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Pension funds and corporate governance in developing

countries: what do we know and what do we need to
know?

MARIO CATALÁN

Journal of Pension Economics and Finance / Volume 3 / Issue 02 / July 2004, pp 197 - 232
DOI: 10.1017/S1474747204001532, Published online: 11 October 2004

Link to this article: http://journals.cambridge.org/abstract_S1474747204001532

How to cite this article:

MARIO CATALÁN (2004). Pension funds and corporate governance in developing countries: what
do we know and what do we need to know?. Journal of Pension Economics and Finance, 3, pp
197-232 doi:10.1017/S1474747204001532

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PEF, 3 (2) : 197–232, July 2004. f 2004 Cambridge University Press 197
DOI: 10.1017/S1474747204001532 Printed in the United Kingdom

ISSUES & POLICY

Pension funds and corporate governance in
developing countries : what do we know and what
do we need to know ?

MARIO CATALÁN*
Johns Hopkins University
(e-mail: mcatalan@jhu.edu)

Abstract
Conventional wisdom holds that pension reforms from pay-as-you-go to fully funded systems
spur the development of stock markets through a corporate governance channel, i.e. pension
funds become large shareholders of publicly traded firms and therefore have the incentives to
monitor managers and improve investor protections. This paper reviews the literature on the
corporate governance channel associated with pension reforms in developing countries, and
asks what we know and need to know about it. We know that pension funds are not yet large
shareholders of publicly traded firms in developing countries. However, econometric results
suggest that pension reforms lead to stock market development, but do not allow us to identify
and separate the corporate governance channel. We know that pension reforms are followed by
pro-investor legislation, but there is no convincing evidence that the pro-investor laws are
enforced. We need to know more about the effects of pension reform on stock prices and
performance of publicly traded firms, and whether pension fund management companies act in
the best interest of pensioners. The paper also reviews the political economy explanations of the
links between pension fund specific capital controls and the corporate governance channel, and
suggests that there is a trade-off between the objectives of pensioners’ welfare maximization,
and corporate governance reform and stock market development.

The largest institutional investors, the group that includes the largest collection of
investment capital in the world, are the pension funds. One of the most important
elements to understanding the current state of corporate governance, as well as its
future direction and potential, is an understanding of this group. (Robert Monks and
Nell Minow, Watching the Watchers : Corporate Governance for the 21st Century).

* The author is professor of International Economics and Finance at Johns Hopkins University, Depart-
ment of International Economics (SAIS), e-mail address: mcatalan@jhu.edu.
This paper was written for the World Bank’s Pension Reform Primer. The author appreciates the
financial support from the World Bank and thanks seminar participants at The World Bank, Robert
Palacios, Gordon Bodnar, Anne Simpson, Alberto Musalem, Augusto Iglesias, Pablo Lopez Murphy,
Fabrizio Iacobellis, Ricardo Adrogue, Ashley Hubka, and particularly to Agustin Cornejo and three
anonymous referees for useful comments and suggestions. The author is also grateful to Tomoko Suzuki
for providing the IFC data on emerging stock markets. All errors remain the author’s own.
198 Mario Catalán

The great enemy of the truth is very often not the lie … but the myth. (John
Fitzgerald Kennedy, Commencement Address at Yale University, June 1962).

1 Introduction
In the last two decades, many developing countries implemented pension reforms
from publicly managed pay-as-you-go defined benefit systems to privately managed
fully funded defined contribution schemes.1 One of the potential macroeconomic
benefits typically associated with such pension reforms is the development of domestic
financial markets.2
In fully funded pension systems, the argument goes, the rapid accumulation
of domestic financial assets by pension funds bolsters the domestic bond and stock
markets. More developed domestic financial markets, in turn, lead to more efficient
allocations of both domestic and foreign savings to productive investments in the
domestic economy, which spurs productivity and growth.
Stock markets, in particular, can be bolstered by pension funds through different
channels. Pension funds could trade frequently, increasing the liquidity of the
domestic stock markets, and thus crowding in savings and new investors. Similarly,
the intense trading of stock by pension funds and their large size may induce them to
seek the introduction of innovations and new financial instruments to lower trans-
action costs, again attracting additional savings and new market participants.
More important, pension funds could develop stock markets by improving the
corporate governance of publicly traded firms. The conventional wisdom holds that
pension funds, as they accumulate domestic shares, become large shareholders of
publicly traded firms, especially in developing countries where stock markets are thin.
The large shareholder status of pension funds provides them with the incentives to
monitor insiders and seek the improvement of shareholders’ legal protections, thus
improving corporate governance. These pension fund actions are aimed at increasing
value for shareholders, and, therefore, they must crowd in savings and help develop
the domestic stock markets. We refer to these corporate governance effects of the
pension reforms as the corporate governance channel.3
1
Developing and transition countries that implemented pension reforms from pay-as-you-go to private
and funded schemes in the last two decades are : Hungary (1997), Poland (1999), Croatia (2000), and in
Latin America: Chile (1981), Perú (1991), Argentina (1994), Colombia (1994), Uruguay (1996), Bolivia
(1997), Mexico (1997), El Salvador (1998) (the year in which the reform was implemented indicated in
parentheses). Clearly, the most drastic wave of pension reforms is concentrated in the Latin American
region. Other more recent pension reforms in Latin America include Costa Rica, Dominican Republic
and Nicaragua. For a recent survey of pension reform in Latin America, see Palacios (2003).
2
In this paper, the expression ‘pension reform’ refers to pension reforms from pay-as-you-go to funded
systems, publicly or privately administered, whereby at least part of the pension funds are allocated to
equity, and pension fund managers are mandated to maximize the shares’ value on behalf of pensioners.
For papers and surveys of the literature on pension reforms and capital markets development, see
Holzmann (1997), Vittas (1998a, 1998b, 1999), Catalán, Impavido, and Musalem (2000), and Walker and
Lefort (2001).
3
The ‘corporate governance channel’ refers to all pension funds’ actions aimed at reducing the ex-
propriative activities of the managers of the corporations in which they invest, where management
decisions are ‘ expropriative’ if they are not aimed at maximizing shareholders’ value. This definition
includes not only the pension funds’ monitoring of management, but also the pension funds’ lobbying for
better investor protection laws. Moreover, this definition is consistent with the Anglo-American notion of
corporate governance, which differs from the Franco-German approach. The Anglo-American model
 Pension funds and corporate governance in developing countries 199

The purpose of this paper is to study the corporate governance channel and to put
it into the broader context of the pension reform and capital markets development
literature. This paper reviews the theoretical and empirical literature on pension
funds and corporate governance and answers the following questions. First, what do
we know, and what do we need to know to ratify or refute the conventional wisdom that
pension funds improve corporate governance in developing countries ? Second, how does
the relation between pension funds and corporate governance in developing countries
compare with that of developed countries ? More specifically, the corporate governance
role of pension funds stems from the separation of ownership and control in the
modern corporation, whereby the corporation is owned by a large number of small
shareholders and the control of the assets is in the hands of managers. Such separation
of ownership and control gives rise to a free rider problem. Small shareholders,
having no individual incentives or ability to incur the high costs of monitoring
management for a pro-rata share of the benefits, are ‘rationally ignorant ’. By con-
trast, monitoring is cost-effective for large shareholders such as pension funds, and
this idea is the basis of the conventional wisdom that links pension fund ownership
with corporate governance.
However, this conventional wisdom, which also applies to developed markets,
has been seriously challenged in the wake of the US corporate scandals. Many
analysts and gurus, notably Robert Monks, have argued that the belief that pension
funds exercise effective monitoring is a myth in the United States and the United
Kingdom, the world’s most developed financial markets. Nevertheless, the gurus’
faith in the principle that pension funds can and should improve corporate govern-
ance remains relatively unscathed in spite of the practical failures, and such faith
has motivated reform proposals and calls for pension fund activism in developed
countries. By contrast, the conventional wisdom about the corporate governance
role of pension funds, which has been held to apply to developing countries as well,
has not been validated or challenged. In the following sections we ask whether the
existence of the corporate governance channel in developing countries is real or
mythical.
We proceed as follows. Section 2 documents the size and importance of pension
funds in the stock markets of different countries, particularly in those Latin American
countries that implemented drastic pension reforms, in order to highlight the potential
macroeconomic and financial relevance of the corporate governance channel associ-
ated with pension funds. Because the corporate governance channel, as we define
it here, can only operate if pension funds are large shareholders of publicly traded
firms, we examine the data and ask whether pension funds are actually large share-
holders in developing countries. For OECD and Latin American countries, we
measure the pension funds’ domestic equity holdings as a percentage of the domestic
stock market capitalization, and find that pension funds are not significant equity

adopts the view that the exclusive focus of corporate governance should be to maximize shareholder
value. By contrast, the Franco-German approach to corporate governance aims at protecting the
interests of shareholders as well as long-term stakeholders such as banks and employee groups. See
Macey and O’Hara (2003). Accordingly, we ignore the corporate governance effects that could stem from
the pension funds’ role as debt-holders.
200 Mario Catalán

holders in Latin America yet, in spite of rapid growth of pension fund assets in recent
years and the thinness of the Latin American stock markets. These findings must
discourage wishful thinking that significant corporate governance effects have been
achieved through pension reforms in the Latin American region.
Alternatively, we could search for the corporate governance channel from a
different angle. Because the corporate governance channel is just one among the
various channels through which pension funds could develop stock markets, we ask
whether there is any evidence that pension fund growth actually develops stock
markets. If we find no evidence of a positive relation between pension funds and stock
markets development, then we should probably rule out the corporate governance
channel as well. On the other hand, finding a positive relation between pension funds
and stock markets development would allow us to be more optimistic about the
existence of the corporate governance channel. Section 3 reviews the literature and
puts the corporate governance role of pension funds into the broader context of
pension reforms and stock market development. The empirical literature finds a
positive relation between pension funds and stock market development. However,
the available statistical and econometric evidence does not allow us to identify and
separate the corporate governance channel from the alternative channels through
which pension funds could spur stock markets. Section 3 also outlines what we need
to know to identify the corporate governance channel. Moreover, our definition of
the corporate governance channel includes different types of pension fund actions
such as monitoring management to detect corporate crimes, lobbying for improved
legislation and investor protections, lobbying for improvements in the enforcement of
the pro-investor laws, and initiating legal action against managers when crimes are
detected. Section 3 reviews what we know and need to know about these different
types of pension fund actions aimed at improving corporate governance. We find
substantial and convincing evidence that pension reforms are followed by pro-in-
vestor legislation. However, there is no convincing evidence that the pro-investor
laws are actually enforced.
Section 4 presents a skeptical view of the advocated net social benefits of pension
reforms and the stock markets development effect. It argues that there is no such
thing as a free lunch associated with the corporate governance channel, because
politically influential financial and corporate interest groups could lobby for pension
reforms and pension fund specific capital controls that create a captive source of
low cost funds for the publicly traded companies that these groups control. In
exchange for this benefit, these groups are willing to accept the real or apparent
corporate governance improvements that make the pension reform acceptable to
workers. Thus, Section 4 provides a political economy explanation of the capital
controls that governments impose on pension funds in developing countries, and
explains the links between such capital controls and the corporate governance
channel. Finally, Section 4 also outlines what we need to know about the corporate
governance of pension funds, i.e. the principal-agent relation between workers/
pensioners and the pension fund management companies. This section shows that
banking institutions own the main pension fund management companies in Latin
America, and discusses the conflicts of interest that arise between the workers and
 Pension funds and corporate governance in developing countries 201

the banks-cum-pension fund managers. Section 5 compares the pension funds’ role in
corporate governance in developed and developing countries. Finally, Section 6
concludes with a summary.

2 An international perspective on the macroeconomic and stock markets

significance of pension funds
The potential macroeconomic relevance of the corporate governance channel must
be weighted by the relative size of the pension fund sector in each country, by the
extent to which pension funds invest in equities, and by the extent to which the equity
investments of pension funds are significant in domestic stock markets.
Figure 1 and Tables 1 and 2 show the macroeconomic significance of pension funds,
measured as the pension funds’ assets as a percentage of gross domestic product (GDP),
and the stock market significance of pension funds, measured as the pension funds’
domestic equity holdings as a percentage of the country’s stock market capitalization.
We consider both OECD countries and those Latin American countries that im-
plemented pension reforms in the last two decades.
We are particularly interested in the stock market significance of pension funds,
because our definition of the corporate governance channel (see footnote 3) implies
that pension funds can only improve corporate governance if they are large share-
holders of publicly traded firms.
Figure 1 shows the pension funds’ assets as a percentage of GDP and the pension
funds’ equity holdings as a percentage of stock market capitalization in the years
1999–2000. The Latin American countries are in the upper part of the figure and the
OECD countries are at the bottom. Within the Latin American and the OECD
groups, countries are ranked by macroeconomic significance.
Chile (47.7%) is the Latin American country with the largest percentage of pension
funds’ assets relative to GDP, followed by Bolivia (28.7%), Argentina (7.2 %), etc.
Among the OECD countries, Netherlands (119.3 %) is ranked first in macroeconomic
significance, followed by Switzerland (110.2 %), United Kingdom (86.8 %), Iceland
(85.8 %), United States (75.4%), etc.
In terms of stock market significance, Chile (8.8 %) is also the highest ranked Latin
American country, followed by Perú (6.2 %). Notice that in three out of the seven
Latin American economies (Bolivia, Mexico and Uruguay) pension funds do not
hold any equity at all, and, therefore, they do not have any role in corporate
governance given our definition of corporate governance (see footnote 3). It is re-
markable that the participation of pension funds in the region’s stock markets is
always below 10 %, and less than 3% in five out of the seven economies. Among
the OECD countries, United States (25.9%), Denmark (25.2%), United Kingdom
(22.3 %) and Australia (19.6 %) are countries where pension funds are large equity
holders. Notice that the ratios of pension funds’ equity holdings to total market
capitalization in these OECD countries are more than twice as high as even the Latin
American countries where pension funds are most significant, e.g. Chile.
Columns 1–5 in Table 2 show the GDP, the stock market capitalization (MC), the
total assets under management of pension funds (AUM), and the equity (E) and
202 Mario Catalán

Figure 1. Macroeconomic and stock market significance of pension funds – OECD

countries (1999), Latin American countries (2000). Source : Tables 1 and 2.

mutual fund assets of pension funds (MF) in Latin America in the years 2000–02.
Columns 6–10 show ratios derived from the information in columns 1–5. Table 1
provides similar data for OECD countries.
 Pension funds and corporate governance in developing countries 203

Table 1. Pension funds macroeconomic and stock market significance in OECD

countries (1999)

GDP MC E AUM/GDP E/MC MC/GDP

Mill US$ Mill US$ Mill US$ % % %

Australia 391,656 427,683 83,954 66.1 19.6 109.2

Austria 208,557 33,025 16 3.6 0.0 15.8
Belgium 249,202 184,942 9,412 9.5 5.1 74.2
Canada (*) 657,856 800,914 91,309 47.4 11.4 121.7
Czech Republic 54,549 11,796 118 2.0 1.0 21.6
Denmark (*) 171,904 105,293 26,580 24.7 25.2 61.3
Finland (**) 126,870 349,409 18,664 53.4 5.3 275.4
France (***) 1,433,142 1,4756,457 NA 5.6 NA 103.0
Germany (*) 2,092,549 1,432,190 36 3.4 0.0 68.4
Greece (***) 119,335 204,213 NA 12.7 NA 171.1
Hungary 47,645 16,317 110 2.2 0.7 34.2
Iceland 8,353 4,807 742 85.8 15.4 57.6
Ireland (***) 94,940 68,773 NA 45.0 NA 72.4
Italy 1,172,335 728,273 1,635 5.2 0.2 62.1
Japan (**) (0) 4,515,312 4,546,937 260,686 18.7 5.7 100.7
Korea (*) (**) 406,265 395,667 1,172 3.2 0.3 97.4
Luxembourg (***) 18,439 35,940 NA 19.7 NA 194.9
Netherlands (1) 395,612 695,209 55,552 119.3 8.0 175.7
Norway 157,268 63,696 2,357 7.6 3.7 40.5
Portugal (*) 114,251 66,488 3,856 12.0 5.8 58.2
Spain (2) 597,748 431,668 40,585 27.9 9.4 72.2
Sweden (*) 250,332 373,278 21,162 39.0 5.7 149.1
Switzerland (3) (*) 256,436 693,127 77,936 110.2 11.2 270.3
UK 1,456,473 2,933,280 654,596 86.8 22.3 201.4
US (*) 9,274,300 16,635,114 4,312,000 75.4 25.9 179.4
Notes :
GDP : gross domestic product, MC : market capitalization, E : pension funds’ holding of shares
issued by domestic residents. AUM: assets under management of pension funds.
(*) E includes the total amount of shares held by pension funds (issued by domestic and foreign
residents). The amount of foreign shares in pension fund portfolios is usually small.
(**) AUM includes only financial assets. The amount of non-financial assets is usually negli-
gible.
(***) The figure for AUM/GDP corresponds to 1996 and is based on OECD (1998).
(0) The figure for AUM/GDP in Japan is based on OECD (2001). There is a substantial gap
between the figure that is obtained in this way and the OECD (1998) figure for 1996, which is
41.8 %.
(1) AUM includes only autonomous pension funds and excludes the non-supervised pension
funds, which are a small fraction of the total.
(2) The Institutional Investors Statistical Yearbook consolidates the assets of pension funds and
insurance companies.
(3) AUM/GDP in 1998 is shown in the table.
Sources : INTERNATIONAL MONETARY FUND (IFS), OECD (2001), OECD (1998),
WORLD BANK (2002).
 204
Table 2. Private pension funds and stock markets in Latin America

GDP MC AUM E MF
Million Million Million Million Million MC/GDP AUM/GDP AUM/MC (E+MF)/AUM (E+MF)/MC
US$ US$ US$ US$ US$ % % % % %
Country (1) (2) (3) (4) (5) (6) (7) (8) (9) (10)

2000
Chile 75,200 60,401 35,869 4,412 897 80.3 47.7 59.4 14.8 8.8

Mario Catalán
Perú 53,428 10,562 2,750 660 – 19.8 5.1 26.0 24.0 6.2
Colombia 82,700 9,560 3,580 91 – 11.6 4.3 37.4 2.5 1.0
Argentina 284,204 166,068 20,381 2,507 1,671 58.4 7.2 12.3 20.5 2.5
Uruguay 20,051 161 816 – – 0.8 4.1 506.8 – –
Bolivia (*) 8,334 1,742 2,395 – – 20.9 28.7 137.5 – –
Mexico 579,910 125,204 28,201 – – 21.6 4.9 22.5 – –
2001
Chile 66,300 56,310 35,441 3,615 851 84.9 53.5 62.9 12.6 7.9
Perú 54,050 11,134 3,307 741 – 20.6 6.1 29.7 22.4 6.7
Colombia 82,300 13,217 4,786 247 – 16.1 5.8 36.2 5.2 1.9
Argentina 268,697 192,499 20,786 1,767 3,638 71.6 7.7 10.8 26.0 2.8
Uruguay 18,540 153 1,045 – – 0.8 5.6 683.0 – –
Bolivia (*) 7,947 1,555 2,508 – – 19.6 31.6 161.3 – –
Mexico 625,640 126,258 42,867 – – 20.2 6.9 34.0 – –
2002
Chile NA 47,584 35,832 3,225 788 NA NA 75.3 11.2 8.4
Perú NA 13,363 4,083 1,143 – NA NA 30.6 28.0 8.6
 Colombia NA 9,664 5,327 283 – NA NA 55.1 5.3 2.9
Argentina NA 103,434 11,923 906 167 NA NA 11.5 9.0 1.0
Uruguay NA NA 804 – – NA NANA – –
Bolivia (*) NA NA 2,749 – – NA NA NA – –
Mexico NA 103,137 47,688 – – NA NA 46.2 – –

Pension funds and corporate governance in developing countries

Notes : The symbol (–) indicates the number ‘ 0’, and NA indicates that the information is ‘ not available ’.
GDP: gross domestic product ; MC : market capitalization (year end); AUM: assets under management of private pension funds (year end); E: equity in
private pension funds’ portfolios (year end); MF: mutual funds in private pension funds ’ portfolios (year end). Average annual exchange rates were used
to convert the GDP figures in domestic currency to US$.
Argentina : The E and MF figures for the years 2001 and 2002 were obtained from the September shares of those assets in the total amount of AUM, and
then applying those percentages to the AUM of December 2001 and 2002. Bolivia : The entire capitalization funds are invested in fixed income
instruments. See Salomon Smith Barney (2002). Chile : The E and MF figures for all years were obtained from the September shares of those assets in the
total amount of AUM, and then applying those percentages to the AUM of the December AUM figures. Mexico: By regulation, pension funds are not
allowed to invest in equity. Perú : The E and MF figures for the years 2001 and 2002 were obtained from the September shares of those assets in the total
amount of AUM, and then applying those percentages to the AUM of December 2001 and 2002.
Sources : MC : WORLD BANK (2002); AUM, E, MF: Salomon Smith Barney (2002); GDP and Exchange Rates: INTERNATIONAL MONETARY
FUND (IFS).
(*) The figures for E and MF exclude the assets in the capitalization fund.

205
206 Mario Catalán

The stylized facts observed in Figure 1 and Tables 1 and 2, can be summarized as
follows :

’ The macroeconomic significance of pension funds : There is substantial cross-

country variation in the size of pension funds relative to GDP. Pension funds are
large when measured as a percentage of GDP in many countries and, therefore,
the investments of pension funds and the regulations imposed on them might
have significant macroeconomic and welfare effects in those countries.
’ The stock market significance of pension funds in OECD countries : The signifi-
cance of pension funds in stock markets among OECD countries exhibits a very
weak correlation with the macroeconomic significance of pension funds. The
evidence shows that pension funds can be large in terms of GDP, while being
small as equity holders. For instance, pension funds’ in the Netherlands hold
only 8% of the domestic equities, but they hold assets that are worth almost
120 % of the country’s GDP. On the other hand, pension funds in the United
States hold almost 26 % of domestic equity, while their assets are 75 % of GDP.
Similarly, pension funds in Denmark are significant domestic equity holders
(25 %) while their assets are only 25 % of GDP. One can say that macroeconomic
significance does not necessarily lead to stock market significance, and, con-
versely, that stock market significance does not require an extremely large
pension fund sector.
’ The relevance of pension funds in Latin American stock markets : Although most
of the pension reforms in Latin America are recent, the Chilean case shows that,
as the private pension systems mature, the assets accumulated by pension funds
eventually reach high proportions of GDP, and pension funds become signifi-
cant from a macroeconomic standpoint. However, as we pointed out above, the
equity holdings of pension funds as a percentage of domestic stock market ca-
pitalization are relatively low in all the Latin American countries, including
Chile. The figures suggest that the view of the Latin American pension funds being
large equity holders in very thin domestic stock markets is, thus far, a myth. The
reality is that pension funds have not achieved prominence as equity holders in spite
of the thinness of Latin American markets.
These facts should restrain our wishful thinking that pension reforms in the Latin
American region have had substantial corporate governance effects. However,
these facts do not reveal whether the still timid participation of pension funds
in Latin American stock markets is explained by repressive regulation or other
factors. Column 8 in Table 2 (ratio of assets under pension fund management
over domestic market capitalization) suggests that the pension funds’ insignificance
in Latin American stock markets is a matter of portfolio allocation as much as
of the immaturity of the pension fund systems. If a larger fraction of the assets
under pension fund management were allocated to the stock market the Latin
American pension funds could actually be as significant domestic equity-holders
as the US pension funds are, and thus play a more significant role in corporate
governance.
 Pension funds and corporate governance in developing countries 207

3 Pension funds, stock market development and corporate governance

Because the corporate governance channel is just one among the several channels
through which pension funds contribute to the development of stock markets, we
ask the general question whether there is any evidence that pension fund growth spurs
stock market development. Having witnessed the rapid accumulation of assets
(including equity) by pension funds, policymakers, practitioners and academics have
recently asked this question, which is relevant not only for developing countries
with mandatory and private funded systems, but also for developed countries
with publicly managed retirement funds. For instance, in 1996 Alan Greenspan made
the following remarks regarding the possibility that US social security trust
funds (public retirement funds) might be partially shifted from US Treasuries to
equity instruments :
If social security trust funds are shifted in part, or in whole, from US Treasury securities to
private debt and equity instruments, holders of those securities in the private sector must
be induced to exchange them, net, for US Treasuries. If, for example, social security funds
were invested wholly in equities, presumably they would have to be purchased from the major
holders of such equities. Private pension and insurance funds, among other holders of equities,
presumably would have to swap equities for Treasuries. But, if the social security trust funds
achieved a higher return investing in equities than in lower yielding US Treasuries, private
sector incomes generated by their asset portfolios, including retirement funds, would fall by the
same amount, potentially jeopardizing their financial condition. This zero-sum result occurs
because of the assumption that no new productive saving and investment has been induced by
this portfolio reallocation process.

Orszag and Stiglitz (1999) noticed that this argument is not really one about whether
public trust funds should be invested in equities, but rather it is about whether social
security funds should be shifted into equities through any mechanism – either
through public trust funds or private accounts.
The assumptions and the argument put forward by Greenspan suggest that one
should expect no stock market development effect from pension reforms even if
pension funds invest in equities. In short, pension reforms are irrelevant for stock
market development.4 The implication of this idea, which I refer to as the Greenspan
‘irrelevance ’ proposition, when applied internationally, is that one should find no
empirical correlation (after control variables are included) between pension fund
and stock market development across countries, i.e. countries where pension funds
develop faster should not exhibit faster capital market development. This finding
would weaken the arguments that positive corporate governance effects stem from
pension reforms because, as we mentioned before, the corporate governance channel
is just one among several possible channels.

4
Notice that the argument expressed in this paragraph, considered in isolation, is one of ‘double irrel-
evance’, i.e. both the accumulation of equity by pension funds and also whether the equity is held by the
government or by the private sector are irrelevant. To be clear, Alan Greenspan’s view on this issue, taken
as a whole, is that the investment of US social security trust funds in equities will most likely be damaging
for the US stock markets, because he doubts that it is possible to secure institutional arrangements that
will insulate the trust funds from political pressures. Thus, his whole view is not one of double irrelevance.
For perspectives from the US president’s commission on Social Security Reform about the investment of
Social Security Trust Funds, see Cogan and Mitchell (2003).
208 Mario Catalán

Stock Market
Development- Pension Fund
D(MC/GDP) Relevance
or D(VT/GDP) (CIM)

Greenspan’s
‘Irrelevance’
Proposition

Pension Funds
Development –
D(PF/GDP)
Notes: D: change in the variable in a given period, PF: pension
or D(CS/GDP)
fund assets, CS: contractual savings, MC: stock market
capitalization, VT: stock value traded, GDP: gross domestic
product, (CIM): Catalán, Impavido, and Musalem (2000).

Figure 2. Pension Funds and stock market development : competing hypotheses

However, Catalán, Impavido, and Musalem (2000) find that pension fund and
stock market development are indeed positively correlated across a large number of
countries, and they conclude that the development of pension funds leads to stock
market development. This finding suggests that, in an international context, one
should reject the assumption upon which the Greenspan’s proposition is based, i.e. that
no new productive saving and/or investment is induced by the equity accumulation of
pension funds. This, in turn, leaves alive the possibility that a corporate governance
channel associated with pension funds might boost stock markets in developing
countries.5
Figure 2 illustrates the contrast between the prediction of the Greenspan’s
irrelevance proposition and the empirical findings of Catalán et al. The horizontal
axis measures the change in the ratio of pension fund or contractual savings6 assets to
gross domestic product and the vertical axis measures the change in the ratio of stock
market capitalization or value traded to gross domestic product in a given period of
time. Each point represents one country and they find a positive relationship between
pension fund development and stock market development. Moreover, Catalán et al.
conduct time series causality analysis and find that pension fund development causes
5
Greenspan assumes that pension funds buy all the equity in secondary markets and, as he explicitly says,
no new saving or investment takes place. However, even if the rapid accumulation of equity by pension
funds leads public firms to issue more shares and finance new investments with the proceeds, it is not
obvious whether stock market capitalization (stock prices multiplied by quantities of outstanding shares)
will increase. The new investments will increase stock prices only if they have a positive net present value
(discounted at the risk adjusted rates of return). If pension funds do not improve corporate governance it
may happen that firms finance new projects with equity issues and the proceeds of such projects are
partially diverted to benefit insiders, in which case stock prices may fall. In this case, the total market
capitalization may increase or fall.
6
Contractual savings include the assets of pension funds and the assets of life insurance companies.
 Pension funds and corporate governance in developing countries 209

stock market development.7 Nevertheless, more needs to be done to test whether the
positive relationship is robust to the inclusion of all relevant control variables.
Because the capital markets development effects and the operation of the corporate
governance channel, if they exist, are likely to be more evident in countries with less
developed capital markets, special attention must be paid to developing economies
that implemented drastic pension reforms. Walker and Lefort (2001) survey the litera-
ture and provide statistical and econometric evidence on the links between pension
reforms and capital markets development in Chile, Argentina and Perú, and find
evidence that the accumulation of assets by pension funds lowered the corporate cost
of capital, and increased the liquidity of domestic capital markets in those countries.

3.1 Funded pensions and stock markets development : what are the channels ?
In order to put our analysis of pension funds and corporate governance into the
context of the capital markets development literature, the following caveats are in
order. First, the definition of corporate governance that we have adopted (see foot-
note 3) has to do mainly with shareholders, directors, management and the effective
exercise of ownership, and therefore, we must restrict our analysis to stock markets
and ignore the influence of pension funds in other markets such as those for corporate
and government bonds. Second and more important, pension funds can affect
the stock markets through at least three channels : (1) the liquidity channel, (2) the
corporate governance channel, (3) the innovation and transaction cost reduction
channel.
’ The liquidity channel : Even if pension funds did not monitor the managers of
public companies, they could be active traders in secondary markets, and thus
increase the liquidity of the stock markets. More stock market liquidity, in turn,
can crowd in investment funds that would otherwise be allocated to other alter-
natives such as bank deposits or real assets. Notice though that the liquidity
channel does not operate if pension funds follow passive (buy and hold or index
tracking) investment strategies.8 However, casual evidence suggests that pension
funds are active traders in most countries,9 though more specific and formal
evidence on the investment strategies of pension funds in emerging markets is
called for.
’ The corporate governance channel : Besides their trading activities, pension funds
may monitor insiders of publicly traded firms to ensure that managers pursue

7
More precisely, pension fund development causes stock market development in the sense of Granger.
8
As we mentioned before, Catalán et al. find a cross-country positive correlation between the develop-
ment of pension funds and value traded, which is a conventional measure of stock market liquidity.
However, they do not analyze to what extent pension funds trade directly in stock markets. The extra
trading associated with the development of pension funds might be accounted for by other market
participants that are induced to trade in stock markets because of the improved corporate governance
brought by pension funds, while pension funds are passive.
9
However, the intensity of pension fund trading activities may change over time. Monks and Minow
(1996) notice that US pension funds hold about 30 % of the equity investments in the US, and identify a
tendency towards passive investment strategies: ‘With all the pension managers grouped together in the
S&P 500, it is not surprising that none of them, over time, beats the markets and that so many of them
have taken the savings available by eliminating the transaction costs in active trading and investing in
‘‘ index funds’’ that replicate the market.’
210 Mario Catalán

the maximization of shareholder value, and may influence the enactment and
enforcement of investor protection laws.10
’ The innovation and transaction cost reduction channel : This channel is also related
to the trading activity of pension funds in stock markets. FIEL (1998) argues
that the predominance of pension funds in securities trading accelerated the
adoption of technological advances such as the creation of a system of cen-
tralized and electronic custody of securities in Chile in 1995.11 Similarly, the
intense trading of stock by pension funds may induce both corporations and
pension funds to seek the introduction of new financial instruments such as
derivatives.
In sum, the evidence so far suggests that pension fund growth leads to stock market
development. However, the evidence that pension reforms cause stock markets
development does not immediately imply that pension reforms improve corporate
governance. We need more direct evidence to filter the corporate governance channel
from the liquidity and the innovation and transaction cost reduction channels.

3.2 Identifying the corporate governance channel

The corporate governance channel can be split into sub-channels. The pension funds’
actions aimed at reducing the expropriative activities of managers of public firms may
be of three different types.12 First, pension funds may lobby the government for
the enactment of pro-investor laws. Second, they may increase the intensity of their
monitoring activities to increase the likelihood of detection of corporate crimes.
Third, they can lobby for improvements in the enforcement of pro-investor laws, and
10
Because the definition of the corporate governance channel includes the pension funds’ monitoring of
publicly traded companies, the question arises whether and to what extent the role of pension funds
overlaps with the role of rating agencies in developing countries. First, if pension funds become large
owners of companies and nominate directors to the boards, the pension funds enjoy more power to
access firm-specific information than rating agencies. Moreover, directors nominated by pension funds
can vote and take direct measures to discipline and replace managers. By contrast, risk rating agencies
are restricted to the information that is voluntarily released by the managers of public firms. Thus, we
can say that the degree of informational asymmetry that characterizes the relation between rating
agencies and the managers of public companies is greater than the one that characterizes the relation
between large owners and managers. Second, the overall evidence indicates that risk rating agencies
perform poorly in developing countries. Credit rating changes are more likely to lag than to lead changes
in market value. This is true both at the microeconomic (across firms in specific industries) and macro-
economic levels (credit ratings fail to anticipate banking and currency crises). See Levich, Majnoni, and
Reinhart (2002), Chapters 7–10.
11
According to FIEL (1998), before the creation of this system, pension funds and insurance companies
were required to keep the securities in deposit with the Central Bank. That system imposed high daily
costs on pension funds that pursued active trading strategies. Being significant traders in the market,
pension funds took the initiative to create the electronic system in order to reduce transaction costs. The
pension funds themselves were initially important shareholders of the company in charge of securities’
custody.
12
In principle, foreign as well as domestic pension funds could improve the governance of domestic
companies. However, even if a foreign pension fund is a large shareholder of a public firm in a developing
country, it is unclear whether such pension fund will have the same or less incentive to monitor the
managers of the firm than a local pension fund with a similar ownership stake in the firm. First, the value
of the ownership stake in the domestic firm will be a smaller fraction of the overall pension fund portfolio
in the case of the foreign pension fund. This may lower the foreign pension fund’s incentive to monitor.
Second, domestic pension funds may have a monitoring cost advantage due to their localness. Perhaps
the monitoring cost advantage of domestic funds explains the recent cross-border cooperation in cor-
porate governance between UK and US pension funds. See Plender (2003).
 Pension funds and corporate governance in developing countries 211

they can initiate legal actions against managers when crimes are detected. A direct
way to identify the corporate governance channel is to look for specific evidence on
each of these sub-channels.
Attempts to find direct evidence on the corporate governance channel have
focused on legal investor protections and law enactment, and, to a lesser extent, on
enforcement.
It is well documented that pension reforms have been followed by pro-investor
legal reforms in Chile and Argentina. Valdes and Cifuentes (1990), Iglesias (1999b),
and Walker and Lefort (2001) find associations between legal and pension reforms.13
Box 1 shows the nature of the pro-investor legal reforms that followed the pension
reforms in Argentina and Chile. It is clear that the pension reforms in those countries
were followed by numerous laws and regulations aimed at protecting investors. The
new pro-investor laws in Argentina and Chile require, among other things, the
public disclosure of transactions that involve majority shareholders, the indepen-
dence of auditors and the risk rating of publicly traded securities. They also regulate
the correct use of privileged information and the transactions between insiders and
related parties. The new legislation gives more rights to minority shareholders to sue
for board decisions and creates preemptive rights to new issues. The post-pension
reform legislation in both Argentina and Chile explicitly mandated insiders’ fiduciary
duty to minority shareholders. Thus, the new laws are aimed at moving both countries
away from their civil law traditions towards practices that are common in countries
of common law origin.
Similarly, a study by Salomon Smith Barney (2002) argues that pension funds in
Brazil14 have influenced the capital markets legislation : ‘In addition, recent changes
to the public takeover bid regulation have been brought about by the influence of
closed (pension) funds. ’
However, the role of pension funds as lobbyists that seek the enactment of
pro-investor laws remains hypothetical. It may be the case that the new laws are
the natural complements to the pension reform while the newly created pension funds
do not exert any effort to promote the enactment of the new laws. In any case,
pro-investor legislation does follow pension reforms.
Nevertheless, good laws are necessary, but not sufficient, for good corporate
governance. Insiders are unlikely to stop their expropriative activities if they believe
that the laws will not be enforced in court. To the extent that insiders believe that
the laws will be enforced with high probability, such laws must have an impact on
behavior. However, all the potential effects of pro-investor laws can only materialize
with effective enforcement and court commitment to protect investors.15 Thus, we

13
Catalán (2003) also points to the fact that recent capital markets legislation in Argentina explicitly
acknowledges that the influence of pension funds motivated the new laws.
14
Even though Brazil has not implemented a pension reform towards mandatory private pensions as other
Latin American countries did, it has developed a voluntary and private pension system that comp-
lements the dominant pay-as-you-go system.
15
For instance, Bhattacharya and Daouk (2002) find that the cost of equity in a country does not change
significantly (in a statistical sense) after the introduction of insider trading laws, but decreases signifi-
cantly after the first prosecution. These findings might suggest that investors consider the mere enact-
ment of insider trading laws as completely irrelevant. However, insider trading is only a minor element
within the broader concept of corporate governance.
212 Mario Catalán

need to look for the direct role that pension funds play in both the enactment and
enforcement of pro-investor laws.
Regarding the enforcement of pro-investor laws there is some, though scanty,
evidence of pension fund activism in Chile. Agosin and Pasten (2001) describe
two cases in which pension funds initiated legal action in defense of minority share-
holders. In one case, pension funds managed to overturn a public tender offer that
gave rise to enormous profits to controllers of firms in which the pension funds had
invested and that imposed unfavorable conditions on minority shareholders.16 In the
other case, pension funds sued controllers for alleged losses from the sale of assets to
another firm in which the controllers had high stakes.
Cases of pension fund activism in developed countries are well documented. Re-
cently, the leading Japanese pension fund association voted to block the re-election of
directors and executives’ retirement payments, and has opposed about 60 % of the
motions put forward by public companies in 2003 annual general meetings.17
Another and more famous example is the corporate governance activist stance of
the California Public Employees Retirement System (Calpers), the largest US pension
fund that manages (as of July 2003) $145 billion in assets (50 % more than the sum of
all the Latin American pension funds’ assets combined).
It [Calpers] is among the US’s leading shareholder activists, one that is ready to face down
the biggest of Wall Street’s bruisers … its top corporate governance strategy is to name and
shame a select group of poorly managed companies … . [Mr Anson, Calpers’ CIO] says the
strategy works because it improves the value of the companies. … For the first ten years of
the focus list, the average company got an additional equity kicker of 12 percent … . There
is another corporate governance tactic used by Calpers : making what Mr Anson calls ‘public
stands ’ on issues such as executive pay.18

It is worth mentioning that these effective tactics cannot be used by pension funds in
Chile due to restrictive regulation.19 In future research, it would be worth exploring
whether pension funds are allowed to use such effective tactics in other developing
countries as well. Policymakers in developing countries should encourage the use of
‘name and shame ’ tactics by pension funds.
In sum, there is clear evidence that pension reforms are followed by pro-investor
legal reforms. However, there is no evidence that the new laws are actually enforced.
Moreover, there is only scanty and unconvincing evidence that pension funds have
pursued the effective enforcement of the pro-investor laws in court.
Another (less direct) way to search for the effects of pension funds in corporate
governance is to look at the effect of pension fund investment on the performance of the

16
In 1997, ENERSIS, the largest Chilean holding company in the utility sector, was sold to ENDESA, a
Spanish multinational company. There were two classes of shareholders of ENERSIS. Class A share-
holders, mainly employees and pension funds, had dividend rights but not voting rights. Class B share-
holders were the controllers of the company. The price that ENDESA offered for a class B share was 840
times higher than the price it offered for a Class A share. Even though the value of Class A shares had
increased several times in previous periods, providing large gains to small shareholders, pension funds
argued that the benefits were unevenly distributed among controllers and outsiders. They succeeded in
voiding the tender offer in courts.
17
See ‘Pensions body targets directors’, Financial Times, 27 June 2003a.
18
‘The watcher and the watched’, Financial Times, 14 July 2003b.
19
See, for instance, Iglesias (1999b: 118).
 Box 1
Selected pro-investor legal reforms in Chile (1982–2002) and Argentina (1994–2002)
Chile
Chile reformed its pension system from a government sponsored pay-as-you-go to
a private and fully funded scheme in 1980 and was implemented in 1981.
The first round of pro-investor laws is contained in the Law of Superintendency
of Securities and Insurance (December, 1980), the Corporations Law (October,
1981) and the Securities Law (October, 1981).
The Law of Superintendency of Securities and Insurance (SVS) creates the
institution that regulates and oversees the issuers of publicly offered securities,
brokers, dealers, stock exchanges, insurance companies and rating agencies. Its
main stated objective is to maintain the public confidence and guarantee the
transparency of Chilean capital markets.
The Corporations Law, the Securities Law and also Regulation 30 of the SVS
(1989) introduce the following improvements regarding the disclosure of relevant
information : it requires public companies to file quarterly and annual reports and
issue press releases when certain relevant events occur. The annual report must
disclose the names of the principal shareholders, describe the management struc-
ture of the company, list the directors and managers, provide information
regarding subsidiaries, release the information regarding the compensation of
managers and directors, and release the comments and proposals of the principal
shareholders in the annual meeting ; it mandates companies to disclose every
declaration of dividends and exchange of shares at least 20 days before the
execution date ; the Corporations Law requires companies to mail a copy of the
agenda for the annual meeting of shareholders to each shareholder and announce
the meeting through a press release ; the Corporations Law establishes that viol-
ations of the disclosure obligations render directors and officers jointly and sever-
ally liable. Criminal liability increases substantially if false or misleading disclosure
is aimed at achieving personal or related third party benefits ; the Securities Law
prohibits false quotations and transactions and the trading of securities for the
purpose of stabilizing, fixing or causing artificial market price fluctuations. Vi-
olators are also subject to criminal liability.
The Corporations Law and the Securities Law provide mechanisms through
which minority shareholders are protected against expropriation from insiders ;
Argentina
Pension funds and corporate governance in developing countries
Law 24,241 of October 1993 reformed the Argentine pension
system from a government sponsored pay-as-you-go to a
funded scheme. The new system was implemented in mid-1994.
The first round of reforms on investor protection took place
in the period 1992–1996. Decree 656 (1992) and Resolution 200
of the Ministry of Economy and Public Services (MEyOSP-
1992) and Decree 2,019 (1993) require the risk rating of public
securities. Res. 204 (MEyOSP-1992) requires the disclosure of
transactions that involve majority shareholders of public firms.
Res. 214 (MEyOSP-1992) requires foreign firms whose securities
are traded in domestic markets to provide daily information
regarding the prices and traded volumes of their securities in
foreign markets. Dec. 1,073 (1993) regulates the public issuance
of debt instruments by medium and small firms. Res. 215 (CNV-
1992) standardize the public offering procedure, eliminating
time-consuming and bureaucratic steps. Res. 227 (CNV-1993)
establishes the obligation of all public firms to inform all
relevant events that could affect market prices and requires
insiders to keep secrecy and not use privileged information
against outsiders. Res. 239 (CNV-1993) establishes that risk
rating agencies must disclose their rating methodologies.
Res. 242 (CNV-1994) defines and regulates mutual funds. Res.
244 (CNV-1994) authorizes pension funds to act as depository
institutions of the ‘ Caja de Valores ’ (system of securities’
custody of the Buenos Aires Stock Exchange.).
Res. 248 (CNV-1994) establishes that the Buenos Aires Stock
Exchange (‘Mercado de Valores de Buenos Aires ’) and the
Electronic Securities Exchange (‘Mercado Abierto Electro-
nico’) are the markets where the securities in which pension
213
funds are allowed to invest can be traded. Res. 249 (CNV-1994)
determines in which foreign markets pension funds are allowed

Box 1. (Cont.)
Chile
Article 30 of the Corporations Law mandates that ‘ shareholders shall exercise their
corporate rights while respecting the rights of their corporation and other share-
holders ’. Therefore, the law establishes the insiders’ fiduciary duty to minority
shareholders.
Appraisal Rights (Corporations Law and the regulation thereof) : ‘a minority
shareholder who opposes a resolution adopted through a shareholders ’ meeting is
entitled to exercise appraisal rights whereby the dissenting shareholder’s stock in
the company must be bought by the company’ ; Preemptive Rights (Corporations
Law and the regulation thereof) : a company’s shareholders have the right to
maintain their equity interest, i.e. avoid dilution whenever a company decides to
issue shares, convertible bonds or any other security that confers stock rights on
the holder. Proxy Rules : Chilean corporations are required to call ordinary
shareholders’ meetings once a year. The Corporations Law enable shareholders to
participate in the meeting through proxies; shareholders may petition the board of
directors to call an extraordinary shareholders’ meeting provided that at least 10 %
of the company’s shareholders support the initiative. It also provides that the an-
nual report shall include an appendix with the comments and proposals of share-
holders representing 10 % of the company’s equity ; Defenses Available Against
Hostile Takeovers : the Corporations Law regulates takeovers, and provides that
every corporation must maintain at its headquarters and branches an updated list
with the names and addresses of all shareholders, and the number of shares that
each one of them holds. This list must be made available to all shareholders (Di-
mension 5 and information disclosure) ; ‘ A number of rules impede the takeover of
a company without prior disclosure of the intent to control to the target’s share-
holders and the SVS. The Securities Law provides that the person or entities that
either directly or indirectly hold 10 % or more of the subscribed shares of a com-
pany…or that acquire 10 % or more of the shares through a stock purchase, must
disclose every acquisition or sale of shares of the corporation within five days after
the date of the purchase or sale. ’ ‘ When a person or entity, either directly or
through certain affiliates, is seeking to obtain the control of a company registered
in the Securities Registry, disclosure in advance to the public is required, stating the
conditions under which negotiations will be carried out. ’
The Corporations Law requires a shareholders’ meeting with an affirmative
vote of two-thirds of the outstanding voting shares to approve the merger of a
214
Argentina
to invest. Res. 250 (CNV-1994) authorizes the ‘Caja de Valores ’
to consider the Superintendency of Pension Funds as an insti-
tution that oversees pension funds. Law 24,522 (1995) reforms
the bankruptcy procedures. Law 24,441 (1995) aims at pro-
moting the securitization of mortgages and Dec. 304 (1995) re-
quires the risk rating of mortgage backed securities. Law 24,552
also allows mutual funds to invest in real as well as financial
assets. Res. 262 (CNV-1995) regulates the acquisition of a
public company’s own stock to guarantee transparency. Res.
276 (CNV-1995) allows pension funds to invest in public debt
instruments issued by medium and small firms. Res. 721 of the
Superintendency of Pension Funds allows pension funds to in-
Mario Catalán
vest in mutual funds. Dec. 340 (1996) defines the concept of
‘ market maker’ for public debt instruments.
The second round of reforms is contained in the Decree-Law
677 of 2001 on ‘ Capital Markets Transparency and Best Prac-
tices ’. The explicitly stated purpose of the law is to protect
investors and increase the liquidity, stability, solvency and
transparency of the markets in order to reduce the cost of
capital and ease the access of domestic companies to external
finance. The law says : ‘ That, additionally this goal is specially
important for the public interest of the REPUBLIC of
ARGENTINA as the largest investments in the domestic
market are made by pension funds, which manage the retire-
ment savings of a large fraction of the population. ’
The law introduces the following improvements in the quan-
tity and quality of the public information : it mandates more
disclosure of information from public firms, it includes
provisions related to the secrecy that must be kept by those
having access to privileged information and describes certain
types of behavior that are contrary to the required trans-
parency ; it enhances the transparency of control transfers
among stock issuers ; it regulates the independence of auditors
to improve the quality of the public information used
 corporation or the sale of all or substantially all of the assets of a corporation,
and any dissenting shareholder is entitled to appraisal rights. It also mandates the
disclosure of shareholders’ agreements that limit the transferability of registered
shares, thereby limiting undisclosed control agreements. Chilean Law prohibits
the repurchase by a corporation of its own stock except in certain limited circum-
stances.
For the first five years after the pension reform, pension funds were not allowed
to invest in stocks. Legislation introduced in January, 1985 and in the period De-
cember, 1985–March, 1986 paved the way for the participation of pension funds in
stock markets. In January, 1985, Law 18,398 ammended the Decree-Law 3,500 of
1980 and created the risk rating commission. Risk rating was required for all the
instruments in which pension funds were allowed to invest. The decisions made by
the commission were initially based on studies conducted by the pension funds. In
October 1987, Law 18,660 created a private system of risk rating that gave origin to
specialized risk rating agencies. The ratings are currently used to determine the
investment limits of pension funds for different types of instruments and they are
also publicly available information.
Circular 574 SVS (December, 1985) defines the concept of related parties and
requires any purchase or sale of securities among related parties to be disclosed.
Thus, it provides an important device for deterrence and exposure of insider
trading. Circulars 585 and 601 of the SVS (January and March, 1986 respectively)
require the public disclosure of transactions involving majority shareholders, di-
rectors and executive managers, and of all material events that could affect the
main business of the company.
The second round of corporate governance reforms regulates and defines the use
of privileged information and the conflicts of interests between controllers and
outsiders. In March of 1994, Law 19,301 amended the Securities Law. It mandates
that persons who have access to privileged information, must keep that infor-
mation confidential and may not use it for their own benefit or that of a third party.
It also prohibits persons who have access to privileged information to acquire for
themselves or for a third party, securities on the basis of such information. The
amendment also includes in the definition of privileged information any infor-
mation regarding the purchase or sale of securities carried out in the market by
institutional investors.
Recently, in June 2003 the ‘ Second Reform of Capital Markets Legislation ’ has
been proposed by the executive.
Source : Hill et al. (1999).
by investors. Auditors must be independent from the com-
pany and the controlling shareholders and the concept of
independence is similar to the one defined in international
markets and corporate governance codes ; it adopts a system of
required and previous public offers to improve the transparency
and efficiency of the market for corporate control ; it improves
Pension funds and corporate governance in developing countries
the sanctioning of conduct that is adverse to the public offering
procedure.
The law specifically targets the protection of minority share-
holders in the following ways : managers of publicly traded
companies are mandated to pursue ‘ the corporate interest ’ that
is explicitly described as ‘ the common interest of all share-
holders’ and interpreted as the ‘ creation of value for share-
holders’ as in other legal systems and the main international
capital markets ; a residual stake acquisition system is im-
plemented to defend minority shareholders of companies that
have already lost their ‘ open ’ nature, granting both controlling
and minority shareholders the right to purchase or sell their
stakes at a fair price ; the transactions with parties that are re-
lated to the issuer are regulated by the guidelines of the
Principles of Corporate Governance of the American Law
Institute; it imposes regulations on those publicly traded
companies characterized by concentrated ownership structures
to guarantee liquidity in the market ; the legal text explicitly says
that the new legal framework guarantees that ‘ the rights of
the controlling shareholders are more evenly balanced against
the rights of the minority shareholders, thus avoiding possible
situations of minority abuse.’
215
216 Mario Catalán

firms in which they invest. If pension funds exercise effective monitoring of corpora-
tions, the performance of publicly traded firms should improve when pension funds
become large shareholders, and stock prices should surge in anticipation of improved
future performance, as soon as stocks become eligible for pension fund investments.
This line of research would follow the tradition initiated by Berle and Means
(1932), Demsetz (1983), Demsetz and Lehn (1985) and others. The Berle and Means’
thesis suggests an inverse relation between the diffuseness of shareholdings and firm
performance, based on the idea that diffuseness lessens the owners’ incentives to
monitor managers. In Berle and Means’ analysis, the causality runs from ownership
concentration to performance. However, Demsetz and Lehn argue that the ownership
structure of a corporation is endogenous rather than exogenously given. Ownership
structures are determined by individuals and groups that participate in stock markets
and in the market for corporate control. If stock and corporate control markets work
smoothly, profitability differences explained by the ownership structure should not
persist for too long, and market forces should quickly adjust ownership structures to
equalize profitability across firms. Thus, there is a two-way causality between own-
ership concentration and firm performance, such that ownership concentration can-
not predict performance or profitability. Recently, Demsetz and Villalonga (2001)
reviewed the literature for the United States, ran new econometric tests, and found
unequivocal evidence for the endogeneity of ownership structure. They concluded
‘the market responds to forces that create suitable ownership structures for firms, and
this removes any predictable relation between empirically observed ownership
structures and firm rates of return ’.
The relation between ownership structure and performance vanishes only if the
stock and the corporate control markets are well developed, so that differences in
profitability across firms can be easily eliminated through adjustments in ownership
structures. In developing countries, where stock and corporate control markets are
underdeveloped and powerful groups exercise financial market power,20 one should
expect the Berle and Means’ predictions to hold empirically. Accordingly, one should
expect the development of pension funds to affect firm performance in developing
countries.21
One could also study stock price reactions to pension reforms and to the accumu-
lation of equity by pension funds. One could ask whether the pension reforms and
the acquisition and trade of large equity blocks by pension funds are empirically
associated with abnormal stock price increases. Following the literature on developed
economies, one could also ask whether block stockholders such as pension
funds affect executive compensation, leverage, and takeover activity22 in developing
countries. I am not aware of studies that address these issues.
Thus far, we have considered potential benefits of pension reforms associated with
stock market development and corporate governance. The potential benefits derived

20
Financial incumbents can, through different means, block the access of people to credit and finance. See
Section 4 and Rajan and Zingales (2003).
21
We are assuming here that pension funds act on behalf of the ultimate shareholders of the firms in which
they invest: the workers-pensioners.
22
For a recent survey of blockholders and corporate control in developed markets, see Holderness (2003).
 Pension funds and corporate governance in developing countries 217

from effective monitoring by pension funds and pro-investor legislation and enforce-
ment would be desirable on efficiency and distributional grounds. Is there any
potential downside associated with pension reforms and the corporate governance
role of pension funds? The next section offers a more balanced and skeptical view of
the benefits and costs associated with the corporate governance channel.

4 Saving pension reforms from the capitalists

In a recent book Saving Capitalism from the Capitalists, Rajan and Zingales (2003)
offer a comprehensive view of the opportunities and impediments to financial devel-
opment in developing countries. They argue that powerful interest groups with
political influence can block financial sector development. By restricting the wide-
spread access of people to credit and finance, financial and industrial incumbents can
prevent competition from potential entrants, keep talented and creative individuals
as captive workers of the firms they control, and pay low wages to skilled workers.
Financial development and widespread access to finance, if they can be unleashed
somehow, would allow talented innovators and entrepreneurs to set up their own
companies and promote competition, thus improving the functioning of markets and,
paradoxically, saving the spirit of capitalism from the power of financial incumbents
or capitalists. Thus, because politically powerful financial incumbents can prevent
financial development, financial reforms can only occur if the interest groups benefit
from them.
This view of financial development suggests that one should be somewhat skeptical
about the advocated net social benefits of pension reforms, and their corporate
governance and capital markets development effects. Why do financial incumbents
not block the pension reforms that will eventually destroy their power, improve
corporate governance, force them to be more transparent and accountable to share-
holders, and punish their expropriative activities ? Catalán (2003) applies the core
idea of Rajan and Zingales to the analysis of pension and corporate governance
reforms (the twin reforms) in developing countries. He observes that all the Latin
American pension reforms were followed by pro-investor legal reforms, and that
pension funds were restricted to hold only domestic securities, i.e. governments
imposed specific capital controls on pension funds.23 The portfolio restrictions on
international diversification are puzzling, because in practice governments insure the
retirement income of the population, explicitly or otherwise, and therefore, it should
be in the governments’ interest to encourage rather than prevent the cross-country
diversification of pension fund assets. The solution of the puzzle is that the portfolio

23
More precisely, governments allowed pension funds to allocate very small fractions of their portfolios to
international investments. Among the Latin American countries the portfolio limits on foreign invest-
ments were extremely low. For instance, as of 1999, the limits were Argentina (10 %), Chile (12 %), Perú
(10 %); foreign investments were not allowed in Colombia, El Salvador, and Uruguay. Because of the
well-known home bias that characterizes international investments, one must ask whether these low
foreign asset ceilings are actually binding. Reisen and Williamson (1994) address this question for de-
veloped countries and observe, ‘when pension funds are free to invest abroad, they tend to extend the
foreign asset share up to around 20 to 30 %, as seen with private Dutch and UK funds’. The lower
potential for diversification within smaller economies, such as the Latin American ones, will result in a
larger share of foreign assets held by pension funds there, i.e. the foreign asset ceilings must be binding.
218 Mario Catalán

restrictions are aimed at creating a captive source of low cost funds for domestic
publicly traded companies, which explains why the powerful financial incumbents
(the owners of the same publicly traded companies) are willing to accept the
pro-investor legal reforms in the first place.24
As mentioned above, the pro-investor legal reforms do not guarantee effective
enforcement in courts. However, Catalán’s paper shows that even if the laws were
enforced, financial incumbents can benefit from the reforms at the expense of
workers,25 and that the pension reforms combined with the capital controls im-
posed on pension funds are the government’s responses to the political influence
of domestic financial incumbents. This arrangement, per se, restricts the capacity of
pension funds to act in the pensioners’ best interests.
To make this point more starkly, consider the pension funds of a developing
country, and imagine that there is no conflict of interest between the pensioners and
the managers of the pension funds. Furthermore, suppose that the government
imposes no portfolio restrictions on pension funds, and, therefore, pension funds can
allocate their assets freely. How should pension fund assets be allocated to maximize
the welfare of contributors ? Given the typical high stock market volatility, the
weakness of investor protections in developing countries, and the low risk tolerance
of large masses of population, one can strongly argue that pension fund assets should
be diversified internationally.26 Surprisingly, this is never the case. This appears ironic
if one considers the high standards of prudence and all the fiduciary duties that
managers of pension funds are required to practice. How relevant is the ‘ prudence of
pension fund managers ’, for instance, for an Argentinean pensioner if the managers

24
The idea that restrictions on international capital movements can benefit interest groups is not new in
other contexts. For instance, a recent article in the Financial Times about corporate governance in Japan
argues ‘Capital controls prevented Japanese from investing their outsized savings abroad, so cheap
money flowed through banks into the corporate sector’. See Randall and Nakamura (2003). See also
Tornell and Velasco (1992). For a survey of the literature on capital controls, see Dooley (1995).
25
In Catalán’s paper, these predictions correspond to pension reforms from compulsory pay-as-you-go to
fully funded systems. Notice that the pension reform combined with the portfolio restrictions on inter-
national diversification can make workers better off. Nevertheless, financial incumbents benefit at the
expense of workers in the sense that the workers’ welfare would improve even more if pension funds were
allowed to invest abroad without restrictions.
26
Investment in stocks is riskier than investment in other assets such as bank deposits and bonds. How-
ever, the investment of individuals’ retirement contributions in stocks is usually justified by the long-term
nature of the pension contract. Thus, even though stock prices exhibit large fluctuations over short
periods of time, over the long run, extreme low returns in some periods will tend to cancel out with
extreme high returns in other periods. In this way, part of the short-term riskiness is diversified away
over time. Thus, one may ask whether the short-run volatility of stock prices in developing countries
actually matters for funded pension accounts. The answer is yes, they do. It matters even in developed
markets. The findings of a study by Burtless (1998) are reviewed by Orszag and Stiglitz (1999). ‘Burth-
less … studied the replacement rates that workers would have achieved (the percentage of their previous
wages that their retirement incomes would equal) if they had invested 2 % of their earnings in stock index
funds each year over a 40-year work career and converted the accumulated balance to a retirement
annuity upon reaching age 62. Workers reaching age 62 in 1968 would have enjoyed a 39 percentage
replacement rate from those investments … By contrast, the replacement rates for workers retiring in
1974 – only six years later – would have been only 17 %, or less than half as much’. Similarly, Thompson
(1998) simulates the sensitivity of pension benefits to the economic environments in developed countries
(Germany, Japan, United Kingdom, United States) for the period 1953–95, and obtains stark compar-
isons of replacement rates under alternative scenarios. He concludes: ‘The history of the last half-
century suggests that uncertainty about future economic developments can easily cause asset accumu-
lations in defined contribution plans to fall one-third short of the initial target and, just as easily, come in
twice as high as the target’ (page 145). See also Alier and Vittas (2000).
 Pension funds and corporate governance in developing countries 219

are forced to invest primarily in domestic stocks and government bonds, which
are highly volatile ? In the United States, company-sponsored pension funds have
been criticized for investing heavily in the stock of the sponsoring company, on the
grounds that such practices are risky and imprudent. However, the stock prices of
many large US companies are less volatile than the stock market indexes of many
developing countries.
Two explanations for the observed deviations from the unrestricted portfolio
benchmark have been put forward. The first justification of the capital controls is
based on the fiscal costs associated with the transition from the pay-as-you-go to
the funded system. The second justification of the capital controls is based on the
existence of macroeconomic externalities that lead to a socially sub-optimal ac-
cumulation of capital in the domestic economy. Now, we summarize each of these
justifications of capital controls, and argue against the observed portfolio regulations
in Latin America.

’ Capital controls and the fiscal costs of the transition :

The transition from a pay-as-you-go to a mature fully funded system typically
occurs over a period of many years during which the government must keep paying
pensions to the retired workers while collecting less tax revenues from the young
workers who contribute to their individual retirement accounts. This gives rise to a
fiscal gap that can be financed with general tax revenues and/or with additional debt.
To avoid imposing all the fiscal burden of the transition on the current workers,
governments must issue substantial debt. In this way, the ‘ implicit’ debt of the
old pay-as-you-go system becomes explicit. Moreover, a ‘refinancing problem ’ arises,
i.e. the reform not only makes the total amount of debt explicit, but its maturity
also becomes explicit. Even though the total (explicit plus implicit) government debt
does not change immediately with the pension reform, the refinancing problem
did not exist under the old pay-as-you-go system because the implicit debt was being
rolled over perpetually through overlapping generations of workers-pensioners.
Given that the access of developing countries to international financial markets
exhibits discontinuities, and ‘sudden-stops’ of capital flows to developing countries
are recurrent, governments must secure the financing of the transition by imposing
capital controls. In other words, if capital controls were not imposed, the argument
goes, the fiscal costs associated with the pension reforms would make the reforms
infeasible.
Taking for granted this justification of capital controls, several questions arise.
First, to the extent that the macroeconomic benefits associated with the pension
reform are widespread and not fully internalized by the workers, why do governments
not impose controls on all capital outflows ? Why do they resort to pension fund
specific capital controls, which clearly discriminate against workers-pensioners?
Second, even if one accepts the imposition of pension fund specific capital controls,
this fiscal explanation can only justify minimum portfolio restrictions on the pension
funds’ holdings of government securities. This approach cannot rationalize the overall
portfolio regulations that one observes in the Latin American region. Although there
are some variations, a stylized and typical set of portfolio restrictions would allow a
220 Mario Catalán

maximum of 10% of foreign investments, while at least 90% of the assets would have
to be allocated to domestic assets. A maximum limit of about 40–50 % of the assets
would be imposed for domestic government securities, while the remaining 40–50 %
would be allocated to bonds and stocks issued by domestic publicly traded firms, and
to domestic bank deposits. Under such regulatory structure, the government attracts
a substantial percentage of the pension fund assets, which guarantees a source of
funds to finance the fiscal costs of the transition. However, it is also clear that this
regulatory structure secures a captive source of funds for private banks and firms that
issue domestic securities. Thus, the regulatory structure in Latin America is consistent
with the political economy explanations of financial repression of Catalán (2003), and
Rajan and Zingales (2003). Most likely, the current portfolio regulations in Latin
America impose significant welfare costs on workers-pensioners for the benefit of
domestic banks and publicly traded firms.27
’ Macroeconomic externalities and capital controls :
This rationale to imposing portfolio restrictions on the international investments
of pension funds was put forward by Orszag and Stiglitz:
The higher financial volatility in developing economies could be attenuated by allowing
individuals to invest in foreign assets. If such investments were appropriately chosen, the
returns should then be independent of outcomes in their own country – insulating the in-
dividuals from the effects of higher domestic volatility. But this approach raises a number of
sensitive issues. For example, in the presence of endogenous growth elements or any differential
between social and private returns to capital, investing abroad is not necessarily equivalent
to investing at home. If pension savings are invested abroad, the country benefits from the
private return to capital in foreign markets, but does not necessarily capture the full potential
social return. This effect could thus provide a policy rationale for limiting investments.
(The Quote is from page 36 of Orszag and Stiglitz (1999)).

This case for the portfolio restrictions is vaguely stated theoretically, not to mention
the unlikely possibility that such externalities exist and dominate the well documented
and enormous risk exposure of pensioners in countries such as Argentina, Bolivia,
Colombia, etc. Moreover, even if such externalities were identified and shown to be
sizable,28 we argue below that the objective of pension reforms should be restated
in the light of corporate governance principles, so as to maximize the welfare of
workers-pensioners. The corporate governance principles would justify the portfolio
restrictions on international diversification only if pensioners could internalize part
of the externalities and be ex-post better off than in the unrestricted case.
There are two ways in which workers could internalize the externalities, if they
exist. The macroeconomic externalities, including the corporate governance and

27
Another potential distortion (social cost) associated with pension fund specific capital controls in
countries with thin stock markets and insufficient investment grade domestic securities is that pension
funds might (if they are allowed) undertake direct investments in housing, commercial enterprises, etc.,
which divert the attention of pension fund managers towards operations with which they are unfamiliar.
I owe this comment to an anonymous referee.
28
A positive externality associated with the development of pension funds in the literature is based on the
idea that the long-term nature of pension fund liabilities allows pension funds to provide long-term
finance to domestic firms, which contributes to national development when long term finance is scarce
due to instability and market failures in domestic banks and financial markets. See, for instance,
Catalán, Impavido, and Musalem (2000).
 Pension funds and corporate governance in developing countries 221

capital markets development effects, can benefit workers through stock price increases
(under the defined contribution fully funded system) or through wage increases. The
capital controls are justified only if the stock price and wage increases are large
enough to offset the worker’s disutility caused by the excessive risk associated with
the lack of international diversification of the retirement assets. This is another reason
why it is important to study the stock price effects of the pension reforms. Given that
the amount of pension funds’ assets are small at the early post-reform stages, and that
stock prices will incorporate the discounted value of future corporate governance
effects as soon as pension funds are allowed to invest in domestic equities, it is
unlikely that workers will be able to internalize large enough gains in this way.29 Even
though quantitative analysis remains to be done, the conditions that must be satisfied
to justify the capital controls seem highly restrictive.
In any case, if pension funds of developing countries were allowed to invest
large fractions of their assets in developed markets, the link between domestic
pension funds and corporate governance would break apart in those countries.30
However, our arguments against capital controls suggest that internationally
diversified pension funds would be acting unconditionally in the best interest of
pensioners, which should be the unique goal of a pension system that is only and truly
accountable to the pensioners. The political influence of financial groups, that reap
the benefits from the captive source of low cost funds created by the reforms and the
portfolio restrictions, prevents the unconditional maximization of the pensioners’
welfare.
In sum, even if there is no conflict of interests between the pensioners and
the pension fund managers, the portfolio restrictions on international diversification
serve the purpose of channeling funds towards financial incumbents at the cost of
reducing the welfare of pensioners. At best, pension funds can exercise good
conditional corporate governance on behalf of the workers-pensioners.
The main lesson for the design of future pension reforms is that there exists, ex-ante,
a trade-off between the welfare of pensioners and the possibility of deriving corporate
governance improvements from the pension reform. On one extreme, if pension funds
are allowed to invest internationally without restrictions, the welfare of pensioners
is maximized but the effects on domestic corporate governance and capital markets
development are minimized. On the other extreme, if pension funds are restricted to hold
only domestic securities, the corporate governance and the capital market development
effects are maximized at the expense of the pensioners’ welfare.
Given this trade-off, the objective of pension reform must be restated clearly.
This is our task in Section 4.1.

29
Definite judgments on this issue require quantitative analysis. Bodnar, Gordon, and Catalán Mario
(Work in Progress) analyze these issues and others, such as the inter-generational distributional issues
associated with the stock price effects of the corporate governance channel.
30
Likely, the whole link between pension reforms and domestic capital markets development might break
apart. Regarding the immediate macroeconomic effects of the abolition of pension fund specific capital
controls, the literature is ambiguous. In theory, the liberalization of capital outflows may cause net
capital inflows (outflows), real appreciation (depreciation) of the domestic currency and a positive
(negative) wealth effect. Reisen and Williamson (1994) argue that the abolition of the UK capital con-
trols on pension funds caused net capital outflows.
222 Mario Catalán

4.1 Restating the objective of pension reform

In 1999, Orszag and Stiglitz issued a warning that is particularly relevant here : the
ultimate focus of pension reform design must be on welfare. They say :
… we need to keep in mind our ultimate objective. Savings and growth are not ends in
themselves, but means to an end : the increase in well-being of members of the society. Thus,
we could perhaps induce people to save more by exposing them to more risk. But that need not
improve their welfare. For example, risk-averse individuals might respond to increased
variance in the real return of their pension plan by increasing their saving rates. The increased
risk, however, would make them unambiguously worse off. The Quote is from page 7 of Orszag
and Stiglitz (1999).

Though the Orszag and Stiglitz warning correctly focuses on welfare, a cor-
porate governance perspective requires the pension system to be accountable
only to workers-pensioners, and therefore the objective of pension reforms must be
the increase in the well-being of workers-pensioners rather than that of all ‘members
of the society ’.31
The due accountability of the pension system to workers-pensioners requires that
pseudo-objectives of pension reforms such as corporate governance improvements of
domestic publicly traded firms or capital markets development must be subordinated to
the pursuit of pensioners’ welfare.
Once an agreement on this point is reached, it is obviously difficult to justify the
portfolio restrictions on international diversification that are pervasive in developing
countries, because one must prove that very restrictive conditions are satisfied.

4.2 Watching the watchers

Thus far, we have assumed that pension funds act in the best interest of pensioners.
Obviously, the trade-off between corporate governance improvements and pen-
sioners’ welfare exists only if pension funds can actually represent the interests of
pensioners conditional on the legislation. Otherwise, if there is only an ‘appearance
of corporate governance’ and pension fund managers act in benefit of financial
incumbents, then the pension reform combined with the portfolio restrictions on
diversification will just cause a redistribution of wealth from workers to financial
incumbents and will not improve corporate governance. This is another element that
can worsen the welfare loss of pensioners relative to the first-best pension reform.32
Future research must focus on these important issues. Most of the literature
on pension reform and capital markets development has taken for granted that
pension fund managers are the watchers of publicly traded companies and that they
31
Although the general corporate governance principle in the whole economy is that fiduciary duties
should be owed exclusively to shareholders, the principle is usually expanded in the special cases of banks
and private pension funds. Thus, the approach to corporate governance is hybrid in the sense that banks
and private pension funds are subject to the Franco-German paradigm. Macey and O’Hara (2003) make
the point about banks clear, and I must add that a similar exception to the general rule has been applied
by Latin American countries to pension funds.
32
The pension reform from a poorly performing pay-as-you-go to a fully funded scheme combined with
portfolio restrictions on international diversification can actually make workers better off, but the point
is that their welfare would improve even more if the international diversification of investments were
permitted.
 Pension funds and corporate governance in developing countries 223

act in the best interest of the pensioners. However, a relevant question is Who Watches
the Watchers ?,33 i.e. the corporate governance of pension funds must be care-
fully analyzed to determine whether they actually represent the interests of pensioners.
Casual evidence from Latin America indicates that financial incumbents positioned
themselves as important players in the private pension fund industry as soon as
the pension reforms were launched. We need to know more about the ownership
structures of pension funds and the extent to which powerful financial groups own
pension funds, directly or otherwise. The ownership structure of pension funds can
point at potential conflicts of interest with pensioners.
Table 3 shows the ownership structure of pension funds in Latin American
countries in 2002. Put it simply, banks control the pension fund business in Latin
America. The main owners are foreign banks such as BBVA, Citigroup, and
Santander. Other domestic and international banks and financial institutions are also
substantial owners of Latin American pension funds. The main international banks
are also controllers of domestic banks and/or have subsidiaries in Latin American
countries. Thus, the table suggests that the attention of researchers and regulators
should focus on potential conflicts between bank activities and pensioners’ interests.
The table shows the current ownership structures rather than the ownership struc-
tures at the moment the reforms were launched. Since the launching of the pension
reforms, mergers and acquisitions have altered the ownership structures in most of the
Latin American countries, and have permitted the entrance of foreign participants
that may have brought some benefits in terms of innovation. Notice though that the
fact that current pension fund owners are not the same as those that might have
lobbied for the reforms is not inconsistent with the ‘ political economy ’ approach
described above, because the politically influential groups that obtain the reform from
the government can liquidate the gains from their lobbying efforts by selling their
pension fund management companies after the regulatory structure is put in place to
guarantee high future profits and a high price for the management company.
Banks, for instance, had large ownership stakes in pension fund management
companies in Argentina in 1994, and substantial fractions of the pension fund port-
folios have always been allocated to bank time deposits. A bank or a group of banks
that manage one or more pension funds may have business relations with companies
in which pension fund assets are invested. If this is the case, the shareholders’
(pensioners) consent to rules voted by pension fund managers is ‘tainted’ by a con-
flict of interest. The directors appointed by the pension funds to the boards of those
companies in which the pension funds invest, might vote in favor of management
proposals they would otherwise oppose, due to the commercial and financial ties
between the companies’ managements and the bank. In such cases, pension fund
managers must obviously fear retaliations, and have an incentive to treat the
companies’ managers nicely, and thus behave against the pensioners’ interests.
Misbehavior in corporate governance can be elusive or illusory, and therefore
detailed research on the relations between the owners of pension fund management

33
This is the title of Monks and Minow’s book, and conveys the idea that boards of directors, trustees, etc
must also be monitored so that they can perform their monitoring roles.
 Table 3. Ownership structure of pension funds in Latin America

224
1st largest 2nd largest 3rd largest 4th largest 5th largest
Pension fund manager shareholder shareholder shareholder shareholder shareholder
( % AUM-market share) % % % % %

Argentina
Origenes (22.5 %) Bank Boston Santander Investment Grupo Pabro Provincia Holbah
AIG (41 %) SA (27 %) (23 %) Seguros (7 %) Merchant (2 %)
Consolidar (20.6 %) BBVA-Banco Frances BBVA (46 %) – – –
(54 %)
Siembra (17.4 %) Citigroup (100 %) – – – –
Maxima (15.1 %) HSBA Chacabuco HSBC (30 %) New York Life – –
Inversiones (45 %) International Inc. (25 %)

Mario Catalán
Bolivia
Prevision BBV (52 %) BBVA (80 %) Other (20 %) – – –
Futuro de Bolivia (48 %) Zurich (57 %) Invesco (10 %) Other (33 %) – –
Chile
Provida (31.5 %) BBVA (52 %) Deposito Central Other (11 %) Alfa Corredores –
de Valores (35 %) de Valores (2 %)
Habitat (23.3 %) Inversiones Inversiones Union Genesis Chile Fund Other (14 %) –
Previsionales Española SA (4 %) Limited (2 %)
SA (80 %)
Cuprum (15.6 %) Sun Life Inversiones Empresas Penta Deposito Central Other (23 %) –
SA (32 %) SA (31 %) de Valores (14 %)
Santa Maria (12.9 %) ING (97 %) Other (3 %) – – –
Summa Bansander (11.1 %) Santander (100 %) – – – –
Colombia
Porvenir (27.3 %) Banco de Bogota Provida (Controlled by Grupo Aval (20 %) Banco de Occidente Other (15 %)
SA (26 %) BBVA) (20 %) (19 %)
Proteccion (22.5 %)
Horizonte (18.7 %)
Colfondos (15.5 %)
Pensiones y Cesantias
Santander (13.1 %)
Banamex (23.6 %)
Bancomer (21.7 %)
Profuturo GNP (9.7 %)
Santander Mexicano (9.2 %)
Integra (31.9 %) Inversiones Wiese del Peru
Union Vida (27.3 %)
Horizonte (25.5 %)
Republica (56.5 %)
Afinidad (17.8 %)
Union Capital (17.1 %)
Integracion (8.5 %)
Source : Constructed from Salomon smith Barney’s report on Private Pension Funds in Latin America (2002).
Inversura (32 %) Corp. Financ. Nal. y Caja Colombiana de Conavi (16 %) Other (13 %)
Suramericana Subsidio Familiar (17 %)
SA (22 %)
BBVA (80 %) Granahorrar (20 %) – – –
Citibank (80 %) Caja de Compensacion – – –
Pension funds and corporate governance in developing countries
Familiar (20 %)
Holding Santander Administracion de Santander Inv. Colombia Santander –
Central Hispano (55 %) Bancos Latinoamericanos (3 %) Investment SA
Santander SL (40 %) (2 %)
Mexico
Citibank (100 %) – – – –
Bancomer (51 %) Aetna (33 %) BBVA (11 %) AFP Provida (5 %) –
Grupo Nacional – – – –
Provincial (100 %)
SCH (100 %) – – – –
Perú
Aetna Inversiones ING (30 %) Negocios e Other (7 %)
SA (30 %) Peru SA (30 %) Inmuebles SA (3 %)
Santander (100 %) – – – –
Holding Continental BBVA (25 %) Provida Internacional Corporacion General –
SA (54 %) SA (16 %) Financiera SA (5 %)
Uruguay
Banco de la Banco de Prevision Banco de Seguros del – –
Republica (51 %) Social (37 %) Estado (12 %)
Banco Commercial Santander (HOLBAH ltd) – – –
(50 %) (50 %)
Boston Inter. Citibank (33.3 %) Banco de Montevideo – –
Holding Corp. (33.3 %) (33.3 %)
COFAC Cooperativo CACDU Cooperativo FUCAC Cooperativo – –
225
(75.5 %) (10 %) (14.5 %)
226 Mario Catalán

companies and publicly traded corporations is needed. The task of assessing mis-
behavior in corporate governance is typically challenging. For instance, if banks
are significant owners of pension fund management companies and the portfolios of
pension funds are heavily invested in bank time deposits, as is actually the case, one
cannot immediately conclude that pension funds are not acting in the best interest of
pensioners. In order to draw such conclusion, one must show that there is a bias that
results from the conflict of interest, in so far as pension fund managers allocate more
assets to bank time deposits or to particular company stocks than they would if the
conflict of interest were absent.
Banks that control pension fund management companies could allocate pension
fund assets to bank deposits in order to satisfy bank regulations (such as the Basel
regulations) or use deposits from pension funds to reduce the probability of facing bank
runs at the expense of pensioners. Future research should explore these possibilities.
Iglesias (1999b) offers an account of how regulators have attempted to mitigate the
agency problems between Chilean pension fund management companies (AFPs)34
and their affiliates. For instance, regulations mandate that no AFP can purchase on
its own behalf stocks that may be acquired by the pension fund, and set maximum
investment limits for stocks of companies related to the AFP that are lower than the
investment limit for stocks in general. In addition, a maximum investment limit of 5 %
of the pension fund is set for the whole group of investments in related companies.
These regulations make sense, however one wonders whether pension fund
managers could sidestep them through triangular or even more sophisticated re-
lationships. Furthermore, the concentration of the Chilean pension fund industry (see
Table 4) promotes reciprocity among pension fund management companies, and such
reciprocity is often difficult to detect, prove and punish, and, therefore, one might
also consider the imposition of regulations that are systemic rather than AFP specific.
These issues also deserve consideration in the research agenda and in the design of
future pension reforms.
In any case, if corporate governance practices had improved significantly during
the 1990s in Chile and in other reforming countries, we should have observed a more
clear and notorious clash between the new pension funds and the old-style managers.
It is unlikely that such a breakthrough occurred, given that we have not observed a
significant number of top managers’ heads rolling. As the recent events in the United
States demonstrate, the louder the clash of swords between regulators, institutional
investors, and corporate managers, the greater the likelihood that public confidence
in stock markets will increase.

5 Some differences between the corporate governance role of pension funds in

developed and developing countries
As we mentioned in the introduction, many analysts argue that the belief that pension
funds exercise effective monitoring is a myth even in developed countries such as the
United States and The United Kingdom. To explain the pension funds’ failure in

34
AFP stands for Administradoras de Fondos de Pension.
 Pension funds and corporate governance in developing countries 227

Table 4. Concentration in the Latin American pension fund industry (1999)

Market share of the three Market share of the five

largest pension funds largest pension funds
Number of pension
fund management Affiliates Funds Affiliates Funds
Country companies ( %) ( %) ( %) ( %)

Chile 8 77.9 70.8 92.8 94.8

Perú 5 75.2 76.2 100.0 100.0
Colombia 8 62.3 62.4 85.2 85.2
Argentina 15 55.2 52.4 77.6 76.6
Uruguay 6 69.1 76.8 94.3 93.8
Bolivia 2 100.0 100.0 100.0 100.0
Mexico 14 43.8 50.4 66.2 68.2
El Salvador 5 81.6 83.6 100.0 100.0
Source : Iglesias (1999a).

this regard, Monks and Sykes (2003) put forward explanations that are based on
coordination failures.35 The argument goes as follows :
We believe in and hope to demonstrate the existence of a significant ‘systemic fault ’ … the fault
cannot be remedied by the individual actions of the various parties concerned even if all would
benefit substantially thereby. Systemic faults require either compulsion or some other external
catalyst, frequently a change in law or regulation, if they are to be remedied. They occur when
the number of entities involved in a malfunctioning system is relatively large. There may be a
large potential gain for the group as a whole from collective action, but there is insufficient
incentive for individual action, particularly when many of the entities, for example, fund
managers, are in competition. In the case of corporate governance the position could hardly be
less favorable to collective action. There is not just one large group that needs to act but several,
each with little contact with the others, and in the case of the many millions of individual and
underlying beneficial shareholders, none at all. This explains why despite the many worthy
attempts at corporate governance reform in the last decade particularly in Britain, achieved too
little. The groups’ individual incentives and conflicts of interest have proved impossible to
overcome by what were essentially appeals for more enlightened behavior without effective
sanctions. (This Quote is from page 2 of Monks and Sykes (2003)).

Two problems that Minow and Sykes point out are reciprocal passivity and short-
termism.
Reciprocal Passivity : ‘Corporate managements exercise power over their own company’s
pension fund trustees and their fund managers to take a non-activist stance on other companies
implicitly in return for similar reciprocal passivity’, and in turn ‘have major powers of
patronage also over most other fund managers seeking their pension fund business, who are
frequently part of wider financial organizations wanting investment banking or insurance
business ’. (These two Quotes are from page 11 of Monks and Sykes (2003)).

Notice that Minow and Sykes do not view reciprocal passivity as the result of a
collusive agreement among companies and pension fund managers, because they
35
Coordination failures are pervasive in financial markets and institutions. For instance, inefficient bank
runs can occur because of the multiplicity of equilibria that arises from short-term liquid bank deposits
that are backed by long-term illiquid bank loans. Government deposit insurance is the policy response
that can eliminate the possibility of bank runs.
228 Mario Catalán

emphasize the large number of players and the collective action problem. Instead one
can interpret that reciprocal passivity among a large number of players as a social
norm that has emerged as a result of a learning process. Note also that reciprocal
passivity benefits managers at the expense of shareholders, because it reduces the
extent of monitoring of managers’ decisions.

Short-termism :
If corporate managements have major inappropriate powers, however, they also suffer from a
major weakness which they share with fund managers. They suffer from a damaging restriction
which handicaps their performance and damages the interests of shareholders. This is the
market pressure to raise corporate performance as measured by share prices over un-
realistically short periods of time, often over only 2–3 years … This pressure, mainly from fund
managers urged on by investment analysts, is itself the result of the increasingly shortening
periods over which fund managers are judged. Perversely, this is largely due to the terms
imposed by pension funds controlled by corporate managements. Such periods are unsuitable
for most industries. They prevent corporate managements and fund managers alike playing to
their long-term strengths to the clear detriment of the much longer-term interests of most
individual and all beneficial shareholders saving mainly for retirement – a particularly serious
weakness. (This Quote is from pages 12, 13 Monks and Sykes (2003)).

By contrast with reciprocal passivity, short-termism does not seem to benefit

corporate managers. However, it is clear that both reciprocal passivity and short-
termism damage shareholders.
The stark contrast between the collective action problems associated with the large
numbers of players in developed and competitive markets, and those of developing
countries becomes evident from an inspection of Table 4, which shows the concen-
tration of the pension fund industry in the countries that implemented pension
reforms.
All countries exhibit very high levels of concentration, which is extreme in the case
of Bolivia that has only two pension fund management companies. Even in Chile,
which has the most mature funded system, the number of pension fund management
companies is eight. For the whole region, the three and the five largest pension funds
manage, on average, 72 % and 90 % of the funds in the private pension systems
respectively. Moreover, industry associations aimed at coordinating the actions of all
the pension fund companies are present in all the Latin American countries.
Such high levels of concentration obviously create incentives for collusive activities,
which might be hard to detect in spite of the regulatory efforts. In any case, Table 4
clearly suggests that lack of coordination cannot possibly account for potential
failures of pension funds to exercise their corporate governance role in developing
countries. However, if there are ties between pension funds, banks and corporations,
reciprocal passivity that damages pension fund affiliates might still arise as the out-
come of collusive agreements. Short-termism, to the extent that is interpreted as a
coordination failure, as described above, seems less likely to occur in highly con-
centrated financial systems such as those of Latin America.
In sum, the contrast between the perceptions of the corporate governance problems
in developed and developing countries that implemented pension reforms can be put
in the following way. In developed countries, there are collective action problems
 Pension funds and corporate governance in developing countries 229

that arise from the existence of a large number of unrelated participants, while in
developing countries the potential source of problems is excessive ownership con-
centration and tight relations between financial and corporate incumbents. While
in developed markets the main concern is to mitigate the powers of managers or
‘dominant imperial CEOs’ who are usually small shareholders of the corporations
they manage, in developing countries the main concern is to mitigate the power of
‘the dominant imperial large owners and financial and corporate incumbents’.
Pension and corporate governance reform proposals in developing countries must
take account of these and other structural differences.

6 Conclusions
This paper provides a framework meant to discipline the study of the corporate
governance channel associated with pension reforms in developing countries, and
to set the ground for future progress in this area. The paper provides a relevant review
of the literature, raises new issues, highlights facts that have been overlooked, and
provides lessons and food for thought to pension reform designers and policymakers
in developing countries.
A short answer to the question : what do we know ? is the following :
’ The international evidence shows that pension funds can be large in terms of
GDP, while being small as equity holders. Thus, the development of pension
funds does not guarantee positive effects on stock markets, including corporate
governance effects.
’ The conventional view that pension funds are prominent equity-holders in
the thin Latin American stock markets is, thus far, inconsistent with the
hard facts. The reality is that pension funds still hold less than 10 % of domestic
equity in such countries, and in five out of the seven countries in the region,
they hold less than 5 % of the total equity. Such ratios are below the standards
for the OECD region. This observation must restrain the wishful claims that
the corporate governance channel has made a significant difference in the region
so far.
’ There is some evidence that pension funds lead to stock market development.
However, theoretical models and a systematic econometric analysis that includes
all relevant control variables must complement the preliminary evidence to draw
solid conclusions.
’ The corporate governance channel has not been filtered from alternative
channels through which pension funds could develop stock markets.
’ While pension reforms do lead to pro-investor legal reforms, there is no
convincing evidence that pension funds lobby for the enactment of pro-investor
legislation, or that these laws are being enforced in a systematic way, or that
pension funds exert pressure to guarantee enforcement in courts.
’ The name-and-shame tactics used by active pension funds such as Calpers (US)
in developed countries do not seem to be commonly used in the Latin American
countries. In Chile, regulators do not allow pension funds to use such strategies.
230 Mario Catalán

’ We know that pension funds in Latin America are controlled by banks and other
financial institutions. We know that conflicts of interest are possible.
’ We know that corporate governance failures in developed and developing
countries are of different natures, and, therefore, the corporate governance role
of pension funds might be different. Ownership and power in financial systems of
developing countries are highly concentrated. Thus coordination failures are less
likely, and conflicts of interests and political economy issues are more relevant in
developing countries.
A short answer to the question: what do we need to know ? is the following :
’ We need to formulate more precise hypotheses and find more conclusive evidence
regarding the link between pension fund and stock market development, and
filter the corporate governance channel from the liquidity and transaction cost
reduction channels.
’ We need to know whether pension funds actually play an active and direct role
in the enactment of pro-investor laws, or whether such laws are natural follow-
ups on pension reforms that are enacted under the pressure of other groups such
as labor unions.
’ We need to study the link between pension funds, the ownership structures of
publicly traded firms, and public firms’ performance.
’ We need to address seriously the question ‘ Do pension funds act in the best
interest of pensioners ?’, i.e. we need to evaluate the corporate governance of
pension funds carefully. We need to detect (if they exist at all) biases in the
investment decisions of pension fund managers, such as excessive allocation of
pension funds’ assets to bank time deposits, and excessive acquisition of equity
of companies that have relations with the banks that manage the pension fund
business. We need to study the behavior of pension fund managers in corporate
meetings as well. In sum, we need to ask whether they are aggressive enough in
their search for corporate crimes and misgovernance, and study carefully the
way they invest, vote, and lobby.
A short list of issues that are relevant for pension reform design and that only
recently have received attention in the literature are :
’ There is an interaction between the corporate governance channel and the
pervasive portfolio restrictions imposed on pension funds to limit the inter-
national diversification of investments (capital controls imposed on pension
funds). Financial groups and publicly traded firms could lobby for the imposition
of the capital controls on pension funds to create a captive source of low cost
funds, and to obtain private gains that offset the corporate governance effects
that pension funds are expected to exert on public firms.
’ The objective of pension reforms must be exclusively defined in terms of
pensioners welfare. The corporate governance improvements of public firms,
the capital markets development and the growth effects must all be subordinated
to the ultimate objective of pensioners’ welfare maximization. This is relevant
because a trade off between the alternative objectives almost certainly exists.
 Pension funds and corporate governance in developing countries 231

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