Pension Supervision

Global Capital Markets Non-bank Financial

Institutions

Fiona Stewart

Pensions Core Course April 8 2013

Structure of Presentation

I. What is pension supervision?

II. Types of pension supervision

I. Style

II. Structure

III. Principles of pension supervision

IV. Risk-based supervision

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I. What is Supervision?

• Regulation = legal foundations and system of rules and

regulations governing the Structure and operation of pension

funds

• Supervision = oversight and enforcement of compliance with the

rules

• May occur within the same organisation and in some cases

simultaneously

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Theoretical Basis for Supervision

• Market imperfections and failures

• Asymmetrical information

• Moral hazard

• Consumer myopia

• Competition and efficiency

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What is distinctive about Pensions?

• High vulnerability leads to low risk tolerance

• Greater share of average member wealth

• Less sophisticated clientele- lower income and less educated

• Mandates and limited choices by consumers

• Higher public fiscal expenditure

• Complex legal and regulatory structure

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Why is Pension Supervision Important?

• Pension supervision focuses on protecting the interests of pension fund

members and beneficiaries, by promoting the stability, security and

good governance of pension funds.

• Pension supervision involves the oversight of pension institutions and

the enforcement of and promotion of adherence to compliance with

regulation relating to the structure and operation of pension funds and

plans, with the goal of promoting a well functioning pensions sector.

• In addition, achieving stability within the pension sector is an important

part of securing the stability of the financial system as whole (as

investments made by pension funds have a major impact on the real

economy in many countries).

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Elements of Supervision

Control of 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

Measurement –Comparison to Normative Standards –Risk Scoring and Evaluation

Communication Disclosure –Outreach and Education –Training

Intervention –Notification of Violations –Directive Actions –Negotiated Resolutions

Correction - Punitive –Remedial –Compensatory

II. Types of Pension Supervision

a). Style of supervision varies by country

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Hinz + Mataoanu (2005) World Bank

Nature of Supervision Varies by Country/ Pension System

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Hinz + Mataoanu (2005) World Bank

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Nature of Supervision Varies by Country/ Pension System

Hinz + Mataoanu (2005) World Bank

II. Types of Pension Supervision

b). Structure of pension supervision - arguments for / against

independent pension supervisory authority

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IOPS Working Papers No. 1+16

Integrated Supervisory Authority

• Better for conglomerates

• Avoids regulatory arbitrage

• Economies scale

• Share information across financial

sectors

Independent Pension Supervisory Authority

• Pensions sufficiently different

• Cross sector gains don’t materialize

• Coordination between authorities can

achieve same effect

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

Different Structures of Pension Supervision

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IOPS Working Paper No. 1

Twin Peaks Model Attracting Attention After Financial Crisis

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IOPS WP 16

III. 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

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IOPS Principles

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

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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

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Principle 9 Transparency – Assessment Questions

• 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?

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IOPS Principles Self-assessment Results

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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

Nigeria – Self-assessment vs. IOPS Principles

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‘Seven Deadly Sins of Supervision’

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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

IV. What is Risk-based Supervision?

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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

Risk-based vs. Compliance-based Approach

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Compliance-based Risk-based

• Focus on compliance e.g. with tax and

labour laws and (often) quantitative

investment rules

• All funds get same degree of attention

• Identifies potential risks

• Assesses mitigating factors

• Seeks proper management of risks

• Allows scarce resources to be targeted

at funds most at risk

• Detailed, often rigid, rules that are

difficult to change to meet urgent

regulatory needs

• Forward looking and principles-based

regulation

• Flexible

• Institutions focus is on compliance with

rules, not risk management

• Incentives for institutions to strengthen

risk management practices

• Point in time focus

• Overlooks major risk areas

• No early warning system

• Supervisors use judgement to assess

risk and quality of management

• Duplicates work of auditors

• Compliance checks done by audit etc. –

removes duplication

• Difficult to get meaningful comparisons • Supervisor can benchmark institutions

and assess overall industry

• Penalises past breaches of rules • Attention directed to emerging problems

Can Combine ‘Risk-based’ and ‘Rules-based’ Approach

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Risk-based Supervision DB vs. DC

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RBS DB

• Focus on sponsor

• Solvency + funding issues key

• Use of quantitative measurement

tools

RBS DC

• Focus on Individual Members

• Focus on Risk-management

systems

• Qualitative measurement more

appropriate

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

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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

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Nzomo Mutuku RBA Kenya

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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

It is worth doing

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IOPS Toolkit for Risk-based Supervision

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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’

www.iopstoolkit.org

RBS Process

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RBS Process

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Supervisory Focus Risk Focus Risk Factors Risk Indicators

Prevent fund failure

Ensure promised

benefits delivered

Funding and

solvency

Investment/ market

risks

Mismatch risks

Actuarial risks

Liquidity risks

Operational risks

Funding levels

Stress test results

Results ALM tests

Volatility measure

Portfolio concentration

Asset correlations

Trustee/ fiduciary knowledge

Prevent excess

consumer loss

Risk-management

systems

Investment / market

risk

Operational risk

Investment strategy

Results VaR tests

Management ability

Outsourcing

Non/late payment

contributions

Ensure fair competitive

markets

Promote market stability

Prevent financial crime

Promote market

development

Conflicts of

interest

Agency risk

Counterparty/ credit

risks

External/ strategic

risk

Law/ regulation risks

IT

Operational risks

Outsourcing

Probability default

Concentration / correlation

Enforceability of contracts

IT security

Sensitivity to fraud

Custody arrangements

Management ability

Risk Scoring Matrix

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Enforcement Pyramid

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Jurgen Boyd FSB South Africa

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IS RBS 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 (?)

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