PENSION REGULATION AND SUPERVISION
Pension Core Course 2018 Richard Hinz Fiona Stewart REGULATION OF PENSION FUNDS DISTINCTION BETWEEN REGULATION + SUPERVISION
• Regulation: Legal Foundations and System of Rules and Regulations Governing the Structure and Operation of Pension Funds Establish form of system and “empower” various parties to perform functions or protect interests • Supervision: Oversight and Enforcement of Compliance With The Rules Collection of information and monitoring of system to support review and analysis
2 WHY PENSION FUNDS ARE DIFFERENT FROM OTHER SAVINGS?
• Vulnerability To Old Age Poverty Leads to Less Risk Tolerance
• Potentially a High Proportion of Average Members Wealth
• Less Sophisticated Clientele – More Likely Low Income and Less Educated if System is Mandatory
• Limited Choice By Consumer Due to Mandates and Constrained Products
3 ATTRIBUTES OF PRIVATE PENSIONS
• Specialized Financial Intermediary • Long Time Horizon • Low Liquidity Needs • Heterogeneous Risk Tolerance • Often Multiple Levels of Intermediation When Employers or Worker Associations are Involved • Use of Commercial Service Providers Creates Complex Incentive Problems • Possible High Fiscal Exposure Through Tax Treatment and Guarantees
4 THEORETICAL BASIS FOR THE NEED FOR REGULATION AND SUPERVISION
• Address Market Imperfections and Failures
• Compensate for Asymmetric Information
• Control Potential Moral Hazard
• Overcome Consumer Myopia
• Stimulate Competition and Efficiency
5 TYPES OF RISKS TO BE ADDRESSED
• Systemic – Vulnerability to Macro Conditions
• Portfolio – Quality of Investments
• Agency – Incentives of Individuals and Institutions
• Principal – Member’s Knowledge and Experience
6 MAIN ASPECTS OF REGULATION COMMON TO ALL SYSTEMS
I. Rules Defining the Structure and Organization of Funds
II. Requirements for the Operation of Funds
III. Authority for Supervision, Sanctions & Remedial Action
7 I STRUCTURE OF PENSION FUNDS
• Licensing of Fund Operators
• Governance of Funds
• Capital and Reserves
• Segregation of Assets
• Custody of Assets
8 II OPERATION OF PENSION FUNDS
• Investment Guidelines
• External Audit Requirement
• Reporting and Disclosure
• Limits on Fees and Expenses
• Guarantees
9 III. SUPERVISION, SANCTIONS AND REMEDIAL ACTION
• Government Agency with Oversight and Regulatory Authority
• Legal Venue and Guidelines for Application of Sanctions – Punitive and Remedial
• Rights of Members and Venue for Resolution of Disputes
10 SOME DIMENSIONS OF VARIATION
11 Two Stylized Models Many Systems Incorporate Elements of Both
LATIN AMERICAN/CENTRAL EUROPEAN ANGLO AMERICAN
• Mandatory Personal Accounts • Voluntary Employment Based DB and DC • Special Purpose Investment Companies • Employer Managed Trusts • Primary Intermediation • Secondary Intermediation • Open Funds • Closed funds
12 LATIN AMERICAN/ CENTRAL EUROPEAN
Structure Pension Funds Are Profit Making Commercial Entities Stockholders and Officers Establish Authority Rules for Operations Directive Outcome Oriented Rules Define Specific Limits and Practices Supervision Directive and Proactive Daily Reporting, Pre-emptive Authority
13 ANGLO-AMERICAN
Structure Trust based, Not-for Profit Entities Governance on Behalf of Members, Agents Rather Than Principals Rules for Operations Process Based – Prudent Man Rules, Control of Transactions Agency/Relationship Oriented - Conflict of Interest Prohibitions Supervision Exception Basis , Re-active Remedial and Punitive
14 REGULATORY STRUCTURE OF LATIN AMERICAN SYSTEMS
• Specific Entry Requirements w/ Capital and Reserve Requirements
• Small Number of Entities Permitted
• Quantitative Investment Standards
• Extensive Interaction and Monitoring
• Preventive Sanctions
15 RATIONALE FOR LATIN AMERICAN/CENTRAL EUROPEAN APPROACH
Low Risk Tolerance of Worker Mandatory Pension Major Source of Security Less Sophisticated, Experienced Population More Volatile Environment Higher Exposure to Macro Instability Less Developed Primary Financial Regulation Lower Opportunity Costs Less Diverse Financial Products Less Competitive Markets Higher Fiscal Exposure Through Politically Necessary Guarantees
16 REGULATORY STRUCTURE OF ANGLO-AMERICAN SYSTEMS
• Minimal or No Entry Requirements - Registration
• Large Number of Funds
• “Prudent Expert” Investment Standards
• Reliance on Disclosure to members
• High Reliance on Other Financial Services and Regulation of Professions
• Exception Based Interventions
• Remedial/Corrective Sanctions
17 RATIONALE FOR ANGLO-AMERICAN APPROACH
Higher Risk Tolerance Primarily Voluntary Occupational Funds Supplement Universal Public Pension Programs – More concentration in higher income groups Highly Developed Primary Financial Services Regulation Extensive System of Civil Law and Liability – Private Rights of Action Potential High Opportunity Losses from Restrictive Regulation Typically Limited Public Guarantees
18 COMPARISON
• Security – Efficiency Tradeoffs
• Stage of Development – Movement To Convergence Over Long Run
• Practicality: Small vs Large Number of Funds
• Different Reliance on Market Forces and Competition
19 NOTABLE DEVELOPMENTS AND TRENDS
• Licensing, Training and “Fit and Proper” Requirements for Trustees
• Introduction of Solvency Standards Linked to Market Derived Criteria – VAR and Asset Liability Matching Models
• Required risk management architecture, procedures or governance oversight groups
• Harmonization with other Financial Regulations – Investment Advice and commissions emerging as key issues
• Movement to Multiple Portfolios and Age Based Portfolio Choices
• Introduction of Automatic Enrollment and Default Portfolios
• Increased Limitation of Permissible Fees and Expenses
• Greater Reliance on Market Disclosure
• Minimum Annutizations, Programmed Withdrawals and Phased Retirement
20 Basic Elements of Pension Regulatory Law
21 THREE LEVELS
1. Statutory (Legislative) Establishes Basic Framework and Rules of System Creates Source of Regulator/Supervisors Authority 2. Interpretive (Regulatory) Extends statutory provisions to make system operational Capacity to adjust to changing conditions, new products & practices Oriented to Standards and Procedures 3. Implementation (Judicial) Application to specific facts and circumstances
22 CONSIDERATIONS IN ALLOCATION AMONG LEVELS
• Civil vs Common Law Environment
• Underlying System Design (Trust vs Pension Companies)
• Strength of Mobilization of Interest Groups & Expectation of Opposition
• Time for Development
• Independence and Technical Capacity Regulator
• Quality and Independence of Judiciary
23 MAIN ELEMENTS THAT NEED TO BE ADDRESSED IN SOME FORM
• Legal Status and Governance of Funds
• Definition and Holding of Assets
• Licensing and Entry Requirements
• Structure and Scope of Regulatory/Supervisory Authority
• Rule Making/Interpretive Procedures
• Funding Source for Regulator/Supervisor
• Relationship of Pension Law to Other Laws Controlling Financial Services
24 MAIN ELEMENTS CONTINUED
• Individual Rights and Dispute Adjudication
• Withdrawal Requirements and Access to Funds
• Liability Structure and Delegations
• Tax Treatment of Pensions
• Reporting, Data and Records
• Conflict of Interest Prohibitions
• Fees and Expenses
• Investment Requirements or Prohibitions
• Penalty and Enforcement Structure
25 LEGAL FORM OF PENSION FUNDS
• Holding/Organizational Entity or Consolidated Financial Services
• Governance Structure and Standards
• Deference to Other Licensing Authorities
• Limitations of Who May Sponsor or Create
• Restriction on use of Term Pension Fund and Marketing Limitations
26 LICENSE AND ENTRY REQUIREMENTS
• Authority for Fit and Proper Tests and Categorical Exclusions
• Capital or Indemnification Requirements
• Fees and Duration of License
• In Regulations: • Procedures for Application and Establishment of Standards
27 DEFINITION AND HOLDING OF ASSETS
• Establish level to be subject to rules – Degree of “look through” to underlying assets
• Holding of title - Common structure requires use of third party custodian
• Statute should establish principle and define entities that qualify to act in this capacity
• Should consider principle of independent judgment of appropriate instructions in law (Maxwell case)
• Regulations can define procedures
28 LIABILITY AND DELEGATIONS
• Establish Structure for Responsibility and Liability (Named Parties)
• Determine Whether Delegations and Shield will be Permissible – All actions require responsible party
• Co Liability and Knowing Involvement Standards
• In Regulations • Standards for proper delegations, reach of liability to involved parties (deemed responsibility)
29 PROCEDURES FOR RULEMAKING
• Need to establish some parameters in advance
• Reference to existing administrative law and procedures can work if effective framework exists
• Explicit framework for industry and public comment desirable – limitations on consultations outside of established framework
• Cost benefit or economic impact requirements (now becoming a major issues in the US)
• Legislative oversight of rule –making and role of judicial challenges
30 TAX TREATMENT
• Conforming Amendments to Tax Law to Ensure Consistency
• Create Specific Principles and Standards for Access to Preferential Treatment
• Often used to achieve distributional outcomes
• May include credits or start up contribution for low income workers or informal sector
31 REPORTING, DATA AND RECORDS
• Need to Provide Authority and Distinguish Three Elements: • Information to be Reported Periodically • Requirement to Retain and Produce Records • Reporting to Individuals Especially Rights and benefits Earned
• Requirement for Third Party Verification of Financial Information
• By Regulation: • Specific contents and forms for reports, specifics on record retentions • Measurement Standards and Qualifications for Audit
32 CONFLICT OF INTEREST RESTRICTIONS
• General principle of exclusion of all transactions and fees with related parties
• Prohibit capacity to control own fees (self dealing)
• Define categories of related parties – Limits of reach
• In regulations: • Specific applications and exceptions
33 INDIVIDUAL RIGHTS
• Define scope and limits of private rights of action against funds
• Prohibition of retaliation for reporting problems or violations
• Appropriate venue and causes of action
• Access to information from funds
• Creation of Ombudsman or other authority outside of regulator
34 PENALTIES AND ENFORCEMENT
• Establish principles of Scope of Penalties in Statute • Punitive, Remedial, Compensatory • Civil money penalties • Exclusion from Pension Business • Application of Criminal Penalties
• Basic Outline of Procedures and Limits in law, Process of imposition and standards by regulations
35 INVESTMENT RESTRICTIONS
• Main principles in law – Interpretation by both regulations and precedent
• Two Basic Approaches • Quantitative Restrictions (results) • Prudent Person (decision process)
• Recent Trend to “Prudent Person Plus” • Specific asset allocation limits by products • Overly of due diligence and expertise in process
36 COMMON ELEMENTS IN QUANTITATIVE LIMITS
• Limits on specific asset classes
• Required diversification – limit on proportion of any single issue and share of portfolio
• Currency matching
• Required minimums and Maximums by asset class
• Consider defining concepts/categories in law
• Limits on Foreign Assets
37 WITHDRAWAL REQUIREMENTS
• Largely a subset of Tax Law
• Need to establish principles of access before retirement age and form of payouts
• Condition for loans, excise tax or penalties for early withdrawals
• Specifics by regulation (possibly tax law)
• Prohibitions against assignment as collateral, access by creditors or payment for civil judgements
38 CONCLUDING THOUGHTS
• No Right or Wrong System - Like Good Architecture - Form Follows Function
• Context is Key Determinant
• 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
39 PENSION SUPERVISION AGENDA
1. Structure of pension supervision
2. Steps to establishing a supervisory framework
3. Risk-based supervision
4. Measuring supervisory success
41 1. SUPERVISORY STRUCTURES
42 CLICKER QUESTION
“The pension system in my country has:
Your answers: A. No supervisory framework B. Pension law but no regulations C. Regulations in place but implementation limited D. Risk-base supervisory framework
43 Elements of Supervision
44 Supervisory Approaches
45 Supervisory Style Depends on Country Context
46 TYPES OF SUPERVISORY STRUCTURE
Integrated Supervisory Authority Independent Pension Supervisory Authority
• Better for conglomerates • Pensions sufficiently different • Avoids regulatory arbitrage • Cross sector gains don’t materialize • Economies scale • Coordination between authorities • Share information across financial can achieve same effect sectors
Lessons Learnt
• Some structures more appropriate for certain circumstances (e.g. occupational pensions more suited to independent supervisory authority / developing economies may want to keep resources in integrated authority or central bank)
• Structure is not the most important thing – authorities which are focused, disciplined and communicate will deliver whatever the structure
47 IOPS Working Papers No. 1+16 TWIN PEAKS MODEL ATTRACTING ATTENTION POST GFC
48 IOPS Working Papers No.16 STRUCTURES OF PENSION SUPERVISION
49 IOPS Working Papers No.1 CLICKER QUESTION
The pension supervisory authority in my country is:
Your answers: A. No supervisory authority B. Central Bank C. Integrated financial sector supervisory authority D. Semi-integrated authority (pensions and insurance) E. Independent pension supervisor
50 2. BUILDING A SUPERVISORY FRAMEWORK
51 SUPERVISORY STEPS
Market Enforcement Development Monitoring / Inspection Reporting
Registration / Licensing
52 REGISTRATION VS. LICENSING
• Registration 1st step establish size / scope of existing funds • Check via tax registration if are tax breaks (e.g. Lesotho/Guyana) • Check via corporate registrations / corporate organisations (e.g. Uganda) • Cross check with mandatory scheme /social security fund registrations (e.g. Kenya?) • Check via main providers (e.g. insurance companies Rwanda)
• Don’t scare the horses – don’t want to close down what already there
• Once universe known establish collaborative relationship - communicate what expected of them (funds and providers)/ what they should expect of the regulator
• Often find regulation is welcome (if not figure out why not – e.g. funding issues/ concerns about onerous administration or will be shut down/ don’t see benefit)?
• Later move to full assessment and granting of full licenses – giving suitable time to comply 53 REPORTING
• Basic data need to do job – foundation on offsite • IOPS WP #14 Efficient Information Collection
• Also act as comparative source to improve / imposing standards on industry
• Role of supervisor in providing comparative data Performance Cost Service
Australia 1 5 7 √
Bulgaria 1 2 (+volatility) √
Chile 1 3 5 (+volatility) √ √
Cost Rica 1 +since inception √ (+volatility)
Hong Kong √ (synthetic indicator)
Israel 1 + quarterly √ (Sharpe ratio)
Italy 1 2 4 5 10 √ (synthetic indicator)
Turkey Daily (Sharpe ratio) √ √ 54 IOPS Working Papers No.15 Spain 1 3 5 10 15 √ REPORTING SUPERVISORY ASSESSMENT/ SCORES
Jurgen Boyd FSB South Africa
55 INSPECTIONS
• Organization – horizontal (portfolio)/ vertical (functional)/ matrix (hybrid) approach
• Central vs. individual supervisory input
• Chile – reactive (follow complaints) /separated out to different department
56 IOPS Toolkit for RBS ENFORCEMENT PYRAMID
57 IOPS Toolkit for RBS INDUSTRY DEVELOPMENT ROLE?
Can be tricky – balance development role vs. oversight role/ can conflict?
1. Structure of industry? (# license/ licensing trustees/ encourage merger into larger pooled funds)?
2. Development of coverage • India • Kenya
3. Development of instruments • Costa Rica (capital markets and pension regulators working together)
58 Oversight of Public/ Social Security Funds
Challenges • Political Boards • Political involvement in investments • Size of assets vs. economy/ markets • Interaction between supervisor and ministry
Solutions • Ensure have legislative /regulatory power o Have to report to supervisor o Have right to audit the fund o Can ask for information/ inspect o Can publish reports o Should follow investment guidelines
• Find a champion to support Regulator
• Get own governance right so have credibility and independence
• Reduce dominance of assets o Enforce diversification requirements o Some overseas o Some outsourcing / competition
• Report o Publish findings (stop rumors) o State publicly if not able to enforce supervisory duties
59 • Sanction o Be prepared to fine fund if rules broken (power back to regulator) / explain why done so CLICKER QUESTION
The major challenges with pension supervision in my country relate to:
Your answers: - Discuss with your neighbours
A. Lack of regulatory structure
B. Lack of guidance/ clarity from supervisory authority
C. One large player distorting the market
D. Political ‘interference’
E. Lack of enforcement capability
60 3. RISK-BASED SUPERVISION
61 What is Risk-based Supervision?
A structured approach focusing identifying potential risks faced by pension funds and assessing the financial and operational factors in place mitigate those risks. This process then allows the supervisory authority to direct its resources towards the issues and institutions which pose the greatest threat.
Can be applied in many different ways • quantitative measures of risk vs. qualitative judgement of risk management • risk-scores for each entity vs. analysis of risks systemic to pension system • identify weak areas within a supervised entity vs. which institutions amongst thousands may pose the greatest threat
Elements common to all RBS systems • Determine objectives of supervisory authority + greatest risks to these • Assess hazard or adverse events + likelihood of these occurring • Assign scores and / or ranks to firms or activities based on assessments • Link supervisory response to the risk scores assigned
62 Risk-based Vs. Compliance-based Approach
63 Can combine the 2 approaches
64 Risk-based Supervision DB vs. DC
RBS DB RBS DC • Focus on sponsor • Focus on Individual Members • Solvency + funding issues key • Focus on Risk-management systems • Use of quantitative measurement tools • Qualitative measurement more appropriate
65 Why Adopt Risk-based Supervision?
• To improve supervisory effectiveness and efficiency
• To address internal organisational concerns
• To adapt to changes in the overseen industry
• To gain legitimacy following supervisory failure
• To meet requirements imposed by legislation
• To adapt to the changing nature of financial risks themselves, as these become more complex and - with the growth of DC pension systems - are increasingly transferred to individuals
66 Challenges to Introducing Risk-based Supervision
• Combining simplicity with complexity
• Knowledge and data
• Ensuring that assessments of firms are forward looking
• Going beyond the individual firm in assessing risk
• Structure and operation of internal risk governance processes
• Changing the culture to embed the risk based approach across the whole organization • Managing blame
• Making resources follow risks
67 Nzomo Mutuku RBA Kenya
68 Is it right for everyone?
Yes if… • lots of funds • DB / guarantees (based on solvency measures) • lots of supervisory resources • integrated authority (apply same model across all sectors)
Not necessarily if…. • only few funds • DC (quantitative not appropriate long term investments/ qualitative too subjective) • developing pension market and supervisory authority (not got resources/ expertise - regulation based more secure / restrictions not such an issue) • specialist authority (?)
69 Lessons Learnt
Adaptation of Models - consult widely but build own/ flexibility, upgrades, pilot test
Application of Models – know weaknesses /use with judgment
Data Collection – plan properly/ use existing where possible/ collect electronically
Reorganisation of the Supervisory Body – allow plenty of time
Staff – train all on philosophy as well as process
Industry – explain new approach and what is expected of them
Powers – make sure sufficient data collection + enforcement powers
Risk-based solvency – apply flexibly in volatile conditions / counter-cyclical
Systemic risk – build into analysis
Think in terms of achievability – target resources for maximum impact 70 It is worth doing IOPS Toolkit Risk-based Supervision
Module 0 ‘Introduction to RBS’
Module 1 ‘Preparation for RBS’
Module 2 ‘Quantitative Risk Assessment’
Module 3 ‘Risk Identification’
Module 4 ‘ Risk Mitigants + Risk Scoring’
Module 5 ‘Supervisory Responses’
71 Risk-based Supervision Process
72 4. MEASURING SUPERVISORY SUCCESS
73 Measuring Supervisory Success
Measures of
Pension System Supervisory Measures
Coverage Activity • # investigations • # complaints handled • # licenses registered
Sustainability Efficiency • Costs vs. # investigations • Staff vs. # entities covered
Service Quality • Time to respond to complains Adequacy • Time to process applications etc.
Effectiveness • Funding ratio • Money $ value funds protected/ lost Efficiency • No. entities moving from higher to lower risk categories Surveys • Industry feedback Security • Industry surveys (improvement in governance etc.)
74 IOPS PRINCIPLES PRIVATE PENSION SUPERVISION
Principle 1: Objective National Laws should assign clear and explicit objectives to pension supervisory authorities
Principle 2: Independence Pension supervisory authorities should have operational independence
Principle 3: Adequate Resources Pension supervisory authorities require adequate financial, human and other resources
Principle 4: Adequate Powers Pension Supervisory authorities should be endowed with the necessary investigatory and enforcement power to fulfil functions and achieve their objectives
Principle 5: Risk Orientation Pension supervision should seek to mitigate the greatest potential risks to the pension system
75 IOPS PRINCIPLES PRIVATE PENSION SUPERVISION
Principle 6: Proportionality + Consistency Pension supervisory authorities should ensure that investigatory and enforcement requirements are proportional to the risks being mitigated and that their actions are consistent
Principle 7:Consultation + Cooperation Pension supervisory authorities should consult with the bodies they are overseeing and cooperate with other supervisory authorities
Principle 8: Confidentiality Pension supervisory authorities should treat confidential information appropriately
Principle 9: Transparency Pension supervisory authorities should conduct their operations in a transparent manner
Principle 10: Governance The supervisory authority should adhere to its own governance code and should be accountable
76 IOPS PRINCIPLES ASSESSMENT METHODOLOGY
Provides a structured framework for assessing the extent to which a pension supervisory authority complies with the spirit and the letter of the Principles Can be used for external or self-assessment Also indicates types of evidence that may help to answer questions Compliance rated as:
• Full implemented – IOPS Principle is implemented in all material respects
• Broadly implemented- IOPS Principle is implemented in all but one or two material respects and the exceptions do not detract from the overall opinion. It should be possible to say something positive about compliance in answer to nearly every question
• Partially implemented – while a negative answer is given to some questions, the response to the majority of questions is consistent with compliance
• Not implemented - there are major shortcomings against the Principle
77 PRINCPLE 9 – TRANSPARENCY ASSESSMENT QUESTION
• Does the supervisory authority publish its rules and procedures?
• Is the supervisory authority subject to appropriate audit and reporting requirements (that do not compromise its independence)?
• Does the supervisory authority publish an Annual Report explaining how it has (or has not) met its objectives?
• Does the supervisory authority explain to individual supervised entities why it has taken particular action?
78 How would you rank your supervisory authority?
Well Implemented Medium Implemented Poorly Implemented
1. Objectives
2. Independence
3. Adequate resources
4. Powers
5. Risk-based supervision
6. Proportionality + Consistency
7. Communication
8. Confidentiality
9. Transparency
10. Governance
79 IOPS SELF-ASSESSMENT RESULTS
Well Implemented Medium Implemented Poorly Implemented 1. Objectives 10. Governance 5. Risk-based supervision 4. Powers 9. Transparency 6. Proportionality + Consistency 7. Communication 2. Independence 3. Adequate resources 8. Confidentiality
80 NIGERIA –SELF ASSESSMENT VS. IOPS PRINCPLES
81 SEVEN DEADLY SINS OF SUPERVISION
1. Structure – lack of independence /opaque appointments/ poor governance/ lack power 2. Staff - insufficient numbers/ poorly paid/ poorly trained/ little guidance material 3. Style - Risk vs. Rules based 4. Statistics – offsite reviews?/ separate unit?/ how much information?/ what to analyse (x summarize)/ trends/ finding relevant peer group/ means what? 5. Scope – what determines inspection cycle?/ full or partial inspections?/ who sets the scope/ what is it based on (offsite analysis/ previous review/ industry gossip/ media)? 6. Significance – report significant matters – not a list of minor transgressions/ require reports to be discussed at Board level/ require a response and plan of action 7. Staying the distance – if it is significant enough to report, it is worth pursuing/ allow reasonable time for response/ written response from the Board not the management/ if action plans have time lines in them, follow up on the date the activity is meant to be completed / arrange for follow inspection not wait till the next routine inspection
82