Pensions Core Course 2013: Regulation of Pension Funds

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  • 1. Regulation of Pension FundsRichard HinzThe World BankApril 8,2012
  • 2. Organization• Theoretical Foundations• Structure and Elements of Regulation• Typical Elements of Legislation ToEstablish Framework for PensionRegulation.
  • 3. Distinction Between Regulation &Supervision• Regulation:– Legal Foundations and System of Rules andRegulations Governing the Structure and Operation ofPension Funds– Establish form of system and “empower” variousparties to perform functions or protect interests• Supervision:– Oversight and Enforcement of Compliance With TheRules– Collection of information and monitoring of system tosupport review and analysis
  • 4. Why Pension Funds are DifferentThan Other Savings?• Vulnerability To Old Age Poverty Leads to LessRisk Tolerance• Potentially a High Proportion of AverageMembers Wealth• Less Sophisticated Clientele – More Likely LowIncome and Less Educated if Sytem is Mandatory• Limited Choice By Consumer Due to Mandatesand Constrained Products
  • 5. Attributes of Private Pensions ThatAffect Approach to Regulation• Specialized Financial Intermediary– Long Time Horizon– Low Liquidity Needs– Heterogeneous Risk Tolerance• Often Multiple Levels of Intermediation WhenEmployers or Worker Associations areInvolved• Use of Commercial Service Providers CreatesComplex Incentive Problems• Possible High Fiscal Exposure Through TaxTreatment and Guarantees
  • 6. Theoretical Basis for The Need forRegulation and Supervision• Address Market Imperfections andFailures• Compensate for Asymmetric Information• Control Potential Moral Hazard• Overcome Consumer Myopia• Stimulate Competition and Efficiency
  • 7. Types of Risks to Be Addressed inPension Regulation• Systemic – Vulnerability to Macro Conditions• Portfolio – Quality of Investments• Agency – Incentives of Individuals and Institutions• Principal – Member’s Knowledge and Experience
  • 8. Main Aspects of RegulationCommon to All SystemsI. Rules Defining the Structure andOrganization of FundsII. Requirements for the Operation ofFundsIII. Authority for Supervision, Sanctions& Remedial Action
  • 9. I. Structure of Pension Funds• Licensing of Fund Operators• Governance of Funds• Capital and Reserves• Segregation of Assets• Custody of Assets
  • 10. II. Operation of Pension Funds• Investment Guidelines• External Audit Requirement• Reporting and Disclosure• Limits on Fees and Expenses• Guarantees
  • 11. III. Supervision, Sanctions andRemedial Action• Government Agency with Oversight andRegulatory Authority• Legal Venue and Guidelines forApplication of Sanctions – Punitive andRemedial• Rights of Members and Venue forResolution of Disputes
  • 12. Some Dimensions of VariationEmployer Sponsored Personal AccountTrust Funded Financial InstitutionSingle Employer Multi-EmployerDefined Benefit Defined ContributionIndividual ChoiceConstrained Choice
  • 13. Two Stylized ModelsMany Systems Incorporate Elements of Both• Latin American/Central European -Mandatory Personal Accounts– Special Purpose Investment Companies– Primary Intermediation– Open Funds• Anglo American -Voluntary Employment Based DB and DC– Employer Managed Trusts– Secondary Intermediation– Closed funds
  • 14. Latin American/ CentralEuropean• 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
  • 15. 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 ofTransactions– Agency/Relationship Oriented - Conflict of InterestProhibitions• Supervision– Exception Basis , Re-active– Remedial and Punitive
  • 16. Regulatory Structure of LatinAmerican Systems• Specific Entry Requirements w/ Capitaland Reserve Requirements• Small Number of Entities Permitted• Quantitative Investment Standards• Extensive Interaction and Monitoring• Preventive Sanctions
  • 17. Rationale for LatinAmerican/Central EuropeanApproach• 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 PoliticallyNecessary Guarantees
  • 18. 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 andRegualtion of Professions• Exception Based Interventions• Remedial/Corrective Sanctions
  • 19. Rationale For Anglo-AmericanApproach• Higher Risk Tolerance– Primarily Voluntary Occupational Funds– Supplement Universal Public Pension Programs – Moreconcentration in higher income groups• Highly Developed Primary Financial ServicesRegulation• Extensive System of Civil Law and Liability –Private Rights of Action• Potential High Opportunity Losses fromRestrictive Regulation• Typically Limited Public Guarantees
  • 20. Comparison• Security – Efficiency Tradeoffs• Stage of Development – Movement ToConvergence Over Long Run• Practicality: Small vs Large Number ofFunds• Different Reliance on Market Forces andCompetition
  • 21. Notable Developments and Trends• Licensing, Training and “Fit andProper” Requirements for Trustees• Introduction of Solvency StandardsLinked to Market Derived Criteria –VAR and Asset Liabilty MatchingModels• Required risk managementarchitecture, procedures orgovernance oversight groups• Harmonization with other FinancialRegulations
  • 22. Trends (cont)• Movement to Multiple Portfolios and Age BasedPortfolio Choices• Introduction of Automatic Enrollment andDefault Portfolios• Increased Limitation of Permissible Fees andExpenses• Greater Reliance on Market Disclosure• Minimum Annutizations, ProgrammedWithdrawals and Phased Retirement
  • 23. Basic Elements of PensionRegulatory Law
  • 24. Three Levels• Statutory (Legislative)– Establishes Basic Framework and Rules of System– Creates Source of Regulator/Supervisors Authority• Interpretive (Regulatory)– Extends statutory provisions to make systemoperational– Capacity to adjust to changing conditions, new products& practices– Oriented to Standards and Procedures• Implementation (Judicial)– Application to specific facts and circumstances
  • 25. Considerations in AllocationAmong Levels• Civil vs Common Law Environment• Underlying System Design (Trust vs PensionCompanies)• Strength of Mobilization of Interest Groups &Expectation of Opposition• Time for Development• Independence and Technical Capacity Regulator• Quality and Independence of Judiciary
  • 26. Main Elements That Need ToBe Addressed in Some Form• Legal Status and Governance of Funds• Definition and Holding of Assets• Licensing and Entry Requirements• Structure and Scope ofRegulatory/SupervisoryAuthority• Rule Making/Interpretive Procedures• Funding Source for Regulator/Supervisor• Relationship of Pension Law to Other LawsControlling Financial Services
  • 27. Main Elements (Cont)• 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
  • 28. Legal Form of Pension Funds• Holding/Organizational Entity orConsolidated Financial Services• Governance Structure and Standards• Deference to Other Licensing Authorities• Limitations of Who May Sponsor or Create• Restriction on use of Term Pension Fundand Marketing Limitations
  • 29. License and EntryRequirements• Authority for Fit and Proper Tests andCategorical Exclusions• Capital or Indemnification Requirements• Fees and Duration of License• In Regulations:– Procedures for Application and Establishmentof Standards
  • 30. 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 useof third party custodian• Statute should establish principle and defineentities that qualify to act in this capacity• Should consider principle of independentjudgment of appropriate instructions in law(Maxwell case)• Regulations can define procedures
  • 31. Liability and Delegations• Establish Structure for Responsibility andLiability (Named Parties)• Determine Whether Delegations and Shield willbe Permissible – All actions require responsibleparty• Co Liability and Knowing Involvement Standards• In Regulations:• Standards for proper delegations, reach of liability to involvedparties (deemed responsibility)
  • 32. Procedures for Rulemaking• Need to establish some parameters in advance• Reference to existing administrative procedurescan work if effective framework exists• Explicit framework for industry and publiccomment desirable – limitations on consultationsoutside of established framework• Cost benefit or economic impact requirements?
  • 33. Tax Treatment• Conforming Amendments to Tax Law toEnsure Consistency• Create Specific Principles and Standards forAccess to Preferential Treatment• Often used to achieve distributionaloutcomes• May include credits or start up contributionfor low income workers or informal sector
  • 34. Reporting, Data and Records• Need to Provide Authority and Distinguish ThreeElements:– Information to be Reported Periodically– Requirement to Retain and Produce Records– Reporting to Individuals Especially Rights and benefitsEarned• Requirement for Third Party Verification ofFinancial Information• By Regulation:– Specific contents and forms for reports, specifics onrecord retentions– Measurement Standards and Qualifications for Audit
  • 35. Conflict of Interest Restrictions• General principle of exclusion of alltransactions and fees with related parties• Prohibit capacity to control own fees (selfdealing)• Define categories of related parties – Limitsof reach• In regulations:– Specific applications and exceptions
  • 36. Individual Rights• Define scope and limits of private rights ofaction against funds• Prohibition of retaliation for reportingproblems or violations• Appropriate venue and causes of action• Access to information from funds• Creation of Ombudsman or other authorityoutside of regulator
  • 37. Penalties and Enforcement• Establish principles of Scope of Penalties inStatute– 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
  • 38. Investment Restrictions• Main principles in law – Interpretation by bothregulations 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
  • 39. Common Elements inQuantitative Limits• Limits on specific asset classes• Required diversification – limit on proportion ofany 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
  • 40. Withdrawal Requirements• Largely a subset of Tax Law• Need to establish principles of access beforeretirement age and form of payouts• Conditionf for loans, excise tax or penalties forearly withdrawals• Specifics by regulation (possibly tax law)• Prohibitions against assignment as collateral,access by creditors or payment for civiljudgements