Supervision of Pensions

Richard HinzThe World Bank

November 17, 2009

Basic Elements of Supervision• Control of Entry - Licensing

– Pension Companies– Fund Managers and Trustees– Custodians, Actuaries and other Service

Providers• Monitoring

– Financial Reporting and Auditing– Actuarial Reviews– On-Site Reviews and Investigations– Receiving Complaints & “Whistleblowers”

Elements of Supervision (Cont)• Measurement

– Comparison to Normative Standards– Risk Scoring and Evaluation

• Communication

– Disclosure– Outreach and Education– Training

Elements of Supervision (Cont)

• Intervention

– Notification of Violations– Directive Actions– Negotiated Resolutions

• Correction

– Punitive– Remedial– Compensatory

Determinants of Supervision• Many different approaches to supervision have

been implemented• Will vary by instensity of oversight and pro-active

vs re-active style of operation• Differences arise from many factors. Some of the

more important include:– Design of Pension System– Number of funds– Level of financial market development– Legal tradition and rule of law

Mandatory Systems Require More Intensive Supervision

• Less Sophisticated Members• Greater Reliance on Pension for Subsistence• Fewer Choices – Less Market Discipline• Voluntary Systems Can Afford Fewer Costs and

Require More Flexibility– Employer Will Not Enter System If Risks Are

Perceived As High– Limits of Compensating Differentials – Cost of

Monitoring and Intervention Will Not be Absorbed by Members

More Developed Economies and Large Number of Funds Reduces Intensity

• More Sources of Information with Greater Reliability Supports Reactive Approach

• Greater Diversity of Fund Design Limits Potential Intensity of Oversight

• More Flexible and Process Oriented Rules Not Conducive to Directive/Pro-Active Methods

• Greater Reliance on Communication and Competition Improves Efficiency

• Typically higher levels of “Financial Capability”

Financial Market Development Facilitates Less Intensive Oversight

• More Products Enhance Competition• Institutional Development Creates Private Third

Party Oversight– Financial Accounting Rules– Auditors

• Development and Supervision of Financial Professionals Limits Need for Specialized Pension Supervision

• Primary Market Regulation Supports Less Intensive Oversight

Enhanced “Rule of Law” Lowers Required Intensity of Supervision

• Greater Capacity for Individual Rights of Action Limits Need For Supervision

• Capacity to Achieve ex post Remedial Sanctions Diminishes Requirement for Pro-Active Methods

• Greater Reliance on Negotiated Process and Litigation

Some Basic Relationships For

Supervision

General Observations on Supervision

• Effective Monitoring and Control are Essential –Wide Range of Feasible Approaches to Measurement an Interventions

• Some Common Elements and Consistent Patterns of Supervision in Relation to Design and Development

• Practices Are Significantly Derived From Matching Context With Methods

Some Illlustrative Examples

• United States – Highly Reactive - Exception Based Interventions

• Hungary – Moderately Proactive, Exception Intervention

• Risk Based Supervision : Australia, Mexico, Denmark and Netherlands

Basics of U.S. Pension System

• Voluntary employment based system• Wide range of permissible benefit design, DB,DC

and Hybrids (eg Cash balance)• Supplements modest universal public system

– 40% Replacement at normal retirement age for average wage, 30% actual due to early retirements

• Incentives through specific tax qualification rules resulting in complex rules and interactions

• Current coverage rate of 50% of current full time private sector workforce– Lifetime rates may be as much as 70%

Regulatory Framework

• Minimal entry barriers• Procedural (prudent person) framework• Highly developed and regulated financial

markets• Multiple levels of financial intermediation

Structure of Supervision

• National Policy, Oversight and Evaluation Unit

• Ten Regions with Five Sub-Regions• Groups (teams) of 8-12 staff conduct

activities• Participant Assistance Staff located in

National Office and all regions

Supervision “Style”

• Re-active, Remedial, Decentralized• Intervention on Exception Basis - Weak

legal authority for pre-emptive actions• No legal authority for punitive or

compensatory sanctions• Emphasis on negotiation based settlements• Civil litigation required to impose monetary

sanctions (except for reporting violations)

Basic Strategies

• Reliance on deterrence• Leverage limited resources• Focused Agenda - Strategic Case

Selection• Voluntary Compliance & Assistance• Mandatory Indemnification/Insurance• Outcome oriented measurement and

evaluation

Reasons for Approach• Voluntary System – Tension Between Security

and Coverage• Low Resource Levels Relative to Scope of

Responsibilities• Regional Diversity in Types of Funds and Service

Providers• Variation in Interpretation of Statute by

Jurisdiction• Strong Regulation of Primary Financial Products• Tradition of Individual Civil Litigation and

Exercise of Rights

Major Challenges

• Political Acceptance Of the Inability To Address All Violations

• Tolerance of a Significant Degree of Agency Risk• Resource Rationing • Sustaining Strategic Objectives• Policy Consistency Over Time and Among

Regions• Reconciling Conflicts With Other Regulated

Sectors

Basics of Hungarian Pension System

• Recently “downsized” Public System Providing Basic Coverage

• Mandatory Defined Contribution Funds Established 1997 - “Carve Out” of Social Insurance Contribution for Younger Workers and New Entrants

• Voluntary Funds Established 1993

Regulatory Framework

• Licensing of Pension Fund Companies• Mutual Organization – Joint Boards• Quantitative Asset Allocation Requirements• Minimum Rate of Return Relative to

Universe of Funds – Reserve Account to Balance

• Decentralized Flow of Funds

Structure of Supervisor

• Integrated Agency (since 2000, began separate)

• Financed by Fees on Funds• Matrix Organization – Functions X Type of

Institutions• Separation of Institutions “Chinese Wall”

Style of Supervision

• Moderately Pro-Active• Extensive Reporting Requirements – Daily

Fund Balances, Annual Comprehensive Financial

• Focus on Negotiated Preventive Measures• Punitive Sanctions by Decree of Supervisor• Emphasis on Publication of Sanctions –

Market Forces

Supervision Methods

• Quarterly Publication of Legal Interpretations• Required Attendance of Supervisor at Board

Meetings• Monthly Preventive Meetings With Managers –

Informal Advice and Counsel• Quarterly Analysis of 80 Financial Ratios and

Management Indicators• Full Inspection 1-2 Years• Application of Sanctions Only After Failure of

Voluntary Compliance

Reasons For Approach• Balance of Emerging Market and New System• Seeking to Enhance Market Competition• New System – Concerns About Depth of Political

Support• Trend to Consolidation – Concerns About

Concentration• Limitation of Entrants to Well Capitalized

Financial Institutions• Strong Public Guarantee Backs Fund Companies

performance

Risk Based Supervision

• Recent Innovation – Rapidly Advancing in a Range of Settings

• Strongly Influenced by Trends in Bank and Insurance Regulation and Developmentof Integrated Supervisory Authorities

• Early Adopters (WB Paper): Netherlands, Mexico, Australia, Denmark, Canada

• Others (IOPS Paper): UK, Germany, South Africa, Croatia, Kenya

Characteristics of Four Systems

MandateCover

%

Assets

%GDP

Number

of

Funds

Legal structureType of

Plan

NetherlandsQuasi-

mandatory 90 120 700 Occupational Mostly DB

DenmarkQuasi-

mandatory 80 124 111 Occupational and open 1

Mostly DC with absolute return guarantee (DB-

like)

Australia Mandatory 90 104 1,004 Occupational and open 2 DC

Mexico Mandatory 28 8 18 OpenDC with ceiling on

downside risk (VaR)

The Basic Risk Management ArchitectureThe Basic Risk Management Architecture

For the institution:For the institution:

Risk management strategyRisk management strategy Board committeesBoard committees Risk management functions Risk management functions

in the managerial structurein the managerial structure Internal controlsInternal controls Reporting responsibilitiesReporting responsibilities

For the supervisor:For the supervisor:

Regulations, including Regulations, including minimum risk management minimum risk management standardsstandards

RiskRisk--based solvency rulebased solvency rule Risk scoring model guiding Risk scoring model guiding

supervisory actionssupervisory actions Internal organization of the Internal organization of the

agency, with specialist risk agency, with specialist risk unitsunits

Market Discipline:

The contribution of the actuary, auditor, fund members, rating companies, and market analysts to sound risk management

Main Elements of RBS

• Requirements for risk management process within institutions

• Solvency standards and stress testing• Risk scoring methodology • Disclosure and market competition• Use of third party reviews• Organization of supervisor

Risk Management Structure and Procedures

• Netherlands– Risk management plan at registration– Centralized function & Accountability of board

• Denmark– Guidelines and plan by Board of Directors

• Australia– Guidelines and risk management plan at licensing.

Trustee licensing standards• Mexico

– Specific requirements for policies, procedures, risk management committees and Chief Risk Officer

Solvency Standards• Netherlands (FTK)

– Annual market value solvency plus 5% margin– Solvency buffer stress test Less than 2.5% probability of insolvency– Long term continuity

• Wage growth, rate of return– Recovery period maximum: One year for margin, 15 for stress test

• Denmark– Traffic lights stress test

• Red Light: Insolvent with decline of 12% equities, 8% real estate, duration based for fixed income

• Yellow light: 30% equities, 12% real estate– Indicator of increased attention rather than trigger for required actions

• Mexico– Value at Risk (VaR) limits, Daily standard: 0.6% for standard portfolio,

0.1% for higher risk portfolio– Directive action by supervisor when limit is exceeded, so far has not

happened

Risk Scoring Methods

• Netherlands (FIRM)– Integrated system applied to all financial institutions – Standard templates and default scores as starting point– Inherent risk –mitigation = net risk– Specific consideration given to management quality and

risk management procedures • Australia (PAIRS & SOARS)

– Risk scores mapped into supervisory response matrix –response is less structured than evaluations

– Distinction by fund size– Probability and impact treated separately

Third Parties and Market Discipline• All systems use third parties auditors and to varying degrees

require assessment of risk management capacity• All impose “whistle blower” obligations to varying degrees• New accounting standards and regulatory requirements

strengthen movement to market valuations• Mexico has extensive monthly disclosure – consistent with

open funds based system• Denmark has annual disclosure – including risk assessment• Netherlands and Australia have less reliance on disclosure –

reflect occupational origins and DB character

Organization of Supervisor

• Australia, Denmark and Netherlands are integrated supervisors – to varying degrees

• Denmark combines life insurance and pensions in operating division – similar to organization of funds

• Australia has little specialization of divisions• Netherlands has modified matrix - dedicated

pension fund units supported by centralized risk assessment technical units

• Mexico remains separate pension fund authority

Initial Assessmentof Risk Based Methods

• Offer Promise of :– Efficiency Gains in Investment of Funds Assets– Lower Interventions and Supervisory Costs– Flexibility to adress differing needs with in same supervisory

system– Alignment of Pension with other Financial Supervision –

Integration of Authority– Political economy of relaxing restrictions

• Challenges:

– Aligning risk standards with retirement income – Potential pro-cyclical nature of systems– Accommodating diversity of members risk preferences – Adequacy of solvency standards– Political economy of acceptable risk levels

Concluding Thoughts

• No Right or Wrong System - Like Good Architecture - Form Follows Function

• Objective and Tradeoffs Define Systems - Every Approach is Inevitably a Compromise

• Optimize Through Evaluating Objectives, Structure and Priorities

• Assume Regulated Will Always Be Well Paid, Creative and Motivated To Find A Way To Get To The Money