35 offers the promise of reduced risk of insolvency of DB funds and potential efficiency gains in DC systems that impose investment restrictions. They potentially provide a common framework to assess the relative risks of DC funds that function in a “prudent person” investment regime. However, as in all such matters, there is likely to be no free lunch. Risk-based supervision systems may lead to more conservative portfolios in DB funds and constrain DC funds to a presumed average risk tolerance, depending on how they are designed. The ability to use derivatives may to some extent mitigate these outcomes but this is not applicable to all countries. Risk-based methods will enable supervisors to better allocate their scarce resources, although they will also impose new technical requirements and a higher level of sophistication from all parties. The further development of these systems will be closely monitored and undoubtedly will provide many more useful lessons as others consider how to proceed down this path.

# **Notes**

1 Bernstein and Chumacero (2007), Hinz and Van Dam (2006), Andersen and Van Dam (2006), Thompson (2006).

2 Andersen and Van Dam (2006), Bernstein and Chumacero (2007), Hinz and Van Dam (2006), and Thompson (2006). See also Black (2004) for a comparative analysis of risk-based supervision of banks. 3 The total number of individual accounts amounts to 84 percent of the labor force, but a large share of pension fund members move in and out of informality and do not contribute on a regular basis. This phenomenon is common in Latin America and other emerging countries (Rofman and Luchetti (2006)). 4 It is interesting to note, in this regard, that Australian regulators have recently implemented a comprehensive re-licensing program based on much stricter licensing criteria that has reduced significantly the number of funds.

5 Dutch funds can opt for an unconditional or a conditional benefit indexation rule. The latter rule introduces an element of risk-sharing, but the Dutch system remains a traditional defined benefit system. 6 It is possible that the introduction of the VaR ceiling was also motivated by the existence of Government guarantees, especially the guarantee that workers with accrued rights in the former PAYG system will not receive a pension lower than the one they would have received (Bernstein and Chumacero (2007)). 7 Mexican supervisors also make use of early warning indicators to guide supervisory actions, but this motivating factor was clearly more important in the other countries, where a much larger number of funds are allowed to operate.

8 Standard and Poors and Moody’s have developed their own methodologies for rating the quality of the internal risk management of insurance companies and take the results into consideration in the elaboration of the final ratings. See, for example, Ingram (2006).

9 The implementation of Basel II will impose similar challenges for bank supervisors.

10 Jorion (2003) provides a review of the debate on mean reversion and empirical tests. See also Bodie (1995), Campbell and Viceira (2002 and 2004), and Campbell, Chan, and Viceira (2003).

11 Jorion (2003) provides a review of the debate on mean reversion. See also Campbell and Viceira (2002 and 2004), and Campbel, Chan, and Viceira (2004).

12 The response of pension institutions to the financial turmoil and the growing use of derivatives are analyzed in some detail in Ladekarl et al (2006).

13 Boeri et al (2006).

14 APRA Annual Report 2006 15 Bernstein and Chumacero (2006).

16 Barberis (2000), Campbell, Chan and Viceira (2002), Campbell and Viceira (2002 and 2004) discuss optimal portfolio strategies with short and long time horizons. Dowd and Blake (2006) present a critical view of VaRs as a risk indicator.

17 At the same time, the disclosure of score results should not lead pension funds to hold very conservative portfolios.