Supervision of Pensions Richard Hinz The World Bank November 16, 2010
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 Mandate Cover % Assets %GDP Number of Funds Legal structure Type of Plan Netherlands Quasimandatory 90 120 700 Occupational Mostly DB Denmark Quasimandatory 80 124 111 Occupational and open 1 Mostly DC with absolute return guarantee (DBlike) Australia Mandatory 90 104 1,004 Occupational and open 2 DC Mexico Mandatory 28 8 18 Open DC with ceiling on downside risk (VaR)
The Basic Risk Management Architecture For the institution: Risk management strategy Board committees Risk management functions in the managerial structure Internal controls Reporting responsibilities For the supervisor: Regulations, including minimum risk management standards Risk-based solvency rule Risk scoring model guiding supervisory actions Internal organization of the agency, with specialist risk units 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