For a pension fund to be managed efficiently, it should establish managing and decision-making procedures as well as define the competence and responsibility of individual executives and managing bodies. There is no need to prescribe these requirements in laws or supporting legislation. They should be outlined in pension funds' by-laws.
As the pension fund market develops, behavioral rules evolve. These rules are observed by every pension fund seeking to have a good reputation.
Requirements for managing procedures, especially executives' qualifications, are often attached to licensing conditions. Supervisory institutions also require a business plan reflecting a pension fund's capacity to plan business activity. However, neither business plans nor requirements regarding qualifications can ensure the proper operation of pension funds. Adequate control on the part of owners is the main thing.
In many cases laws require that pension fund members participate in pension fund management. This requirement may be implemented only in employer-sponsored pension funds where participants constitute a fairly concrete group of individuals. Still, even in this case desired results may fail to be achieved, as many pension fund participants have insufficient knowledge of management of financial institutions. Their representation is usually formal. Allowing participants to freely withdraw from pension funds can ensure a more effective control.
4. Capitalization
Minimum capital requirements are usually applied to pension funds operating as asset management companies. It is often required that pension funds ensure a certain ratio of equity capital to members' capital. Although such requirements are often used to secure credibility of pension funds, the former poses a barrier to market entry, while the latter hinders the development of the pension fund industry.
Capital adequacy requirements are applied to pension funds operating based on a defined-benefit principle, given that such pension funds assume all the risk related to undertaken liabilities and therefore function similarly to insurance companies. For this reason requirements applicable to pension funds and insurance companies should be the same: periodic actuarial reports, reinsurance, etc.
The capital adequacy requirement should not be applied to defined contributions, as there are no clearly defined financial liabilities for which capital reserves should be formed.
Pension funds should not be subject to any liquidity norms either. Managing the liquidity risk is the responsibility of pension fund managers. This risk does not exist while pension funds are in the process of accumulating money and not paying benefits. At a later stage this risk will be different for every pension fund, therefore a uniform method for maintaining liquidity will not ensure a proper management of liquidity risk.
5. Investment portfolio
Investment risk is the main risk confronting fully funded pension funds. The state almost always regulates its management one way or another.
Investment supervision best reflects the two regulatory approaches elucidated earlier in the paper: the prudent man and the listing approaches.
If the prudent man rule is used, legal acts prescribe procedures for a prudent and honest behavior by pension fund managers as well as their responsibility in case their activities deviate from the established rules. Pension fund managers are not responsible for the results of their activities if these were conducted in line with the prescribed rules.
If the listing approach is used, laws specify permissible and forbidden activities. This model regulates in detail allowable types and size of investments. Investment restrictions refer to the types and issuers of assets, the category of risk, and likely conflicts of interest.
Restrictions by type of asset define what kinds of assets (securities, real estate, bank deposits, etc.) are allowable and what portion of the investment portfolio they may constitute. These restrictions are used to prevent the purchase of illiquid or speculative assets.
Restrictions by issuer define securities, and their proportions, into which investments can be made. This is intended to protect pension funds from investments into illiquid assets and investment concentration.
Restrictions by risk category allow investments only in securities and markets the risk of which does not exceed a certain level of risk defined by credit rating agencies.
Restrictions by likely conflict of interests are designed to prevent concentration of investments into related persons.
Restrictions are often imposed on investments abroad, seeking both to prevent exchange or foreign market risks and to direct investments into the domestic economy (especially government securities).
Evidence shows that investments supervised under the prudent man rule bring much higher returns than those based on the listing approach. If investment managers are only expected to act in the best interest of pension fund members, they can adapt to market changes faster and better than those who must coordinate their decisions with the supervisory authority.
Any investment restriction reduces investment returns by forcing investment managers to avoid the most effective means of investment. Restrictions on investment abroad reduce diversification, and thus safety, of investments. In order to achieve a level of diversification compatible to those offered by international markets, the domestic market should be highly segmented and versatile and not oriented toward one product or one group of products.
Investment restrictions may set both lower and upper limits. Lower limits are particularly harmful, as pension fund investments are turned in one direction indicated in advance. Obviously, efficiency of such investment is much lower relative to investments that are freely chosen on the market.
If conditions are proper, investments should be governed by the prudent man rule. However, if market relationships and financial institutions are underdeveloped, investment supervision may resort to the listing approach. In this case only upper investment limits should be set. The sum of limits of investments allowed into separate types of assets or issuers should not be lower than 200 percent so that investment managers have enough room for independent decision making.
No restrictions should be imposed on investment abroad. Prohibitions to invest abroad are usually intended to direct investments into the domestic economy. Also, the aim is to avoid the exchange risk that may injure pension fund members. Managing the exchange risk should be the responsibility of investment managers, and no directive norms should be imposed.
6. Asset valuation
Asset valuation may be needed to appraise the liabilities relative to the assets owned, investment returns, and individual indicators used to compare different pension funds.
Assets are usually evaluated at the so-called market value, or the price obtained if a similar (or analogous) asset is sold in the market. Although this price is not accurate (in reality it may alter due to changing demand), this kind of valuation is much more objective than calculation based on the balance value.
Asset valuation does not pose any problem if investments are made into liquid assets, which have relative market prices. To appraise the value of illiquid assets, pension funds may use methods they develop themselves. Detailed regulation by the supervisory authority is not necessary. Pension funds should only report, while presenting the valuations, what method they use and should adhere to it for an established period of time.
General principles and methods of asset valuation may be useful in comparative analysis of pension funds. Such principles may be established by pension funds themselves, pension fund associations, or other professional (auditors, accountants, asset valuers, etc.) organizations.
7. Marketing and administrative costs
Both marketing methods and administrative costs should be regulated by market forces and through competition. In a competitive environment, pension funds are forced to improve the quality of services, to lower costs and to promote products that best meet customers' needs.
If participation in pension funds is mandatory, marketing is frequently regulated. The supervisory authority defines marketing rules, advertising requirements, the work of sales agents, etc. In some cases the supervisory institutions place limits on administrative costs.
Such regulations are harmful for pension funds and their members. If limits are imposed on administrative costs, resources that are used for service supply are reduced and quality suffers. Interventions in sales curtail the degree of individual choice of acceptable products.
Interventions in market processes should be minimized even if participation is mandatory. Creating a competitive environment for pension funds is critical.
8. Collection of contributions
Collection of contributions is supervised if participation in pension funds is mandatory. It is important to ensure that those segments of the population for which participation is mandatory pay contributions in a timely and accurate manner. Contributions may be collected in a centralized manner by one state agency or by pension funds themselves. The state may impose sanctions in case of non-compliance.
If participation is voluntary, the terms of terminating payment of contributions, changing the level of contributions, etc., are defined in pension contracts. The contracts should also outline the consequences of such modifications. These issues are left to the discretion of, and free agreement between, pension funds and their members. No restrictions should be applied here.
9. Accounting
Accounting in pension funds differs from that of other financial institutions. This raises a problem of defining accounting rules for pension funds.
There is no need for the supervisory authority to establish uniform accounting rules. Pension funds themselves should be allowed to define internal accounting procedures and to follow them for a definite period of time. Any changes should be recorded and explanations submitted together with financial accountability. Limits may be imposed on the frequency of modifying accounting procedures.
10. Protection of member interests
Protection of participants' interests is one of the most important objectives of pension fund supervision. To achieve it, a number of measures are used, including financial control, freedom of choice, information disclosure, and others. This section addresses the problems of portability, pension contracts, and non-discrimination.
Participation rules (pension programs, contracts, pension funds' by-laws) constitute the main document of a pension fund. Requirements regarding the contents of participation rules and approval from the supervisory authority may be expedient. Every person who wishes to become a pension fund member must be familiar with these rules. The supervisory institution should approve changes to the rules. Pension fund members should be notified about any modifications before they come into effect. Participants should be allowed by law to withdraw from the pension fund if they find the changes adopted unacceptable. The conditions of withdrawal should be defined by law. Likewise, the law should define the conditions of settling payments with the participants upon withdrawal. This is particularly important for defined-benefit schemes where actuarial calculations are made to determine the share of the fund belonging to each individual participant.
In defined-benefit schemes, especially employer-sponsored, a vesting period is used. This means that participants acquire the right to their accumulated assets after a certain period of time. In addition to that, participants are not always allowed to withdraw the money or transfer it to another fund. The money may be kept in the pension fund until the participant reaches the retirement age. Such stipulations are not expedient, especially if pension contributions are viewed as deferred earnings. They impede the mobility of labor force and so structural changes of the labor market.
If such limitations are nonetheless used, the law should define principles by which assets continue to be accumulated, and the future pension calculated, if a participant changes pension funds. It is important to ensure that the rights of all members - both quitting and remaining - are treated equally.
In the case of employer-sponsored pension funds, the law frequently outlines provisions on non-discrimination, or the creation of uniform conditions. However, non-discrimination should be understood as equal treatment regardless of sex, race, convictions, etc. Other considerations, e.g. differences depending on employees' qualifications, should be left to free agreement between the employer and employee. However, no individual conditions should be applied to persons related to pension funds.
The law should define general principles of non-discrimination on the basis of sex, race or similar considerations as well as prohibitions on abuse of power or the granting of special conditions for related persons.
11. Benefits
When members of a defined-benefit scheme reach the retirement age, they receive annuities or, in addition, a survivor's pension. For mandatory plans, the law establishes a pension formula and conditions of benefit payment. The supervisory authority controls the payment of benefits.
In voluntary insurance, the size of the pension is indicated in a pension contract. In an employer-sponsored pension fund, the employer assumes the obligation to pay pension benefits and establishes a pension formula.
Defined-contribution funds may pay annuities with the accumulated sum or periodical benefits from personal accounts. For mandatory plans, the law also defines conditions of benefit payment. If participation is voluntary, they are prescribed in pension contracts. Yet, the size of pension benefits is not definite, as it depends on the amount accumulated and on developments on the insurance and capital markets.
Annuity control should be coordinated with supervision of the insurance market. The annuity fund should be administered according to laws regulating insurance activity.
In annuity supervision, it is important to ensure an adequate capital adequacy and reinsurance. For this purpose actuarial calculations are made. It is also essential what standards and assumptions are used in such calculations. A technical basis for actuarial calculation may be created by actuarial associations.
12. Protection of property
Separation of members' funds from the assets of the pension fund, the management company or the sponsor is the main instrument of ensuring safety of pension assets. Pension assets should belong to members by the right of ownership. The law should establish protection of ownership rights.
Accumulated assets (securities and uninvested funds) should be transferred for safekeeping to an independent depository. The depository becomes an inseparable part of pension fund supervision, as its duty is to check whether every transaction concluded by the pension fund is in line with statutory requirements.
The law should prohibit pension funds from using pension assets for mortgaging or guaranteeing without members' consent. Likewise, pension assets cannot be used to extend loans.
13. Guarantees
Guarantees for pension fund members are usually granted by the state, the pension fund sponsor (usually the employer), and pension funds themselves. Guarantees may cover the size of pensions, minimum benefits, and investment returns. If participation is mandatory, guarantees are usually established by law.
In defined-contribution schemes, the state usually guarantees the minimum level of benefits. Pension funds are required to guarantee a certain level of investment returns. Guarantees may cover nominal or relative investment returns. A relative investment return is calculated based on the average investment return on the pension fund market. If a pension fund generates lower returns than the average, it must compensate the shortfall from a special reserve fund formed with equity or members' capital.
Defined-benefit funds undertake a firm obligation to pay a certain level of pension benefits when they conclude pension contracts with their participants. Such liabilities are guaranteed with the asset of the pension fund or its sponsor. In employer-sponsored pension funds the employer covers any shortfall of funds that may occur because of insufficient contributions, insufficient investment income or for other reasons. Defined-benefit funds are often required by the state to reinsure their liabilities in insurance companies or in a centralized guarantee fund. In some cases defined-benefits funds are required to ensure an established pace of increment.
All financial guarantees imply costs, even if they are not financed directly (e.g. by paying reinsurance premiums). These costs may entail a potential shortfall of income or higher taxes.
Guaranteeing nominal investment returns is the most expensive, especially if this requirement applies on a yearly basis. The minimum benefit guarantee is the cheapest, as it is provided only if a member fails to accumulate a sufficient amount of money to receive a minimum pension. In this case only the difference between the required and accumulated amount is covered.
A nominal investment return guarantee is the most inefficient way to protect member interests. Nominal investment returns are usually set at a level that is acceptable for all pension funds. If pension funds are required to ensure a certain level of investment returns every year, they are forced to invest only in stable, and therefore the least profitable, assets. Investments into riskier but more profitable areas are discouraged, as pension funds are obligated to cover any shortfall with their own money. Likewise, excess investment income is not accrued on members' accounts, as it may be needed to cover possible future downfalls. Under such conditions, pension fund members are only paid the minimum.
The requirement for a relative investment return also compels pension funds to invest "averagely." In this case guaranteeing means equalization of income with members' money during profitable and unprofitable years. A relative investment return has one advantage: in case of market fluctuations in specific sectors, pension funds are not required to cover losses sustained given that all pension funds earn less. Still, pension assets do not grow as much as they could because part of the assets is put aside and investment decisions are hidebound.
Charges for mandatory reinsurance reduce funds used for pension contributions.
Guarantees, which are intended to protect pension fund members, are in most cases financed by the members themselves. Due to guarantee-related restrictions, pension fund members earn less than they could. If guarantees are financed by external sponsors (the employer or the state), pension fund members pay for them indirectly, through lower pays or higher taxes.
Mandatory guarantees should not be used. They stifle incentives to act in the most effective way and reduce income. If guarantees are provided by a third party (the sponsor or the state), they induce imprudent behavior or attempts to take advantage of existing guarantees. The financial burden of such guarantees is placed on pension fund members or the society. Mandatory guarantees do not meet the purpose of protecting member interests.
14. Information disclosure
Information disclosure is one of the key factors of market self-regulation. Availability of information facilitates individual choice by allowing market participants to make well-considered decisions. So the more information available, the smaller the need for state regulation. On the other hand, standardized operational and information disclosure procedures make it much easier to present and understand information. It is important that pension fund members and the society do not only obtain information but also know how to assess it.
Information disclosure standards may be established by pension funds or professional associations (accountants, auditors, etc.). The state supervisory authority should only define what information should be disclosed. Creating standard forms is costly and inexpedient. Typical forms do not allow pension funds to take into account their specific needs and so prevent the most appropriate disclosure of information.
Pension funds are in the first place accountable to their owners. They are obligated to submit to their owners information about the state of the pension fund.
Information should be presented to pension fund members in the following cases:
- when a person wishes to join a pension fund;
- when a pension contract is concluded;
- at least once a year;
- upon withdrawal from a pension fund;
- upon the commencement of the payment of benefits.
The manner of information disclosure should enable pension fund members to:
- understand the services and peculiarities of the pension fund;
- evaluate the management and financial status of the pension fund;
- evaluate the pension fund's investment policy.
At least once per year every member should receive a statement of his individual account (in case of a defined-contribution scheme) or a notification of the size of pension accrued until that date (in defined-benefit schemes). Such notifications should also indicate the amount of contributions paid (by third parties included), the amount of investment income accrued, and charges deducted. If accounting is made by means of an agreed unit, this information should be presented in the same unit and the unit's value should be indicated. Pension fund members should be notified about contribution arrears.
In addition, pension fund members should receive comprehensive annual reports on the management and financial status of the pension fund. Such reports should include auditor's conclusions and be publicly announced.
Pension funds should submit information to the supervisory authority. The aim of regular accountability is to inform the supervisory authority and to provide an opportunity to evaluate the fund's performance. In addition to that, a database may be created for analysis of the pension fund industry.
Reports should be clear and credible. The supervisory authority should require information that it will use or check. Reports should indicate the number of participants, entrances and withdrawals, the financial status (income and expenses, contributions and benefits, actuarial valuation, administrative charges), investment policy and income, and other important changes that have occurred since the date of the previous report.
The supervisory authority should receive periodical reports from related market participants: depositories and management companies.
The supervisory institution should announce periodically the number of pension funds, the amounts of money administered, the number of participants, and the average investment return.
1. The establishment of the supervisory institution
In establishing a supervisory institution, it is necessary to decide:
- what position it will take with regard to other supervisory institutions of the financial market;
- what degree of independence it will have;
- what functions it will perform;
- who will appoint its head and for how long;
- how market participants it supervises will complain against the supervisory institution.
Pension fund supervision may be performed by a specialized institution or delegated to an existing supervisory agency. If supervision of the whole financial market is consolidated, pension funds should be included in the system.
Independence of the supervisory institution also depends on whether it itself performs regulatory (establishment of rules) and supervisory (enforcement of rules) functions, or whether these functions are separated.
The budget of the supervisory institution may be formed in two ways: through allocations from the state budget or a special fee charged on market participants. The latter ensures a greater degree of independence. It is more acceptable when participation in pension funds is not mandatory for all residents.
In defining the powers of the supervisory authority, it is important to decide in what cases it will have the power to impose sanctions on market participants and when this will be done by court. Investigation of complaints is also an issue related to the division of competence between the supervisory authority and courts.
2. Principles of supervision
State supervision of pension funds should be:
- Market oriented. Bureaucratic interference in the pension fund market should be minimized and market developments should be accommodated. That which can be regulated by market forces should not be regulated by the state. The state should only ensure equal opportunities for competition, obtaining of information, etc.
- Independent. Supervision should be free from political interference and transparent in its decision making. It should not favor certain funds or market participants.
- Accountability driven. Pension fund executives should be held accountable for prudent management of pension funds. Supervision itself should be accountable for its activity to the pension fund industry and the society at large.
- Effective and efficient. Suitable powers should be given to the supervisory institution so it can monitor the industry. It should have adequate resources and quality staff and should use them in the most effective way possible.
- Discretionary. The supervision staff should have an opportunity to assume responsibility for decisions that deviate from the established procedures. A proper balance should be found between clearly defined supervision rules and opportunities to make discretionary decisions in application and enforcement of these rules. To that end, the supervision staff should have proper qualifications.
- Open and consultative. There should be close liaison with market participants, professional associations and consumer groups in order to obtain information about the market and community views on policy proposals and administrative measures. This will give room for entrusting more supervisory functions to self-regulation.
