The Investment Governance Guidelines recently issued by the Australian Prudential Regulatory Authority (APRA) highlight the emphasis that is being placed on process with respect to investment management in DC schemes. The focus of the Guidelines is on the investment process, with return and risk objectives mentioned, but the Guidelines do not include a discussion of outcome objectives.

This focus on processes rather than outcomes can mean that regulators and supervisors actually introduce misaligned incentives into the management of pension funds and can actually increase rather than mitigate the key pension risk which is what should be the main focus and objective.

This is most clearly seen in the way investment risk is managed, where the focus has been on generating short-term returns rather than long-term pension incomes.

# **_Asset Class Restrictions_**

Pension investment regulation in most countries currently serves to reinforce this focus on the short-term generation of investment returns rather than the long-term generation of a pension income. Investment risk is generally controlled via limits on the amount of a portfolio which can be invested in certain (risky) assets.<sup>19</sup> The main issue with these asset class restrictions is that they focus on short-term volatility without considering the ultimate risk to pension fund members – i.e. will they receive an adequate retirement income.<sup>20</sup> Indeed, it often leads to an overly conservative investment approach - which is initially supported by the members of the pension plan due to financial literacy and behavior economic biases reinforcing the focus on the short-term and the avoidance of risk.<sup>21</sup> Consequently, though protecting against short-term portfolio losses, these investment approaches will not be sufficient to deliver an adequate retirement income over the long-term.

In most of the countries sampled during the study, investment limits were mandated in either the law or regulations that were beyond the control of the supervisory agency. The supervisors were concerned on two levels – did the PFMC have the systems and procedures in place to ensure that the limits were not breached (operational risk) and were the limits breached (compliance or legal risk). Where the approach to investment was more _laissezfaire,_ the concerns of the supervisors were different. The supervisors’ activities focused on: (1) did the PFMC disclose its investment strategy to members and potential members; and (2) did its actual strategy align with that which was disclosed;. Again, this approach resulted more in a measurement of operational and compliance (legal) risks than investment risk.

# **_VaR as a Regulatory Tool_**

Some supervisory authorities have tried alternative measures for controlling investment risk as asset class restrictions have been removed. Yet these also control short-term volatility rather than pension risk.

> 19 Details of investment restrictions around the world can be found in the regular OECD survey:

> - <u>http://www.oecd.org/daf/fin/private pensions/2011SurveyOfInvestmentRegulationsOfPensionFunds.pdf</u> 20 As described by Blake et al (2008) this is the equivalent of worrying about air turbulence on a flight without considering whether the plane is actually going to reach its destination.

> 21 See for example Benartzi and Thaler (2007).

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