Pensions and Collective Investment Schemes

FIRST has engaged in funding technical assistance (TA) for pensions sector and collective investment schemes (CIS) because both of these sectors may contribute substantially to the growth, size and diversity of the financial sector, and in many cases, positively impact poverty reduction. Learn More...

Whilst CIS does not of itself involve pension obligations, the common link with funded pensions is the requirement to manage funds or assets and in some instances institutions like life insurance companies may be involved in both the sponsorship and management of assets under a pension scheme as well as the sponsorship and management of assets under a CIS. The collection of pension contributions from employees, and sometimes employers, effectively mobilizes long term savings for funding the eventual retirement of pension schemes members. The contributions collected can become very substantial over time and these funds then need to be prudently managed and invested. The investments may constitute a very substantial inflow to the capital markets over time, and create a substantial demand for investment opportunities in a variety of instruments that may range across fixed income assets (for example, government issued bonds or private sector corporate bonds) as well as equities or shares in companies (thereby providing opportunities for private companies to raise capital through initial public offerings via the stock exchange as well as liquidity in the secondary market that helps maintain realistic pricing of quoted equities or shares).

As the capital markets grow-spurred by the development of private funded pensions and CIS, institutions involved in the market also grow: asset/fund management companies; trading systems for clearance, deposit, custody and settlement of transactions in investment instruments; trustees for pension scheme administration; brokers that process and execute orders for purchase and sale of investment instruments; companies listing their shares or bonds for trading on the stock exchange; specialist asset managers that might include subsidiaries of banks, life insurance companies or mutual fund type asset managers and so on.

In order to protect consumers, such as the members of pension schemes or small savers invested in CIS, from abuse or poor investment management practices and to ensure the financial stability of the various providers of CIS and pension scheme management, there is a need for these sectors and activities to be well regulated and supervised. Usually the regulation and supervision task will be carried out by a specialist capital markets regulator (as in Uganda or USA), sometimes by a unified financial sector regulator (as in UK and some developing countries), and it sometimes involves more than one regulator (such as in Colombia where both the Central Bank and the Capital Markets Regulator are involved).

CIS as mentioned earlier does not involve liabilities for future pensions but otherwise does provide a vehicle whereby small savers can gain access to capital markets products (such as investments in bonds and or shares) in amounts that they may not easily be able to invest directly in such instruments. A CIS expands investment opportunities for the small saver beyond such traditional ones such as bank deposits. A CIS mobilizes lots of small savings amounts so that the aggregate size of the CIS provides a large pool of funds that can then be invested in a wide variety of investments; this also provides a spread of risk that in theory protects the small saver better. Clearly, just as for pension schemes, regulation and supervision is needed to protect the small savers from abuse and to ensure financial stability of asset/fund managers.

Pension schemes may be divided into two basic types:

Defined contribution schemes (DC)
Defined benefit schemes (DB)

Essentially the DC schemes are safer in so far as assets and liabilities tend to be matched. The aggregate contributions for any particular individual pension scheme member are effectively accumulated and accounted for over the term the individual is a pension scheme member, so that by retirement age the exact amount on the members account is a known figure. That figure can then be invested in an annuity (typically sold by a large life insurance company) that “guarantees” the retired person an annual pension of a certain amount for the remainder of their life. There are many formulae for purchasing and valuing annuities that may include building in inflation proofing, passing on benefits to surviving spouse etc.- all of these affect the level of the starting annuity.

The DB schemes may be either funded or unfunded. The DB scheme typically offers its members a pension that is expressed as a percentage of their salaries in the last few years before retirement; for example, the pension might be equal to 50% of the last year’s salary before retirement and continue at that level for the remainder of life. Some schemes also build in inflation protection. Most private companies that operate DB schemes for their employees place contributions into funds that are then managed by an asset manager and separate from the company’s business assets, so that if the company becomes insolvent the pension fund is still intact. These funded DB schemes are carrying an ongoing liability to pay all members a set (DB) pension on retirement for life, and therefore, the amount of the total pension fund needs to be regularly assessed by actuaries to determine whether the fund is large enough to cover the pension liabilities; if the fund is not large enough the company may need to contribute more money to the fund (“top-up”). The actuaries periodic assessments takes into account issues like life expectancy, return on the investments in the fund in order to determine the amount required to meet all future pension commitments. With the increase in longevity in many countries, the potential liabilities have been increasing and many companies are now unwilling to continue to accept the financial burdens involved, and are therefore terminating their DB schemes replacing them with DC schemes.

The DB risk may be even greater when the schemes are unfunded (usually law and regulations will not allow schemes in the private sector to be un-funded). Un-funding is however, often the case when the State is involved. The State may offer DB pensions for public sector workers such as civil servants, military, police, judiciary, and may also a further minimal pension cover for all citizens (“Social Protection”). The State often considers that separate aggregation of contributions into a fund is not necessary, and that it will meet its future pension commitments out of the general pool of taxes collected by the State (a “pay as you go” system). With increased longevity (in part due to improved medical treatments), the potential future burden on the State, and therefore its tax-paying citizens, is in many instances (including developed countries such as the USA, UK, France) becoming unsustainable. Therefore, many governments are now commissioning actuarial studies with a view to determining the size of the future financial burden and as a consequence what reforms to the pension system may enable a reduction in the future cost of providing pensions. For example, a government might decide to change raise retirement age, but such a policy is then likely to entail transitional arrangements and involve negotiations with trade union groups and other special interest lobbies. Hide...

Summary of Lessons Learned

As of December 30, 2008, FIRST had provided technical assistance on 18 completed projects in pensions and CIS with a total value of US$ 3.5 million. Three of these projects were related to development of strategies for public sector pension reform, seven were for strengthening regulation and supervision for private funded pension schemes, and four were for regulation and supervision of collective investment schemes. Learn More...

Lessons Learned

Working with regulators to strengthen their regulatory and supervisory capacity including assistance with improving regulations and amending the legal and regulatory framework was productive in all the projects where this was the focus of the technical assistance.
Identifying potential roll-out of follow-up technical assistance in certain regions can be built on. For example, the shared basic principles of legal and regulatory frameworks in CIS and capital markets such as East Africa suggests that TA can be often better focused, with economies of scale, if delivered on a regional as opposed to country by country basis.
Looking beyond the field of CIS or pensions to the wider country economic situation and tax regime is important. If, for example, there is not a level playing field between investment choices such as bank deposits versus CIS, then the success in launching CIS may be limited; or, if the supply of investment funds increases too fast for a matching growth in prudent investment opportunities (bonds, equities etc.) then the excess demand can cause over-pricing of securities with obvious dangers- “bubbles” in certain asset classes.
In some instances there is more than one regulator dealing with asset management, pension schemes and CIS. This can be caused, for example, by banking groups owning asset management companies, sponsoring new CIS funds, owning securities brokerage subsidiaries, alongside some similar activities by insurance companies and finally alongside with the listing and trading in securities (including CIS) on stock exchanges. So the central bank, insurance & pensions regulator and capital markets regulator could all justify their role and need for intervention. In these circumstances, coordination between regulators can be difficult and the regulated may be able to play one off against another (regulatory arbitrage). FIRST needs to be careful in providing TA support in such a situation unless it can be judged that there is a will to move responsibility to a single regulator for certain activities such as asset management and that the recipient has developed good, systematic coordination with other relevant regulators.
FIRST has also learned that is not suited for providing the longer term TA required for helping develop public sector pension reform strategies and or social protection pension reforms (safety net pensions for all retired citizens) even though the latter may have a substantial impact on poverty reduction, for the following reasons: i) pension reform at the unfunded public sector level is unlikely to have any significant impact on development of the financial sector. Unlike funded pension schemes (private or public) which will require investment management, development of prudent investment rules and growing and often substantial funds to invest in capital markets (both domestic and foreign); ii) pension reform at the social protection level, usually substantially unfunded, and extended either for public sector workers or even across a larger profile of the population at a minimal social protection level, tends to be highly political, highly complex to negotiate and often requires a long period of time for reform implementation; and, iii) such unfunded DB schemes require regular actuarial assessments and the development of financial modeling skills, with built in actuarial software: this involves considerable investment in IT (which does not fit with FIRST’s Charter for eligible TA support) and considerable training of regulator staff if they are to build their own in-house capacity.

Based on these lessons FIRST has decided that engagement with unfunded social protection type pension reform projects do not fit the remit given by its donors, which is to provide support in relatively short interventions that have a demonstrable impact on financial sector growth and diversification (even though the fiscal impact may be significant).

FIRST continues to be ready to support the strengthening of regulation and supervisory capacity for funded and private pension schemes as well as strategy for widening the private funded pension sector and collective investment schemes. Both these areas offer potential savings products for small savers and contribute to development of the financial sector: widening the product base for insurance companies (often managing pension funds), for investment managers, and potentially bringing investment demand and greater liquidity to local capital markets. Hide...

Selected Project Profiles and Reports

FIRST disseminates project outputs that are potentially of value to other countries that are undertaking reforms in the pensions and CIS sector. FIRST does not consider that all of the material developed is appropriate for dissemination, because in many cases it is too specific to the particular country. The project examples and outputs shared in this section are chosen because they may apply to other countries' reform context in collective investment schemes and pensions.