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# **Minimum Return Guarantee**

79. The regulatory framework includes a minimum return guarantee that differs from the well known relative return guarantee adopted in Chile and the absolute return guarantee adopted in Switzerland. In Chile and most other countries that adopted the Chilean system, the minimum return guarantee is relative – defined in relation to a band around the average rate of return of all pension funds over a rolling 36 month period. If the rate of return is lower than the lower band, the asset manager needs to make up for the difference from its own minimum reserves. If the return is higher than the upper band, the difference is placed in a profitability reserve in the pension fund. The extreme herding by pension funds in Chile has led to very similar returns, implying that profitability reserves have not been built, nor asset managers have had to use their own minimum reserves to increase returns to the minimum.

80. The absolute guarantee in Switzerland (3 percent p.a.) is backed by an industrywide guarantee fund. This construction, similar to pension benefit guarantee schemes in defined benefit systems, and bank deposit insurance schemes prevalent in many countries, raises moral hazard issues that have not yet been satisfactorily addressed in Switzerland.

81. In Hungary, the benchmark is not the industry’s average return, nor an absolute return, but a rate of return target that is determined primarily by a basket of long-term Government securities. If the rate of return exceeds the upper band the excess would need to be placed in the liquidity reserve. If the rate of return is lower than the lower band it should be increased to the minimum with transfers from the liquidity reserve. The liquidity reserve cannot be larger than 4 percent of total assets. Therefore, the rate of return guarantee in Hungary seems an internal smoothing device, designed to avoid extreme fluctuations relative to the benchmark.

82. The minimum return guarantee in Hungary does not seem to have affected investment policies in practice, possibly because there are questions of whether it can be legally enforced, and because the supervisor has set wide bands that make the guarantee effectively innocuous. This pragmatic approach by the supervisor has been appropriate, because this type of guarantee could lead asset managers to adopt defensive strategies and avoid entirely assets with higher risk-return characteristics, and could also lead to extreme herding behavior among pension funds, even when the asset manager does not have the formal obligation to back the minimum return with its own resources.<sup>23</sup>

# **Accounting Standards and Valuation Rules**

83. Pension fund portfolios have been marked to market daily by the custodian, based on settlement prices during the trading day. The prices of listed and traded assets are provided by the Budapest Stock Exchange (BSE) and the Debt Management Agency (AKK). Apparently, the prices of assets traded in the over-the-counter (OTC) market are also reported. Assets which have not been traded for more than 30 days are valued by the lowest between the purchase price and the latest traded price. Real estate is valued once a year. It is not clear how other non-listed securities are valued, but exposure to these assets is very small. Capital gains and losses are split between realized and unrealized, but both

> 23 Herding has also been observed in the UK, where pension funds do not need to meet formal minimum returns (Blake _et al_ .  2002), but is probably intensified in the presence of formal guarantees.