CSSPP/DNB INTERNATIONAL SEMINAR JUNE 9 – JUNE 11 2010 Supervision on Pension Funds Experience from...

CSSPP/DNB INTERNATIONAL SEMINAR

JUNE 9 – JUNE 11 2010

Supervision on Pension Funds

Experience from Romania and The Netherlands

Supervision on pension funds

Introduction to the seminar

Adina Dragomir/Leendert van Driel

Bucharest, Romania

June 9 to June 11, 2010

Supervision on Pension Funds

Objective of seminar Introduction of participants

Programme Seminar

Wednesday, June 9

09.00 Welcome and Introduction (Adina Dragomir/Leendert van Driel)

09.15 Review and summary of DNB seminar 2009(David Schelhaas/Leendert

van Driel)10.15 Morning coffee break

10.45 Review and summary of DNB seminar 2009 (2)

12.30 Lunch

Programme Seminar

Wednesday, June 9

14.00 IOPS Principles of Pension Supervision (Rick Hoogendoorn)

15.30 Break

16.00 Pension Fund Supervision in Romania

17.00 End of day programme

18.30 Dinner

Programme seminar

Thursday, June 10

09.00 Pension Fund Governance: OECD Guidelines (Rick

Hoogendoorn/David Schelhaas)

10.15 Morning coffee break

10.45 Risk Management (Paulus Dijkstra)

11.30 First Round of Investment Game (Paulus Dijkstra/David Schelhaas)

12.30 Lunch

Programme seminar

Thursday, June 10

14.00 Investigation into investments of pension funds during credit crisis (Paulus Dijkstra)

14.45 Afternoon coffee break15.15 Supervision in practice (Leendert van

Driel/David Schelhaas)16.00 Second Round of Investment Game

(Paulus Dijkstra/David Schelhaas)17.00 End of day programme18.30 Dinner

Programme seminar

Friday, June 11

09.00 Council of Europe position in respect of pension rights (Sixto Molina)

10.00 Morning coffee break 10.15 Final round of Investment Game

(Paulus Dijkstra/David Schelhaas)11.30 Seminar evaluation (Leendert van

Driel/David Schelhaas)12.30 Lunch14.00 End of seminar

Review seminar 2009

Summary

1. Pensions in the Netherlands2. FIRM and FAF

3. Dealing with the crisis in Holland

4. Dealing with the crisis in Europe

5. Financial crisis and the impact on pensions in Europe

The Netherlands:

1. Pension system

2. Pension supervision

Pensions in the Netherlands

Apeldoorn

• State• PAYG• Premiums via income taxes• All citizens• Mandatory

• Private• Capital-funded• Employment-related• Premium paid by employer/ee• “Voluntary”• Pension funds ánd insurers• Collective

• Private• Capital-funded• Voluntary• Insurers only• Individual

Main Features Dutch pension system

3rd Pillar

2nd Pillar

1st Pillar

• State• PAYG• Premiums via income taxes• All citizens• Mandatory

• Private• Capital-funded• Employment-related• Premium paid by employer/ee• “Voluntary”• Pension funds ánd insurers• Collective

• Private• Capital-funded• Voluntary• Insurers only• Individual

flat rate “AOW” for all Dutch citizens

Self-employed; Others: “the icing on the cake”

(1) Company (2) professional (3) multi-employer industry-wide pension funds

pension funds are autonomous; no link with sponsoring company

pension premiums are tax-deductable

Main Features Dutch pension system

3rd Pillar

2nd Pillar

1st Pillar

Figures 2008 second pillar Company funds number 526/participants 850.000

Industrywide funds number 91/participants 5.048.000

Occupational funds number 13/participants 44.000

Total assets Euro 688 billion/1,25 x GDP

Insurance companies 22.000 pension schemes/ 834.000 participants

Total number of employees in the Netherlands: 7.200.000

Pensions in the Netherlands

Participation in pension schemes

• Netherlands - Indirect system: participation is mandatory through collective agreements between employers and employees - Economic motives: level playing field, cost efficiency - Social motives: further reducing room for non- participation - What about self-employed?

• Elsewhere - Only 11 out of 30 OECD countries have mandatory private pension schemes - These countries show a high participation compared to countries with voluntary private pension schemes

Funded pension schemes in OECD

Funded private mandatory pension schemes in OECD

Statutory compulsory through employer

Statutory compulsory through employee

Compulsory through collective agreements

AustraliaIcelandSwitzerland

DenmarkMexicoHungaryPolandSweden

DenmarkNetherlands Sweden

Source: Pensions at a Glance, Public Policies across OECD Countries, OECD Publishing 2005

Why mandatory participation?

• Behavioral pitfalls

- Lack of self-control: inertia and procrastination- Hyperbolic discounting and myopia- Framing- Inconsistent preferences

• Financial (il)literacy

• Reduce negative external effects; poverty

• Cost efficiency

Conclusions

• International comparison indicates that compulsion is attended by higher participation

• Empirical evidence shows that Dutch pension savers too are prone to behavioral pitfalls

• On balance the public seems to be aware of this, given the dominant preference for a mandatory system with high certainty and limited autonomy

Conclusions

• Is our current pension system optimal?

- Overall, our pension system performs well vis-à-vis that in other industrial countries, but….

- Issue requires a broader analysis from different angles

- Broad spectrum from fully mandatory system to full autonomy; introducing more autonomy while at the same time preventing people from making major mistakes could be the way forward

- How to improve pensions for the self-employed?

The Netherlands:

1. Pension system

2. Pension supervision

Contents

Apeldoorn

• Regulation - 1st pillar: Old Age Act (“AOW”) - 2nd Pillar: Pensions Act (“PW”)

• Regulator - Ministry of Social Affairs: pensions

- Ministry of Finance: all other financial markets segments

• Supervisor- DNB: De Nederlandsche Bank - AFM: Autoriteit Financiële Markten

Regulation

• In 2004 the Twin Peaks model was introduced - prudential supervision of financial institutions by DNB - supervisor for market conduct (“AFM”)

• Cooperation between two ‘Peaks’ is essential- potential for overlap/white spots- covenant between DNB and AFM

• Experiences

- more effective supervision- better grip on financial stability risks

- substantial cost savings

Supervision

• Supervisory principles:– Principle-based / Prudent person in investments– Risk-oriented– Integrity– Transparent / ICT facilitated

• Executive powers:– Quarterly and annual statements– Contractual agreements– Investment plan / strategy– Actuarial and business memorandum– Fit and proper test board & management– On-site inspections

• Sanctions and redress:– Imposing a binding direction– Fines and penalties– Appointing interim managers / administrator– Replacing the Board

In practice:• Open discussions• Principle-based• Discretionary powers• Sanctioning only if

dialogue fails• Focus on prudential

supervision (funding and solvency)

Supervisory approach

Review seminar 2009

Summary

1. Pensions in the Netherlands

2. FIRM and FAF

Pension right

€ 1000,- whenretired

Pension fund

Risk based supervision

• Quantitative:Pension fund as a ´money factory

• Qualitative:Pension fund as a company

EUR 200 billion!

FIRM: Financial Institutions Risk Management method

Judgement based on risk analysis FIRM

Solvency Liquidity IntegrityControl &

Organisation

PlanningIntervention

Protect creditors and policy holdersContribute to the integrity of the financial system

Overall objectives DNB

Uniform methodology for risk analyses Applicable for all institutions supervised

Standardized approach Covers ‘all’ supervisory activities

Promotes objectivinessSystematic

Smaller chance overlooking relevant informationSupports planning

Allows for allocation of scarce resources

Financial Institutions Risk Management Method

Risk and control assessment

Inherentrisks Mitigating

controls

Netrisk

Assessment of inherent risks and mitigating controls gives insight into the overall risk profile of the supervised institutions

Inherent risksmitigated by

controls =

net risk

Inherent risksmitigated by

controls =

net risk

Four-point scale to assess risks and controls

1 Low risk2 Limited risk3 Material risk4 High risk

Unknown / Not applicable

1 Low risk2 Limited risk3 Material risk4 High risk

To identify“white spots” »

Risk scoreRisk score

1 Strong control2 Satisfactory control3 Unsatisfactory control4 Weak control

Control scoreControl score

Using default scoresfor inherent risks

Matching/interest rate risk

Market risk

Operational risk

Credit risk

Insurance risk

Outsourcing risk

Business risk

IT- risk

Integrity risk

Legal risk

Risk categories

Governance

Solvency management

Risk based supervision

Integrity risk

Marketrisk

Legal risk

Insurance risk

Outsourcing risk

Risks, some examples

• ´Qualitative´:

• Bad management (governance)

• Lehman as transition manager (legal)

• Real estate fraud (integrity)

• `Madoff´ (outsourcing)

• IT systems failing (IT)

• Investments in weapons or child labor (integrity)

• Employee taking money from the fund (integrity)

Risks, some examples

Quantitative:

• Underfunding (solvency management)

• Great losses due to risky investments or credit crunch (market or credit)

• Raise in obligations due to declining interest rates (matching)

• People live ´too long´ (insurance)

Quantitative risks:Financial Assessment Framework (FAF)

• FAF is part of new Pension Law (2nd Pillar)

• FAF objectives:

Insight in the financial position of a pension fund

Market value valuation of investments and liabilities

Risk based approach

Risk sensitive capital requirements

Structured early intervention

Analysis of availability and power of policy instruments in the long run

Financial Assessment Framework

• Market valuation

• Full funding requirement

• Cost-effective premium

• Strict rules for premium rebates or contribution holidays

• Risk based solvency requirements & recovery plans

• Prudent person approach

• No investment restrictions

• Except for investments in the sponsoring company

Financial Assessment FrameworkThree questions

Does the pension fund have sufficient:

• 1. Assets to cover the liabilities?• Actual value (market-consistent)• Market rates, no fixed discount rate

• 2. Surplus to cover risks? • Risk horizon of 1 year• confidence level 97,5%, ‘once in 40 years’• Test available solvency to required level in solvency test

• 3. Flexible policy instruments to deal with long term risks?• Continuitiy analysis• Investment, premium and indexation policy

1. Possible funding ratios(regulatory intervention levels)

Contribution reduction possible

Free surplus

Level needed to fulfill indexation promises

Solvency deficit- Max recovery period 15 years

*) for a typical pension fund

Capital requirement

Funding deficit-Max recovery period 3 year

Minimal capital

requirement

Market value technical

provision

127% *)

Continuity Analysis

Goals from perspective of regulator/supervisor:

• Investigate the balance between premium-, indexation- and

investment policy

• Incorporate a long-term perspective

• Identify possible problems at an early stage

• Bring forward the moment of intervention

• Stimulating risk-awareness

• Tribute to more transparency and communication

Funding ratio

Dekkingsgraad

0 5 10 15jaar

2,5% percentiel mediaan 97,5 percentiel

´Factor analysis´

Δ DG (oorzaken voor mutaties van de dekkingsgraad)

Jaar DG primo premie uitkering toeslag rente rendement DG ultimo

% Δ%-punt Δ%-punt Δ%-punt Δ%-punt Δ%-punt %

2008 125,0 -1,0 1,3 -2,1 0,0 3,2 126,4

2009 126,4 -1,1 1,3 -2,3 0,0 3,3 127,7

2010 127,7 -1,1 1,4 -2,4 0,0 3,3 128,9

2011 128,9 -1,2 1,4 -2,6 0,0 3,3 129,9

2012 129,9 -1,2 1,5 -2,7 0,0 3,4 130,9

2013 130,9 -1,2 1,5 -2,8 0,0 3,4 131,8

2014 131,8 -1,3 1,6 -2,9 0,0 3,4 132,6

2015 132,6 -1,3 1,6 -3,0 0,0 3,4 133,3

2016 133,3 -1,3 1,7 -3,1 0,0 3,5 133,9

2017 133,9 -1,4 1,7 -3,2 0,0 3,5 134,5

2018 134,5 -1,4 1,7 -3,3 0,0 3,5 135,0

2019 135,0 -1,4 1,8 -3,4 0,0 3,5 135,5

2020 135,5 -1,4 1,8 -3,4 0,0 3,5 135,9

2021 135,9 -1,4 1,8 -3,5 0,0 3,5 136,3

2022 136,3 -1,5 1,8 -3,6 0,0 3,5 136,6

Summary

• Many risks regarding pension rights, both qualitative and

quantitative

• Supervision is risk based

• FIRM tool for assessment risks and controls

• Financial Assessment Framework for assessment and control of

quantitative risks

Review seminar 2009

Summary

2. FIRM and FAF

5. Financial crisis and the impact on

pensions in Europe

Agenda

• Full funding requirement

• Key developments in 2008

• Security mechanisms in the Dutch system

• Long term solutions

Why full funding is important

• Underfunding has a price • High and volatile recovery costs: prevention cheaper than cure

• Uncertainty reduces consumption and increases savings

• Funding contributes to confidence in pensions• Employees will be more confident that their pension will be there when they retire

• Encourages labour mobility: facilitates transfer of accrued rights

• Funding is a hedge for an ageing society• The ratio of retirees to workers is to double the next 30 years

• Less opportunity to ‘pass on the bill’

How is funding measured?

• Funding ratio = market value assets / market value liabilities

• Assets = all assets at free disposal of the pension scheme

• Liabilities = all non-discretionairy liabilities (accrued benefit

obligations) discounted at the current term structure of interest rates

Possible deficits

• Solvency deficit • Funding ratio is above 105% but

• Below the required level (127% for the average pension scheme)

• Long-term recovery plan (max 15 years)

• Funding deficit • Funding ratio is below 105%

• Short-term recovery plan (max 3 years)

Key developments in 2008

• The MSCI World total return index decreased by 37% • Solvency test is based upon a 25% decrease

• Overall, the interest rate term structure dropped by 140 basis points• Solvency test is based upon a 100 basis points decrease

• Intra year swings even bigger

Analysis of the change in funding ratio

Q2 2007 Q3 2007 Q4 2007 Q1 2008 Q2 2008 Q3 2008 Q4 2008

due to interest rates changes

due to investments results

Fundig ratio - right hand scale

%Change

How to safeguard pension liabilities in a defined benefit environment

• Security mechanisms in the Dutch system• Regulatory own funds

• Increases in the contractual contributions

• One-off sponsor commitments

• Adjustments in investment policy

• Reduction of future indexation

• If all security mechanisms are exhausted• Accrued pension rights can be reduced

• Note: there is no pension guarantee fund in the Netherlands• Like the PBGC in the US or the PPF in the UK

Supervisory dilemma

• Prevent unnecessary reduction of accrued pension benefits and

cause social disorder

…versus…

• Delay emergency measures for too long and let the situation

develop from bad to worse

Problems associated with current system

• Who provides the nominal pension guarantee, and is there a fair compensation for providing it? With the guarantors’ agreement?

• Conditional indexation is an option to reduce the real value of the pension. What if there is no inflation?

• If the funded ratio declines towards 105%, either contributions must be raised, or risk and hence higher return prospects must be removed from the balance sheet. Both are particularly unfair to young workers (especially in an aging society)

Problem #2Problem #2

Long term solutions

• Volatility in funding ratios seems to be underestimated

• Existing policy instruments have relatively low risk absorption

capacity

• Is the Dutch pension system in need for higher regulatory own

funds?

Reduction of balance sheet volatility can be accomplished by

• Investing in matching assets• Consider a pension scheme as a risk management vehicle

• Creating alternative liabilities• Consider a pension scheme as an life-cycle saving and investing vehicle

• Combination of the above

Matching assets

• Pension schemes can lay off risk in the international capital market

by funding pensions with corresponding assets

• A key purpose of funding is to diversify risks over international

markets

• Possible issue is the low liquidity in inflation let alone wage-indexed

products

Conclusion

• In both cases, at a macro level the pension sector can do with lower

solvency requirements

• In the first solution, matching assets allow for lower regulatory own

• In second solution, the youth bear the residual risks of the

guarantees given provided to the elderly

Review seminar 2009

Summary

2. FIRM and FAF

5. Financial crisis and the impact on

pensions in Europe

Agenda

• Effects of the crisis on different systems

• Responses to the crisis

• Possible effects of the crisis

Effects of the crisis

Asset side of the balance sheet

• Decreasing value of equities

• Increasing value of fixed income products

(caused by decreasing market interest rate)

Liabilities side of the balance sheet

• Increasing liabilities

(caused by decreasing market interest rate)

Effects on different systems

Pay-as-you-go system

• Pensions in payment untouched

• Indirect effect through lower purchasing power?

Funded system

• Lower capital

• Lower interest rates when converting capital into annuity

Effects on funded systems

Defined Benefit

• No change to benefits

• Pension in payment continue as planned (for now)

• Recovery takes time and/or money (pro-cyclical)

• Direct loss of purchasing power for pensioners when indexation is

conditional

Effects on funded systems

Defined Contribution

• Direct effect on new pensioners

(lower than expected pension annuities)• No possibility for recovery

• No direct effect on active members

Reduction of effects through system choices

Defined benefit

• Adequate buffers (NL?)

• Quantitative restrictions• Limitations to equity investments

• Limitations to foreign investments

• Limitations on securitised products (DE)

• Technical provisions• Fixed discount rate (ES, DE)

• Expected return on investment (UK-funds, IE)

• Corporate bond yield curve (UK-employers)

• Positive effect of currency risk (UK)

Reduction of effects through system choices

Defined contribution

• Effects only for people reaching retirement age during crisis

• Young DC-systems (RO, SK, etc)

• Life-cycling

Dutch response to the crisis

Defined benefit

• In ‘normal’ market conditions the maximum recovery period is 3

years once the minimum funding level of 105% is breached

• Given the exceptional circumstances, the minister of Social Affairs

has decided to extend this period to 5 years

• The recovery period for a solvency deficit remains at 15 years

Defined benefit (2)

• Recovery plan must contain measures how to get back to the

minimum funding level of 105% within 5 years• If all other measures fail, reduction of accrued benefits might be neccessary

• Reduction of benefits no earlier than April 1st, 2012• Result of discussions over total crisis management package between

government and social partners

Defined contribution

• In ‘normal’ market conditions, a life-time annuity must be bought at

retirement

• Given the exceptional circumstances, the minister of Social Affairs

has decided to allow a capital segmentation

• This is a temporary measure, for those who retire before 2014

Defined contribution (2)

• Capital segmentation:• Step 1: what would be the life-time annuity under current market

conditions?• Step 2: accrual of that benefit for 5 years• Step 3: the rest of the pension capital remains invested and (hopefully)

profits from market recovery

• If ´satisfied´ with current market circumstances, the remaining

pension capital can be used to buy a deferred life-time annuity

(following on the temporary annuity).

Possible effects?

Short-term effects

• Reduction of benefits

• Investing in liquid assets (with government guarantee)

Long-term effects

• Lower pensions promise, even with steady premiums

• Shift from DB to DC?

• Doubts on adequacy of DC-schemes• Closure of voluntary schemes (IT)

• Return of mandatory schemes to the public system (SK)

Review seminar 2009

Summary

2. FIRM and FAF

Agenda

• Pension savings in the European Union• Consequences of the financial crisis• Are private pension savings a thing of the past?• The importance of pension plan design: lessons from the Dutch

experience?• Concluding remarks: policy recommendations• Questions/discussion

Three pillars of a pension system

1st pillar 2nd pillar 3rd pillar

• pay-as-you-go• organised by government• compulsory

• funded• occupational pension funds• (semi-)compulsory

• funded • individual savings• voluntary

First versus second/third pillar

First pillar• Financed by taxes/public

funds• Demographics have strong

impact• Inflation has little impact• Financial markets have little

impact• Fiscal policy has strong

impact

Second pillar• Financed by private

savings• Demographics have little

impact• Inflation has strong

impact• Financial markets have

strong impact• Fiscal policy has little

impact

Ageing and the dependency ratio

Collective versus individual

Collective scheme• Low cost• No conversion risk• Little choice• Professional management

Individual scheme• High cost• Conversion risk• Adaptable to individual

preferences• Behavorial finance

arguments

An unprecedented shock

Funding ratio Q2 2008 143.2%

Required funding ratio Q2 2008 121.9%

Hypothetical funding ratio assuming a correlation of 1 between shocks

112.3%

Realised funding ratio Q4 2008 103.7%

Stress testing with respect to one of APG Group’s client funds

Funding ratio in perspective

Interest rate Funding ratio

Estimated

(Swaprate end 2008)

(Former fixed interest rate)

5% 110%

6% 126%

The glass is half full…

Dutch lessons?

• Automatic enrollment• Default asset mix• Low costs• Mitigation of conversion risk• Governance• Transparency and communication

Interesting for other Member States

• Even though the Dutch system cannot be transferred one-on-one to the EU, the Dutch experience and expertise in this particular area appears to be of interest to other Member States

• If an exportable Dutch pension product can be defined, which markets would potentially be fertile grounds for the Dutch pension system?

Construction of the so-called transferability index

• “the Dutch pension system” ≈ the pension deal as it is common in the Dutch second pillar, macro perspective; no distinction w.r.t. individual pension products

Two important factors

• Need for reforms

Member States that have to move from PAYG to funded schemes are potentially interesting export markets

• Characteristics

Those countries that bear most similarities with the foundations of the Dutch pension system should be the ones most susceptible for it

Analysis of the results

• Belgium, Finland France, Germany, Ireland, Spain and the United Kingdom show highest transferability opportunities

• For Estonia, Hungary, Poland and Slovakia transferability is lowest• Transferability for several countries could change in upcoming years• When considering the exportability of Dutch pension asset

management as such, all countries in quadrant I, II and IV should be considered

• For Member States with the largest need for reform (quadrants I and IV), two options for future development exist

Concluding remarksPolicy recommendations

• Need for private pensions savings

in the EU has increased:– Higher estimates costs of ageing– Worse budgetary positions

• Appropriate policy incentives– Automatic enrollment

• Importance of pension plan design– Avoid pitfalls of traditional DC– Lessons to be learned from the Dutch?

Rick Hoogendoorn

Seminar ‘Supervision on pension funds, experience from Romania and the Netherlands’

June 9-11, 2010

IOPS PRINCIPLES OF PRIVATE PENSION

SUPERVISION

Agenda

1. Introduction: How to use the Principles

2. OECD Core Principles of Occupational Pension Regulation

3. IOPS principles of pension supervision1. The principle

2. The assessment questions

3. Applying the principle to the Netherlands

4. Pitfalls to this principle

Introduction: How to use the principles

Methodology (1)

• Provides a structured framework for assessing the extent to which

regulation (OECD) / a pension supervisory authority (IOPS)

complies with the letter and spirit of the Principles

• Can be used for external or self-assessment

• Also indicates type of evidence that may help to answer questions

• Accountable to e.g. Parliament, members and beneficiaries

Introduction: How to use the principles

Methodology (2)

Compliance is rated as:

• Fully implemented: the Principle is implemented in all material respects

• Broadly implemented: the Principle is implemented in all but 1 or 2

material respects and the exceptions do not significantly detract from the

overall opinion.

• Partly implemented: while a negative answer is given to some questions,

the responses to the majority of the questions are consistent with

compliance

• Not implemented: there are major shortcomings against the principle

• Not applicable: the Principle does not apply due to structural, legal or

institutional features

OECD Core Principles on Occupational Pension Regulation

The OECD Council has published 7 Core Principles on Occupational Pension

Regulation. Various guidelines have been approved which develop specific

core principles.

# Core Principle Corresponding guideline

1 Conditions for effective regulation and

supervision

2 Establishment of pension plans,

pension funds and pension fund

management companies

IOPS-OECD Guidelines on the Licensing of

Pension Entities

OECD Core Principles on Occupational Pension Regulation

# Core Principle Corresponding guideline

3 Pension plan liabilities, funding rules,

winding up and insurance

OECD Guidelines on Funding and Benefit

Security

4 Asset Management OECD Guidelines on Pension Fund Asset

Management

5 Rights of members and beneficiaries

and adequacy of benefits

OECD Guidelines for the Protection of

Rights of Members and Beneficiaries in

Occupational Pension Plans

6 Governance OECD Guidelines for Pension Fund

Governance

7 Supervision IOPS Principles of Private Pension

Supervision

IOPS Principles of Pension Supervision

The International Organisation of Pension Supervisors (IOPS) was

formed in 2004 as a world-wide forum for dialogue and the

exchange of information as well as the standard setting organisation

promoting good practices in pension fund supervision.

IOPS currently has around 60 members and observers representing

approximately 50 countries and territories worldwide

The aims and purposes of IOPS are:

• Serving as the standard-setting body on pension supervisory

matters and regulating issues related to pension supervision

• Promoting international co-operation on pension supervision

• Providing a worldwide forum for policy dialogue and exchange of

information on pension supervision

• Participating in the work of relevant international bodies in the area

of pensions

More information about IOPS can be found on: www.iopsweb.org

Element

SeparationSeparation

Description

• Pension assets are legally separated from the corporation in a trust

MandatoryMandatory• The Minister of Social Affairs may make participation in an industry

wide pension scheme mandatory for the profession as a whole

Risk SharingRisk Sharing • Risks are shared within and across generations

EfficientEfficient • Significant economies of scale through large pension providers

Prudent personPrudent person• The Pension Act imposes no investment restrictions, except for

investments in the sponsor

Elements of the Dutch pension system

Principle 1

National laws should assign clear and explicit objectives to pension

supervisory authorities

• Strategic objectives should be clear and public

• Responsibilities of the pensions supervisor should give a clear

mandate and assign specific duties

Principle 1: Clear and Explicit Objectives

Assessment questions

• Is there legislation providing for a pension supervisor?

• Does the legislation set out objectives?

• Are the objectives public and binding?

• Does the legislation explicitly set out responsibilities and duties of the pension

supervisor?

• Does the supervisor explicitly set out its responsibilities and duties?

Assessing the Dutch supervisory system

Principle 1 is fully implemented in the Netherlands. The supervisory objectives are clear

and the supervisor has set out how it deals with these objectives. Rules are in the

Pension Act and DNB has published a strategic ‘Vision on supervision’ for 2010 -

2014. This document states the objectives, responsibilities and duties of DNB.

Pitfalls

Principle 2

Pension supervisory authorities should have operational independence

• Autonomy in day-to-day operations and decision making

• Funding to ensure independence

• Appointment procedures transparent

• Judicial review of supervisory actions

Principle 2: Operational Independence

• Is the supervisory authority established as a body with operational independence?

• What type of restrictions exist on the ability of the government to make directions to

the supervisory authority?

• Is there transparency in the process for appointing senior positions ?

• Is there transparency in the process for terminating senior positions?

• Are senior officers replaced when there is a change of government?

• If funded by levies on supervised entities is there freedom from interference by these

entities?

Principle 2 is broadly implemented in the Netherlands. DNB operates under full

operational independence. A flaw in this respect might be the fact that DNB can be

held liable in civil court actions.

Pitfalls

Principle 3

Pension supervisory authorities require adequate financial, human and

other resources

• Able to conduct functions efficiently and independently

• Funding to ensure independence

Principle 3: Adequate Resources

• Is the budgetary timeframe long enough (e.g. 3 years) to provide stability in planning

and recruitment?

• Is the budget sufficient to enable the supervisory agency to meet its responsibility?

(very subjective)

• Does the agency have freedom in hiring with regard to staff numbers and salary?

• Are senior staff appropriately qualified?

Principle 3 is fully implemented in the Netherlands. DNB is able to (and has achieved

to) hire adequate, experienced and expert staff. DNB is granted access to sufficient

resources to enable it to properly perform its duties. Even so, the credit crisis proved

that external shocks can seriously put pressure on the organization and its capacity.

Pitfalls

Principle 4

Pension supervisory authorities should be endowed with the necessary

investigative and enforcement powers to fulfill their functions and

achieve their objectives

• Powers appropriate to the system being supervised

• Powers appropriate to the manner of supervision e.g. appropriate

investigatory and enforcement powers

Principle 4: Adequate Powers

• Are the supervisor’s powers clearly established by its governing legislation?

• Can the supervisor gain access to the information it needs?

• Is there a licensing or registration process that enables the supervisory agency to

obtain relevant information and to reject/amend/revoke the license/registration in the

case of serious non-compliance ?

• Can the supervisor enforce legislation relating to funding/capital adequacy, fitness

and propriety?

• Have there been difficulties in using available powers?

Principle 4 is broadly implemented in the Netherlands. DNB has adequate powers to

deal with pension funds breaching their legal obligations. DNB can also obtain any

information it deems necessary, from any party at no cost. The only flaw with respect

to this Principle is the limited direct access of DNB regarding third parties performing

outsourced pension fund functions.

Pitfalls

Principle 5

Pension supervision should seek to mitigate the greatest potential risks

to the pension system

• Objectives of supervision should be risk-based

• Allocate supervisory resources to highest risk areas

• Pro-active approach to avoid problems before they occur

Principle 5: Risk Orientation

• Are the supervisory authority’s objectives risk based rather than focusing on

compliance?

• Are resources of the authority allocated to the highest risk areas?

• Do the supervisors consider both the probability and likely impact of potential risks?

• Does the supervisor assess risks for each entity under supervision (for example by a

risk scoring model)

Principle 5 is fully implemented in the Netherlands. DNB uses a risk assessment

approach for its supervision of pension funds. Both the risks and the risk control

mechanisms are scored in the risk scoring model FIRM. Priorities in supervision d

allocation of resources are based on aggregate and individual scoring in the FIRM

system.

Pitfalls

Principle 6

Pension supervisory authorities should ensure that investigatory and

enforcement requirements are proportional to the risks being

mitigated and that their actions are consistent

• Important to have the appropriate range of legal powers and tools

• Similar cases dealt in similar manner

Principle 6: Proportionality and Consistency

• Can the supervisory authority vary its activities according to the risks being

addressed?

• Does the supervisory have procedures for helping the choice of a proportionate

response, such as an enforcement pyramid?

• Does the supervisory allow entities appropriate flexibilty in deciding how to comply

with legislation?

• Are there processes in place to ensure consistency between actions where

circumstances are similar?

Principle 6 is fully implemented in the Netherlands. DNB has attention for the

proportionality and consistency of its actions towards pension funds. Proportionality

is ensured through the use of the FIRM system and consistency through well-

developed documentation systems.

Pitfalls

Principle 7

Pension supervisory authorities should consult with the bodies they are

overseeing and cooperate with other supervisory authorities

• Industry consultation assists to get ‘buy-in’

• Information exchange with co-regulators at home and under cross-

border arrangements promotes efficiency and supports preventive

measures

Principle 7: Consultation and Cooperation

• Does the supervisory authority consult with the pensions industry when determining

strategic supervisory approaches?

• Is the supervisory authority empowered to exchange information with equivalent

oversees authority, subject to appropriate requirements?

Principle 7: Consultation and Cooperation

Principle 7 is fully implemented in the Netherlands. DNB is open towards pension funds,

pension fund associations, social partners and other supervisory authorities, within

the limitations of its confidentiality requirements. This includes consultations with the

pension sector when DNB is considering new regulation and regular meetings with

these parties to discuss developments in the pension sector.

Principle 8

Pension supervisory authorities should treat confidential information

appropriately

• Only release if permitted by law

• If in doubt, check first

• Principle extends ‘down the line’

Principle 8: Confidentiality

• Does the supervisory authority have a confidentiality policy which sets out the

authority’s procedures to prevent inappropriately disclosure of non public

information?

• Are there mechanisms to prevent disclosure of confidential information by staff,

including after they have left the supervisory authority?

Principle 8 is fully implemented in the Netherlands. The Pension Act sets high

confidentiality standards, complemented with processes and rules to ensure that

information on individual funds is not shared if the confidentiality of that information is

not protected with the envisaged recipient.

Pitfalls

Principle 9

Pension supervisory authorities should conduct their operations in a

transparent manner

• Adopts clear, transparent and consistent processes

• Regularly reports on policy and performance

• Subject to external review

• Publishes industry information

Principle 9: Transparency

• 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 actions?

Principle 9: Transparency

Principle 9 is fully implemented in the Netherlands. DNB is transparent with regard to its

supervisory processes. An example of this transparency is Open Book Supervision

(on DNB’s website www.dnb.nl ), an information system that discloses regulations,

policy rules, supervisory processes and Q&A’s.

Principle 10

The supervisory authority should adhere to its own governance code

and should be accountable

• Controls, checks and balances

• Code of conduct

• Decisions are reviewable

• Accountable to e.g. Parliament, members and beneficiaries

Principle 10: Governance

• Does the supervisory authority have appropriate codified procedures for internal

governance, and is compliance with these monitored and enforced?

• Is there a code of conduct for all staff regarding gifts, hospitality etc and declaring

conflicts of interest?

• Is there independent review within the agency of decisions which have significant

implications for the supervised entity?

• Is there an appeals process against decisions?

• Does the supervisory agency measure its performance against objectives and provide

external stakeholders with the results?

Principle 10 is fully implemented in the Netherlands. DNB has established clear

governance codes and due processes to be held accountable for its conduct and

activity.

Pitfalls

Clear and Explicit Objectives National laws should assign clear and explicit objectives to supervisor

Operational Independence Supervisor should have operational independence

Adequate ResourcesSupervisor requires adequate financial, human and other resources

Adequate PowersSupervisor should have the necessary investigatory and enforcement

powers

Risk OrientationSupervisor should seek to mitigate the greatest potential risks to the

pension system

Summary of IOPS Principles

Proportionality and Consistency

Supervisor should ensure that investigatory and enforcement requirements are proportional to the risks being mitigated

Consultation and Cooperation

Supervisor should consult with the they oversee and cooperate with

othersupervisors

ConfidentialitySupervisor should treat confidential information approprisate

TransparencySupervisor should conduct its operations in a transparent manner

Governance Supervisor should adhere to its own governance code and should beaccountable

Summary of IOPS Principles

Self-Assessment Results

Well Implemented

Principles

Medium Implemented

Principles

Poorly Implemented

Principles

1. Clear and Explicit

Objectives

2. Operational

Independence

3. Adequate Resources

4. Adequate Powers 9. Transparency 5. Risk Orientation

7. Consultation and

Cooperation

10. Governance 6. Proportionality and

Consistency

8. Confidentiality

David Schelhaas + Rick Hoogendoorn

Seminar ‘Supervision on pension funds, experience from Romania and the Netherlands’

June 9-11, 2010

PENSION FUND GOVERNANCE: OECD

GUIDELINES

Agenda

1. OECD Core Principles of Occupational Pension Regulation

2. OECD Guidelines on Pension Fund Governance

3. Governance in Practice

Governance structureGovernance structure

Governance mechanismsGovernance mechanisms

8 guidelines about the structure of pension fund governance 8 guidelines about the structure of pension fund governance

3 guidelines about mechanisms that should enable boards to govern pension funds

OECD Guidelines for Pension Fund Governance

11• Identification of responsibilities: there should be clear identification and separation

of operational and oversight responsibilities

• Identification of responsibilities: there should be clear identification and separation

of operational and oversight responsibilities

• Accountability: the governing body should be accountable to the pension plan

members and beneficiaries, its supervisory board and the competent authorities.

• Accountability: the governing body should be accountable to the pension plan

members and beneficiaries, its supervisory board and the competent authorities.

• Governing body: every pension fund should have a governing body vested with the

power to administer the pension fund.

• Governing body: every pension fund should have a governing body vested with the

power to administer the pension fund.

• Suitability: membership in the governing board should be subject to minimum suitability standards in order to ensure a high level of integrity, competence, experience and professionalism in the governance of the pension fund

55• Delegation and expert advice: the governing body may rely on the support of sub-

committees and may delegate functions to internal staff or external providers

• Delegation and expert advice: the governing body may rely on the support of sub-

committees and may delegate functions to internal staff or external providers

• Actuary: an actuary should be appointed by the appropriate body for all defined

benefit plans financed via pension funds.

• Actuary: an actuary should be appointed by the appropriate body for all defined

benefit plans financed via pension funds.

• Auditor: an independent auditor should be appointed by the appropriate body to

carry out a periodic audit consistent with the needs of the arrangement.

• Auditor: an independent auditor should be appointed by the appropriate body to

carry out a periodic audit consistent with the needs of the arrangement.

• Custodian: custody of the pension fund assets may be carried out by the pension entity, the financial institution that manages the pension fund or by the independent custodian.

Governance mechanismsGovernance mechanisms

99• Risk-based internal controls: there should appropriate controls in place to ensure

that all persons and entities with responsibilities act in accordance with objectives.

• Risk-based internal controls: there should appropriate controls in place to ensure

that all persons and entities with responsibilities act in accordance with objectives.

• Disclosure: the governing body should disclose relevant information to all parties

involved.

• Disclosure: the governing body should disclose relevant information to all parties

involved.

• Reporting: reporting channels between all persons and entities involved in the

governance should established.

• Reporting: reporting channels between all persons and entities involved in the

governance should established.

Governance in Practice

Liabilities

Pensions

Finance Investments

Governance in Practice

Liabilities

Management

Pensions

Finance Investments

Supervisory strategy 2010 - 2014

• Supra institutional

benchmarking

thematic investigations

• Conduct and culture

Supervisory themes 2010

• Pension Fund Governance

• Follow up investment investigations

• Financial structure

• Outsourcing

• Quality of provided data

• Evaluation of recovery plans

Pension Fund Governance

• Decision making process

• Transparency

• Consistency

• Balanced representation of interests

Pension fund governanceDecision making processes

• Selection process of advisors

• Financial agreement

• Self assessment process of the board

• Internal supervision

Risk management for investments

Paulus Dijkstra

Reinsurance and Asset & Liability Management

department

June 10 2010

Agenda

• Supervision and risk management

• Levels of risk management

• A simple case

• Sources of complexity

• Example

Supervision and risk management

• Risk management central part of governance

• Prime focus of supervision: Assessing quality and independence of risk

management function

• Risk management not only technical:

– Tone at the top

– countervailing power on all levels

Levels of risk management

Board levelFinancial setup:Premium policyIndexation policy

ALMConsultants

Board Staff/Investment CieMandates to asset managers

Investment Advisory Cie

Asset Manager

Performance and risk reports

Aggregatedperformanceand risk reports

Supervision and risk management

• Our pension fund law is principle-based:

• Boards should behave as prudent person• Business environment should be controlled and integer

• In practice: Balance between complexity of investments and robustness of risk control

No one size fits all!

A simple case

• Investment mandate in liquid asset class with:

• Clearly defined market index as benchmark: Communicates strategic risk-return preferences Broadly defines desired portfolio composition Yardstick for measuring market and active performance

• Limited degrees of freedom for active positions• No ‘out of benchmark’ positions• No (non-linear) derivatives (including embedded options)• Limits on concentration risks• Effective limits on active risk exposures (e.g. duration bands, tracking error)

• Risk management: ex post checking of compliance with guidelines and restrictions

Signs of complexity

• Broadly defined investment universe, more room for ‘new ideas’• Significant use of derivatives (especially option-like)• Higher risk asset classes• Illiquid asset classes• Alternative asset classes• Asset classes that involve underlying cash investments (e.g. commodities)

Risk management much more proactive:• Continuous monitoring of actual portfolio composition• Identification of type and form of risk exposures• Frequent assessment of adequacy of risk measures and methodologies• Challenging of choices made by asset managers

Alternative asset classes

• Issues that complicate risk management:

• Lack of suitable benchmarks to

– Guide composition of actual portfolio

– Distinguish between market performance and active performance

• Lack of transparency of portfolio and risk composition

• Fee schedules encourage high risk taking

• Higher levels of leverage

• Illiquidity hides true risk profile (smoothing)

Example: Fiduciary management

• Common division of roles and responsibilities:

• Board determines strategic asset allocation

• FM responsible for implementation of SAA

– Goal:

• FM outperforms strategic benchmarks ...

• … within a preset budget for active management risk

• Remuneration:

• FM gets base fee plus performance related fee

• Services outsourced to FM:

• Selection of active managers

• Risk control of active management risks

• Potential conflicts of interest:

• Investment mandates managed by FM

• Performance related fees and risk management responsibilities

8 700 1140 -100Japan 16 400 860 -20

3 600 1400 -975US small cap 20 500 925 -325

23 500 950 -890EM 1 14 550 550 -50EM 2 17 600 1600 315Total 101 220 525 -261

54 200 850 -231038 200 530 -21028 250 1325 -890

US HY 13 250 250 6007 250 250 215

Total 140 110 415 -1060

20 350 490 -285

GSCI 25 300 950 -855

GTAA 25 140 180 -88

FM product 60 500 -1500

Total 371 130 260 -792,55

Active Risk Budget

Asset class Mandates AUM (mln) Target TE (bp) Realized TE 60 days Excess return ytd (bp)

Equity Europe

Global

Global small cap

Fixed IncomeEuro govt AAAGlobal IG credit

Emerging market govt

Europe HY

Real estate Global listed

Commodities

Hedge funds

De Nederlandsche BankInvestigation into investments of pension funds

Paulus DijkstraReinsurance and Asset & Liability Management departmentJune 10 2010

Investigation into investments

• Presented findings are based on:

Sectorwide analysis of quarterly and yearly standard reporting and

recovery plans.

Experiences of regular supervision (among which a quick scan on

active management).

In-depth investigations into investments of 10 pension funds

Overall picture

Total loss of reserves of pension sector in 2008 was: € 219 bln, roughly for

60% caused by decreasing asset values and for 40% due to increasing

value of liability

Losses attributable to severity of crisis, strategic exposures of pension

funds and additional losses in implementation of these strategies

Loss due to implementation around € 20 bln

Risks of investments generally underestimated

Boards not always in control

Risk management function generally not robust enough

Strategic investment policyThere is a strong relationship between required capital (RC) and losses as a percentage of initial funding ratio.

However, there is a large degree of dispersion around this relationship

0% 10% 20% 30% 40% 50% 60% 70%

x-as: required capital in percentage of liabilitiesy-as:decraese in funding ratio as a percentage of initial funding ratio

Decrease in funding ratios

Some questionable strategies:

• A large number of funds lost more than 60 percentage points of funding ratio (more than twice the required capital of a standard pension fund).

• Some funds even lost more than 100 percentage points

• A large number of funds had a fairly aggressive asset mix, even when funds where closed for new participants

• A number of funds in liquididation maintained their original market and interest rate risks.

2,6%5,8%

5,2%1,6% 1,3% 0,0% 1,0% 0,3%

<10% <20% <30% <40% <50% <60% <70% <80% <90% <100% <110% =110%

Impact crisis and strategic choices not easily separable, but ….

x-as: decrease in funding ratio in percentage points

y-as: percent of pension funds

High degree of optimism

- 163 -

Of all funds with a recovery plan 13% used return assumptions that were unacceptable. These funds account for 64% of the total value of liabilities. 55 %of funds used acceptable return assumptions.

4,5% 5,0% 5,5% 6,0% 6,5% 7,0%

Maximaal rendement volgens DNB vastgestelde grenzen

Onacceptabel rendement

Acceptabel rendement

High degree of optimism on::

•Return expectations•Premium increases•Suppletions•'bad weather' scenarios

This generally leads to more risky asset mixes

Buffers and valuations

Zakelijke waarden Omvang schok FTK

Realisatie indices

Credit spread 10 jrs punt

Omvang schok FTK

Realisatie indices

Mature markets -25% -40% A+ 40% 249%Emerging markets -35% -52% A/A- 40% 162%Private equity * -30% -62% BBB 40% 496%Indirect vastgoed -25% -46% euro financial t.o.v. swap

Direct vastgoed** -15% 3% Curve dalingOmvang schok FTK

Realisatie indices

Commodities -30% -46% 23% 27%

* DJPE index **ROZ/IPD index gemiddeld over curve

Price declines where extreme; magnitude of shocks larger than presumed in required buffers

Not all risks are accounted for:Liquidity risks,Refinancing risks Concentration risks,Risks of active management

Standard approach is alwaysapplied

Valuation of assetsSometimes problematic

Implementation investment policy

Implementation losses due to active management, rebalancing, impact rerfinancing- en liquidity risks.

Explicit and implicit forms of leverage due to use of derivaten, securities lending, direct borrowing and product with embedded leverage

(Indirect) exposure to counterparty risks

Assumption that riskprofile is determined by strategic exposures is less and less relevant

28,7% 29,6%

5,7%1,9% 1,3% 1,3% 0,3%

<1,00 <1,25 <1,50 <1,75 <2,00 <2,25 <2,50 <2,75 <3,00 =3,00

Losses due to implementation € 20,5 bln

x-as: factor (decrease funding ratio / RC)y-as: percentage pensionfunds

Governance• CONTROL

Strong tendency towards active investment risks and innovative investments.

Board is vulnerable for creative ideas.

Loss of direct control in cases of outsourcing not compensated by additional control measures.

Information provisioninsufficientto enable adequate steering of risk profile.

Countervailing powers are not organised to arrive at balanced decision making.

RISK MANAGEMENT

Magnitude of Investment risks is generally underestimated.

Role and importance of adequate risk control underestimated.

Risk identification and analysis underdeveloped.

Independence adequate weight of risk control function in the organisation not adequately safeguarded.

Supervision in practice

David Schelhaas/Leendert van Driel

Bucharest, Romania

June 10, 2010

Life cycle of a pension fund

Stages in the life cycle of a pension fund • Setting up of a pension fund

• Legal requirements and documents

• Regular meeting with board

• Inspection of a fund

• Winding up of a fund

Setting up of a pension fund• Legal requirement:

• Within 3 months submission of articles of association• Within 3 months submission of regulations of the fund

• Submission of Actuarial and Technical Business Memorandum (abtn)• Abtn should outline:

• Accrual and funding of pension benefits• Composition and valuation of fund´s assets and liabilities• Management and internal control• Assets and liability matching• Buffer capital

• Submission of funding agreement between employer and fund

Regular supervision is based on risk analysis.

• Following sources of information are used:• Articles of association and funding agreement• Actuarial and Technical Business Memorandum• Periodic returns and annual accounts• Quarterly reports• Reports requested on ad hoc basis

• Main objective is determination of present and future solvency of the fund• Assessment of annual returns is partly automated. Information is read into a

database and the system indicates when assessment is needed

Regular supervision

Main objective of consultation

To determine and ensure that pension funds are:

• Financially sound

• Well organised and controlled

• Meet legal requirement

• PPL = cash value of expected future benefits

• Funding ratio = investments/PPL

KEY QUESTIONS

• How to determine the value of pension liabilities

• Size of buffer

• Measures in case of deficit

Assets Liabilities

Investments Provision Pension Liabilities (PPL)Reserve/buffer

The frequency of consultation depends on factors

as the size and risk profile of the fund

Risk profile depends in general on

• Insured plan vs. own risk

• Self administered vs. outsourced

Consultation is done through:

• Periodical meetings (once every 1,5 years)

• Special investigation

In general consultation is done by a supervisor and

a business analist. If deemed necessary, they are

supported by a supervisor specialist.

Periodical meetings

A periodical meeting :

• Takes one to two days

• Is on location

Periodical meetings – continued

In preparing a meeting, the following steps are taken:

1. Set a meeting date.

2. Request meeting notes of board meetings and participant meetings over

the last 2 years.

3. Business analist scans the available information at DNB,

(i.e. meeting notes, fund profile, FIRM, plan rules, articles of association, actuarial and technical business

memorandum, funding agreement, annual report, management letters of auditor and actuary, annual DNB

statements, quarterly investment reports, etc.)

4. Business analyst drafts a report of preliminary findings including an

update of the fund profile.

5. Report and fund profile are discussed with supervisor.

6. An agenda is set and sent to the fund.

• Periodical meetings – continued

During a meeting DNB will need to have access to

all local documents, procedures, etc.

Consultation can be with board of directors,

management of the fund, auditor, actuary

administrator, investment manager, etc.

The actual meeting day(s)

• Start with a short mutual introduction including focussing on any actual developments

of the fund.

• Based on preparation perform a (quick) scan of available local documents and

procedures.

• Based on agenda (and new findings)have a meeting with the board, administrator,

actuary, auditor, etc.

• Set concluding remarks and follow-up activities.

Periodical meetings – continued.

After the meeting:

• Findings, concluding remarks and follow-up activities arre confirmed

in writing by DNB (TRIM)

• Follow-up activities are placed on the agenda (TOETSY)

• FIRM and fund profile are updated

• Toetsy - Workflow management

• TRIM - Digital archives

• FIRM - Risk analysis

Group transfer of benefits• This can for example happen when a part of a company is sold• The fund that is transferring must inform DNB about:

• Number of participants to be transferred• Size of the benefits to be transferred• Institution where benefits will be transferred to• Financial consequenses for the fund• Intended transferral date

Winding up of a fund

Board of the pension fund decides about termination of the fund. Following information must be submitted to DNB:

• Minutes of meeting where decision has been taken• Liquidation report of accountant• Information about spending of possible surplus• Method of information of parties involved• Agreement with new pension executive

CSSPP/DNB INTERNATIONAL SEMINAR JUNE 9 – JUNE 11 2010 Supervision on Pension Funds Experience from...

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