_34_ _Mexico: The 1997 Pension Reform_ The choice of benefits, as well as its fiscal cost, will depend on variables such as inflation, the real return on transition workers' post-1997 contributions and the real rate of growth of the minimum wage. Higher inflation will lead to less people choosing the former pension, since it was computed from the retiring worker's average nominal wage. Higher earnings and rates of return will lead to higher individual savings and higher pensions under the new law. Should real returns be higher than expected, more transition workers will take their benefits under the new program, thereby reducing fiscal costs.

For transition workers, the minimum guarantee is grandfathered from the old system, because of legal constraints related to acquired rights. For them, the minimum guarantee continues to be: (i) based on an average of their last 5 years' nominal wages, or (ii) equal to the minimum wage at their point of retirement, indexed to the minimum wage thereafter - whichever is higher. If inflation becomes very low, the first clause will be operative and the fiscal costs could be large. If inflation is high the second clause is operative, as it is now for 80% of retirees. In this case, all transition workers would be entitled to 38% of the average wage, indexed to (minimum) wage growth-still a high guarantee. It will be even higher if the minimum wage is raised faster than the average wage. This is very likely because the minimum is now at a historical low relative to the average and political pressure from workers and prospective pensioners could easily push it up to 50 or 60% of average. This would have immediate fiscal implications and might compromise the long-run sustainability of the reform. Notwithstanding this warning, as a result of the appropriateness of the timing of the reform, the estimated fiscal costs are so low that even if there are setbacks to the reform program as a result of design limitation, fiscal costs are expected to remain below 2% of GDP per year.

**Limited funding of AFORES and the role of INFONAVIT.** AFORES will manage, in individual accounts, between 7.5 and 12% of workers' salaries, depending on salary level, before fees and commissions. Fees and costs are currently approximately 2% of salary, leaving at most 5.5-10% in the AFORES investment accounts. This amount itself is insufficient for a reasonable retirement pension for most workers. The rest would have to come from the housing fund contribution (5%) managed by INFONAVIT. Hence, under the reform, contributions to INFONAVIT will represent between 30 and 40 % of total contributions to pension accounts. It is critical that INFONAVIT earn a positive real rate of return, assuring better pension benefits for workers and reducing the fiscal costs of the reform.

The ramifications of INFONAVIT not earning positive real rates of return include: (i) higher fiscal costs as a poor financial performance by INFONAVIT lowers total returns on individual accounts and increases the probability that younger transition workers will choose the old PAYG over the new system or that the Government will have to provide for a MPG for new workers; and (ii) the loss of potential retirement income by workers just entering the new system which could lead to continued evasion.

**Impact of Administrative Costs**<sup>**9**</sup> **.** In Mexico, each AFORE has selected its own approach to the setting of commissions, since the government does not regulate the level nor the form of commissions. Commissions charged by Mexican pension managers are currently in line with, or slightly lower than, those computed for defined contribution plans in other Latin American countries.

9 This section is based on on-going work by Olivia Mitchell (The Wharton School) financed by the World Bank.