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III Conference on Insurance Regulation and Supervision in Latin

America

Private Pensions in OECD countries

Juan Yermo, OECD

Santiago, Chile, 9 October, 2002

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Problem: Pensions are complicated

Confusion between social and economic objectives

Confusion between plan and fund

Confusion between fund and entity

Confusion between defined benefit and defined contribution

Confusion between occupational and personal plans

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Private Pension Plans in OECD countries

Occupational Plans – two distinct funding mechanisms:– Pension fund – different legal forms of administering entity– Insurance contract – personal or group policies

Personal Plans – multiple funding mechanisms

Occupational and personal plans raise somewhat different principal-agent concerns:– In occupational plans members are “captured” by employer; in

personal plans they may be “captured” by financial institutions– Employers may bear investment and longevity risk in occupational

plans; insurance companies are main risk bearers in personal plans– Interaction with financial institutions is intermediated through

employers in occupational plans; no intermediation in personal plans

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Occupational versus Personal Plans

Pro Occupational Plans:– Employer can use plan to attract and retain valuable

employees, hence may contribute more than to personal plans

– No marketing costs as in personal plans– Group negotiation with financial institutions leads to lower

administration costs than in personal plans– Employer staff (e.g. treasury department) can assist in

pension plan management– Fixed costs are lowered if employer facilities can be used

(e.g. for account management)

Pro Personal Plans:– Member is not captured as in occupational plans (though in

Latin America they often are – switching restricted)

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Main Trends in Private Pensions

Mainly introduced as complements to public, PAYG systems – Chilean type reform only pursued in a handful of OECD countries

Most OECD countries would prefer to encourage occupational rather than personal plans (and within these industry-wide schemes, e.g. Belgium, Finland, Germany) but personal plans are growing fastest

Most new schemes are DC, but definition not always clear (e.g. employers may guarantee investment returns DB under IAS)

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Regulating and Supervising Private Pensions

Regulatory principles should be common to all countries– OECD Basic Principles– OECD-INPRS Methodology for Basic Principles

Supervisory model depends on system structure:– Occupational plans: Anglo-Saxon model with thousands of

plans and funds does not permit fund by fund supervision. Industry-wide model on the other hand allows close supervision (e.g. Netherlands)

– Personal plans: supervision should rely as much as possible on existing framework for financial institutions.

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Regulating Occupational plans – OECD-INPRS Basic Principles

Despite many differences in risk allocation and legal traditions, most occupational pensions have common principal-agent issues.

15 Principles can be grouped according to objective --– Functional: regulation of pension plans from a consumer

protection or beneficiary right perspective.– Institutional: regulation of pension plan administrators, from a

financial security perspective (prudential regulation).

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Functional regulation

Eligibility and access to schemes– Avoid exclusion based on age, gender, salary, etc, and ensure

equity in distribution of tax benefits

Vesting, portability and indexation– Mainly an issue in DB schemes, where portability losses

(vesting and pension annuity losses) are much more significant

Disclosure and education– Mainly an issue in defined contribution plans, and where

members exert choice

Disclosure of benefits, returns, fees– Transparency is not enough, comparability is necessary

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Prudential regulation

Governance – Regulatory policies:

• responsibilities, accountability, and suitability of plan administrators

• delegation

• redress

– Pension concerns: • voting with one’s feet (leaving the plan) often not possible, member

representation as monitors necessary

• if employer bears risk he has an interest in control of pension entity - arm-length relationship between employer and entity may not be entirely feasible (e.g. with respect to investment strategy)

• cost effectiveness of using employer staff in pension entity vs. conflicts of interest

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Prudential regulation (cont.)

Funding– Regulatory policies:

• pension assets should be legally separated from plan sponsor• minimum funding rules • actuarial techniques based on transparent standards

– Pension concerns:• if funded through an insurance policy, assets no longer property

of members – special safeguards in case bankruptcy may be needed

• for pension funds, is winding-up or on-going more important as a solvency measure?

• how much “smoothing” of returns should be permitted?• plan members should have priority creditors’ rights in case of

employer bankruptcy

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Prudential regulation (cont.)

Investment regulation– Regulatory policies:

• principles of diversification, dispersion, and maturity and currency matching;

• both quantitative and prudent person; limit self-investment

– Pension concerns:• DB plans have liabilities indexed to salaries (unlike liabilities of

insurance companies), which cannot be matched perfectly before retirement (bonds are best match once salary is known) – equity may make sense for young schemes

• alternative investments can be twisted by interest groups (ETI)

• individual choice can lead to conservative asset allocations

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Concluding remarks

Pensions are complex, they have both social and economic functions

OECD-INPRS Basic Principles are universal, but regulations need to be tailor-made for each country

Pension entities raise special governance, funding and investment concerns.