing some $63 billion in Chilean equities, corporate bonds, local REITS, and other instruments. The remaining $129 billion are diversified among public sector instruments, local private assets, and foreign assets. Domestic investments, including government bonds, represent 54% of total investments, while international allocation is 46%. Importantly for Chilean consumers, the pension backed capital market has effectively underwritten long term mortgage finance, helping to create one of the most affordable housing markets in Latin America.
Since its creation in 1981, Chile's mandatory pension system has also generated a positive effect on total private savings. It's estimated that during the first 30 years of the AFP system the impact on total savings was 2.7% of GDP. The effect on investment was 1.2% of GDP. And the effect on the level of GDP was between 8.6% and 14.4%. This positive influence on national savings in Chile both increased and stabilized the supply of funds available in the national capital market, which provided financial institutions and companies access to financial resources for long term investments.
The Chilean model remains a benchmark for the global pension industry. But, it's important to acknowledge that Chile's AFP system has delivered these impressive results despite working within significant design flaws that have existed since the system's inception in the early 1980's. Per capita, savings in the mandatory AFP system remain at 10%, which is much lower than the average across OECD economies of 19%. The pension industry has consistently encouraged Chilean governments to take up key reforms to improve retirement preparedness for Chileans.
To improve the Pension system, three reforms are critically needed. First is initiating an employer contribution of 6%, as proposed by a number of experts and pension advocates in Chile. Second is raising the salary cap on the 10% personal contribution significantly, to allow savings above the artificially low $38,000 limit that was put in place in the 1980's. Third is expanding voluntary savings programs for both formal and informal (gig) workers, with appropriate tax incentives for employers and employees. We have joined our industry as well as organizations such as the OECD in encouraging these kinds of reforms in Chile, to ensure the country maintains the extraordinary public benefits that have accrued from two generations of savings.
Although pension reform remains a moving target, we can see from Mexico and Chile that there are clear societal benefits to mobilizing national savings in a funded, multi-pillar system. It's also worth repeating that funded, multi-pillar systems help nations in three ways. First, by providing improvements to lifelong financial security for people. Second, by building deep capital markets that finance private economic activity as well as public goods. And third, by relieving governments of a portion of the costs of aging societies and longevity risk.
These benefits are among the many reasons we're encouraged by the pension policy developments happening in China. Chinese policymakers are to be commended for recognizing the urgency given to pension reform due to rapid aging. Within the next 30 years, one in three Chinese citizens will reach retirement age. China, however, has already started building up per capita private pension savings to meet this challenge, with $550 billion in assets under management in the country's Enterprise Annuity and Occupational Annuity retirement savings programs.
China's policymakers are encouraging broad wealth creation in a way that reduces income gaps across various social demographics. This is a policy challenge encountered by most countries, including the ones I mentioned earlier. However, China is in a favorable position to leverage innovations in both pension system design and fin-tech digital tools to mobilize pension savings in a way that rapidly builds a deep capital market, the kind that can provide critical finance to important areas of public development.
I appreciate recent comments by CBIRC Chairman Guo Shuqing that China should "accelerate the growth of pillar two and pillar three pension so that pension funds become a major force in China's capital market to a level as high as those in other developed countries." We could not agree more that long term wealth accumulation for retirement should be part of China's national approach to offset the challenges of an aging society. The much anticipated pillar three policy will offer the chance for Chinese citizens to have their own Individual Retirement Accounts, where part of the trillions of yuan in bank savings can be channeled into long term assets investing in a variety of stable, qualified pension products.
As China continues to develop its retirement policy framework, we look forward to discussions that include the appropriate role of tax incentives, the merits of an employment based pillar or option, and how the pension industry can help provide financial education, guidance, and advice to millions of Chinese workers. At Principal, we've spent almost a century and a half helping our customers safeguard their long term financial security. We believe this type of stable investment approach is one of our industry's most important contributions to capital management, not only for our customers, but also in the societies, in which we operate.
The evolution of the second and third, voluntary pillar of China's pension system will allow millions of more Chinese people to protect their financial futures, while also building a capital market that can serve as an engine of economic growth and development. We've partnered with China over the last 20 years, and we look forward to many more decades of continued collaboration to build a stable and durable pension system positioned to effectively help our Chinese customers for generations to come.
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