# **I. Introduction**

The main goal of any pension system is to ensure that members receive an adequate pension income when they retire. While traditional defined benefit (DB) pension plans set out what that pension income will be in advance and then strive to deliver it, the growing number of defined contribution (DC) plans accumulates a sum of assets which can then be turned into a pension income on retirement. However, the amount of this retirement income is not set in advance. In the absence of a proper regulatory framework, this feature of DC plans leads to a focus by not only pension providers, but also regulators and pension plan members themselves on the short-term accumulation of pension assets rather than the longer-term goal of securing an adequate retirement income.

Risk-based supervision (RBS) for pension funds is currently defined as an approach by which the supervisory authority directs its scarce resources towards the main risks posed to pension fund members - as opposed to rules or compliance-based supervision which involves rigorously checking compliance with a set of rules, irrespective of their relative importance to meeting the contributor’s objective.

This paper first looks at how the RBS approach was adopted from the banking and insurance sectors, but has had to be adapted for DC pension funds. The capital requirements which are at the core of RBS in the banking and insurance sectors are not appropriate for, and indeed can introduce misaligned incentives into DC pension systems.<sup>2</sup> In the absence of a capital adequacy tool in defined contribution systems, RBS faces limitations in helping to ensure adequate pensions for individuals.

The paper goes on to argue that, as a consequence, RBS for pensions has been defined as a much less specific way compared with banks and insurers- as a process for the allocation of supervisory resources towards the greatest potential risk. However, based on the examination of World Bank case studies from a number of countries,<sup>3</sup> this paper argues that pension supervisors have not properly defined the objectives of DC pension systems. Ultimately they should be concerned with delivering adequate pensions, and therefore on the risk of individuals receiving pensions different than a target– which is termed ‘pension risk’.

The paper discusses how, by focusing on processes rather than outcomes, operational rather than investment risk and the short-term accumulation of assets rather than the long-term delivery of an adequate retirement income, RBS has failed to fix many of the problems associated with DC pension systems, and indeed may even be contributing to them. A solution for realigning interests, and anchoring RBS to the outcome objectives and minimizing pension risk through the use of benchmarks is proposed. In this context, it is essential to reconnect the role of supervision with the replacement rate objectives of the pension system. The paper explores how the institutional design of the pension fund management industry and the use of market surveillance (basic package of regulation) are efficient in mitigating operational risks in most of the emerging economies with funded pension schemes.

Finally, the paper also acknowledges that RBS does not come without costs, and discusses, in the absence of a proper, outcome focused pension objective, whether the benefits of

> 2 The focus of the discussion on DC pension schemes is related to the accumulation phase. In the payout phase, many of these systems offer annuities, which have explicit liabilities, and consequently the most traditional concepts of RBS are applicable.

> 3 The analysis in this paper in built on the analysis of case studies in Chile, Colombia, Peru, Mexico, Kazakhstan, Hungary, Lithuania, Poland, Romania and the Russian Federation.

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