33387 World Bank Pension Reform Primer Supervision Building public confidence in mandatory funded pensions T he regulation and supervision of individual between capital markets, insurance and social pension accounts has been a neglected issue. security. In contrast, much has been written on financing Thirdly, consumers are often suspicious of the the transition to funded pensions and the design of efficiency and transparency of existing supervisory benefits. Yet effective regulation and efficient agencies. Existing pensions in some reforming supervision are crucial to the success of pension countries were under-regulated or even reform. This note explores six issues in the design unregulated in the past. Public confidence in the of a supervisory regime. It makes some new system would be undermined if the perceived comparisons between the performance of agencies inadequacies of existing supervision were carried in different countries and looks at four important over to the new system. areas of supervision: institutional and financial controls, and membership and benefits However, a new agency alone will not be procedures. sufficient. The financial system is interwoven. Problems elsewhere, in the banking system, for A new agency? example, are likely to damage the new pension Most of the activities of a pension supervisory regime. And the same problems are likely to agency are already carried out by existing develop in the pension fund supervisor unless the authorities, such as central banks, tax collectors underlying causes of regulatory ineffectiveness are and capital-market regulators, such as securities addressed. and exchange commissions or insurance regulators. Grafting responsibility for the new The relationship between pension-fund pension system onto these existing agencies would supervisors and other agencies in OECD countries be efficient. But a new, specialized agency might is shown in Figure 1. In six -- including two be more effective, for a number for reasons. First, former-socialist countries, Hungary and Poland-- the scheme is mandatory, unlike other kinds of and France and Italy--an independent, separate savings. So the government has a greater pension-fund agency has been established. responsibility to ensure that managers comply with Pension funds fall under the insurance regulator in basic rules and are carefully supervised. seven countries, including Germany, and are part of a universal financial-services supervisor in a Secondly, pensions are more complicated than further six, including Canada and the United most other forms of savings. They are long-term Kingdom. Finally, ministries of finance or labor contracts and there are complex interactions supervise funds directly in six countries, including Japan and the United States. This note is part of the Pension Reform Primer series of the World Bank. It was written by Edward Whitehouse of Axia Economics, London. Please contact the Social Protection Advisory Service, World Bank 1818 H Street NW Washington DC 20433, telephone +1 202 458 5267, fax +1 202 614 0471, e-mail socialprotection@worldbank.org. All of the notes are on the internet at www.worldbank.org/pensions. World Bank Pension Reform Primer Pension supervision in OECD countries 1 Independent Independent Independent Ministry Separate Insurance Universal France Australia Canada Austria Hungary Belgium Denmark Finland Ireland Germany Korea Greece Italy Luxembourg Norway Japan Poland Netherlands Sweden Spain Portugal United Kingdom United States Switzerland Regulation versus supervision The main danger of the proactive model is that it Regulation--setting the rules--and supervision-- can stifle innovation. Supervisors will naturally be enforcing them--are distinct activities. They can keen to avoid the failure of any fund, which might either be assigned to one institution or divided indicate a failure of supervision. This leads many between different institutions. Regulation is to forbid any new development by fund managers mainly the responsibility of the same institution as unless it can be positively proven to be in supervision in 13 of the 25 OECD countries in members' interests. The system's stability will be Figure 1. Ministries mainly set the rules in the rest. bought at the cost of much slower development of the industry, to the detriment of members. In The advantages and disadvantages of these two reactive models, in contrast, fund managers are approaches are finely balanced. A single free to innovate provided change does not imperil institution probably enjoys economies of scope. solvency. The market determines the shape of the Separate agencies can be more effective, as financial sector, not the supervisor. supervisors approach their job without preconceptions. The only caveat is ensuring that Supervisory autonomy lines of responsibility are drawn clearly, to avoid The authority of the supervisor must be shielded duplication or gaps. from political pressures to protect the long-term stability of the system and security of individuals' Models of supervision funds. As funds grow--they are worth 45 per cent The philosophies of different supervisory systems of GDP in Chile, 17 years after pension reform-- can be divided into two broad camps. First, supervisors will be lobbied vigorously. To proactive models involve detailed specification of minimize this risk, the agency should preferably be most of the activities of pension-fund managers. autonomous. Its director should be appointed This requires equally detailed supervision and audit transparently--perhaps with parliamentary to check the rules are being kept. Secondly, confirmation--for a fixed period. reactive models involve a greater degree of self- regulation. The incentives for pension-fund Figure 2 shows that supervisors are managers are assumed to be in the right place, and administratively independent in three Latin so supervisors need to intervene only rarely. American countries. They are also financially independent, levying their own supervision fees It is unsurprising that many reforming countries directly on pension funds. In Colombia and have chosen a proactive model, because they have Uruguay, pension funds supervision is part of the little tradition of regulatory enforcement and an central bank (although these institutions can of unreliable record of supervision. course be independent in turn). Chile is a halfway house: the agency is formally autonomous, but administratively, politically and financially 3 Supervision dependent on the ministry of labor and social advantage that salaries keep pace with the private security. sector, where pay in financial services has tended to increase more rapidly than in other industries. Financing Other countries have set competitive salaries A separate supervision fee is appealing compared initially, but these have eroded over time. with financing from the central budget. First, it bolsters the independence of the supervisory Although it might be tempting to staff the agency agency. Secondly, it avoids cross-subsidies from with secondees from existing agencies and people who do not participate in the new system. departments of government, this should be Argentina is a good example. The legislation sets a avoided. The agency will need a mix of staff with budget ceiling of 1.5 per cent of the pension public- and-private sector experience. To ensure system's total revenues. The agency then spends that knowledge of the industry is kept up-to-date, as necessity dictates and takes periodic transfers there needs to be a continual flow of recruits from from the managing companies (AFJPs) to cover the fund-management industry, including at senior expenses. Budgeted costs have been below 0.5 per levels. cent of total revenues. Supervisory `capture' Supervision in Latin America 2 The risk of a `revolving door' between the fund management companies and the supervisory Government Funding agency is that of industry capture, where the Autonomous supervisor puts the interests of the industry before the protection of pension-scheme members. Argentina Labor ministry fee Mexico Treasury fee (partial) The best answer to this problem is a separation of Peru Economy ministry fee Dependent responsibilities for the market as a whole from individual fund managers. Regulation and analysis Bolivia Treasury fee of the system's performance, where the damage Chile Labor ministry budget Colombia Central bank fee from capture is large, can be separated from Uruguay Central bank budget prudential supervision, where detailed knowledge of the industry is needed but the damage from capture is smaller. Staffing the supervisory agency Supervisory performance Finding the right staff for a new supervisory agency can be a challenge. Professionals with Comparing different systems is complicated broadly relevant experience might be scarce. And because of their different characteristics. Figure 3 the supervisory agency will be competing with concentrates on Latin America. pension-fund managers to hire qualified staff and to train others with the right aptitude. The Mexican agency is the largest and most costly, with 214 employees and a budget of $26 million. It is important that the agency is able to attract and This probably reflects the fact that over 11 million retain the right workforce, so it must be free to employees are covered in Mexico, compared with offer competitive pay and benefits. This will around 6 million in Argentina and Chile, 2½ probably surpass the packages offered to other million in Colombia, just over 1 million in Peru government officials. But this is probably and fewer than half a million in Bolivia and unavoidable. In Argentina, for example, the Uruguay. Consequently, the ratio of supervision pensions law requires that supervision employees employees to pension-fund members is the second receive a salary greater than or equal to the average lowest in Mexico, after Colombia. paid by the 50 per cent of pension-fund managers with the highest wages. This rule has the Supervision 4 The very high ratios in Bolivia and Uruguay value is close to 10 in most cases. The exceptions probably result from the relative youth of their of Colombia and Uruguay reflect the fact that systems and the small number of pension-fund supervision is part of the central bank, and so members, which may cause problems due to lack support services are part of the larger organization of scale. In contrast, the high ratio in Peru may and outside the supervision agency. indicate inefficiency. The ratio of employees to the number of operating pension funds is the most consistent indicator: its Performance indicators of supervisors in Latin America 3 Country Employees In direct control Budget Employees/ Employees/ fund members funds number % $m per million number Argentina 183 43 12.5 31 10 Bolivia 21 43 1.9 64 11 Chile 134 69 7.0 23 10 Colombia 30 73 -- 12 3 Mexico 214 25 26.3 19 13 Peru 85 19 5.1 74 14 Uruguay 21 81 -- 46 4 Institutional supervision (covered elsewhere in the Pension Reform This covers the authorization and licensing of Primer), inspections and audits. pension-fund managers and, where necessary, their Financial supervision dissolution through merger or liquidation. It also Regular financial reporting from funds to the includes vetting company officials and sales forces supervisor is essential, covering investment and registration of fund managers' branches. policies, portfolios, revenues and expenditures. They must also include the finances of the Institutional controls will be very important in the managing companies. These reports can be cross- first few years after pension reform, but will then compared with data from custodians, the stock contract. The initial effort of licensing new exchange and other financial institutions. funds--scrutinizing legal and financial requirements, such as minimum reserves and Other important financial supervisory tasks are capital--will be complete. Uncertainty over the valuing funds' portfolios, supervising restrictions performance of the new system will diminish as it on asset holdings, ensuring safe custody of assets beds down. and calculating and applying guarantees of funded pensions' returns. Merger and liquidation will also be more common in the first few years. There were initially 26 funds Membership and benefits in Argentina, now down to 15. In Chile, there are Membership control looks at enrolment of 10 funds compared with 21 at the beginning of members, marketing and transfers between funds. 199. There have been three liquidations in Chile, Benefits control, monitoring the calculation of but none in Argentina. entitlements, becomes more important as the system matures. Other important issues in institutional control include marketing and advertising controls 5 Supervision Further reading Conclusions and recommendations Demarco, G. and Rofman, R. with Whitehouse, E.R. (1998), `Supervising mandatory funded q the professional expertise, transparency pension systems: issues and challenges', Social and perceived independence of Protection Discussion Paper no. 9816, World supervisory agencies is essential to the Bank. success of pension reform Duval, D. (1999), `Institutional arrangements for q in countries where existing regulation is mandatory funded pension schemes', Social weak or ineffective, a new, separate Protection Discussion Paper, forthcoming, agency is probably best placed (but not World Bank. certain) to avoid repeating past failures Rofman, R. and Demarco, G. (1999), `Collecting q a proactive model, with detailed and transferring contributions in multipillar specification of funds activities might be pension schemes', Social Protection needed initially, but the system should Discussion Paper, forthcoming, World Bank. move towards reactive supervision over Laboul, A. (1998), `Private pension systems: time to avoid stifling innovation regulatory policies', Ageing Working Paper no. q financial autonomy, with the agency's 2.2, OECD, Paris. budget paid by pension funds rather than Vittas, D. (1998), `Regulatory controversies of general government revenues, will private pension funds', in Institutional Investors in protect supervision from undesirable the New Financial Landscape, OECD, Paris. short-term political pressures q administrative independence is similarly preferable q salaries must be competitive with the private sector (and remain so) to recruit qualified personnel from public and private sectors and to limit corruption risk q separation of regulation and supervision can help limit the risk of regulatory capture