no longer receiving contributions from workers that join the new system. The resources in second-pillar pension funds have been tapped for this purpose (as well as for general government deficit financing needs), and this has typically being aided through regulations mandating a that a high share of pension fund portfolios be allocated to government paper. It is thus not surprising that the portfolios of most second-pillar pension funds in the region are rather undiversified and dominated by government debt securities.<sup>40</sup> The second competing policy objective has been to harness pension funds’ investment power to stimulate the development of local financial markets and the local economy, especially by supplying long-term finance to the private sector, without sacrificing their primary fiduciary duty.<sup>41</sup> This objective has led to a reluctance among Latin policy makers to give AFPs ample latitude to diversify pension fund portfolios through investment in foreign assets. This reluctance has been often reinforced by a nationalistic discourse and concerns that allowing AFPs to find assets in international markets smacks of an official blessing to capital flight. As discussed in the previous section, expectations that pension funds would diversify into a very wide range of local assets, including SME finance, proved to be misplaced. In any case, as the growth of pension funds has been clearly outstripping the availability of suitable assets at home, policy makers have been prompted to raise the ceiling on pension fund investments abroad, albeit ever so gradually and reluctantly. Chile is again well ahead of the pack in this regard, currently allowing up to 30 percent of pension fund portfolios to be invested in external assets.

Finally, the room to relax pension fund investment regulations has been constrained by a deeper policy concern, present especially in countries where the second pillar constitutes the core of the national social security scheme. Allowing pension funds to take on more risk in order to raise returns implies also that losses would be made now and then. But such losses would raise greater political sensitivities in countries with a second-pillar dominated national pension systems, where workers bear all the market risk, compared to countries where the second pillar is a complement to a core PAYG system and where, as a result, workers bear less market risk overall (Rocha, 2004). Hence, in the case of the former countries, a full liberalization of pension fund investment regulations cannot be reasonably expected. Rather, it should not be surprising to find, as in fact we do, that regulators in such cases tend to be more risk averse and regulations more biased in favor of conservative portfolio allocations.

In all, the policy objective of raising expected replacement rates via the liberalization of pension fund regulations is caught up in a nontrivial tension with other policy objectives that pull in a different direction. While reasonable people can differ on the relative weight that should be given to each of the competing policy objectives, there is no question that the policy path towards higher replacement rates via a freer pension portfolio allocations is fraught with complications that were not fully foreseen at the time of the reform.

> 40 Chile and Peru are exceptions where government debt does not absorb the lion share of pension fund portfolios.  Data on pension fund portfolio composition is presented, for instance, in Gill, Packard and Yermo (2004) and De la Torre and Schmukler (2004b).

> 41 In effect, fostering financial development at home can be in fact consistent with pension funds’ fiduciary duties to the extent that domestic financial deepening promotes growth.

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