Pension schemes: need for regulatory board

This the second and concluding part on occupational pension schemes. The first part was published on December 14.

IN THE Indian context, a comprehensive retirement benefit package includes provident fund, gratuity and superannuation (pension) benefits. While provident fund schemes are predominantly of the defined contribution type, gratuity schemes are of the defined benefit type. Most private corporate superannuation schemes are of the defined contribution type.

The point is that both defined benefit and defined contribution schemes tend to co-exist; and hence the legislative framework governing occupational pension schemes must address the regulatory concerns/ issues associated with both types.

Defined benefit schemes

Some of the important regulatory concerns in the context of defined benefit (DB) schemes are: providing security of accrued benefits; framing an appropriate investment policy and portability of accrued pension benefits.

Providing security of accrued benefits: The dominant concern in the context of defined benefit schemes is the security of accrued pension benefits of the members. The minimum level of security of benefits can be provided by setting up the pension scheme under a trust, which ensures that the scheme's assets are separate from those of the employer. However this is by no means a guarantee that the assets of the scheme accumulated through employer (and employees') contributions are adequate to meet the accrued pension rights.

The security of the accrued pension benefits can be endangered if the employer stops sponsoring benefit accrual; and/or the employer goes out of business. Under such circumstances if the existing assets of the scheme are not adequate to meet the defined accrued pension benefits of the scheme, then the shortfall is unlikely to be bridged by the sponsoring employer; and the members stand to lose. So it is important to ensure that the scheme is solvent through periodical actuarial reviews. The typical regulatory requirements must therefore aim at ensuring solvency; and protecting the interests of the members. These regulatory requirements can include:

Periodic actuarial reviews to assess whether the scheme is solvent on the assumption that both the scheme and the sponsoring employer are ongoing entities; and disseminate the actuarial opinion on solvency through the scheme's annual reports.

Periodic actuarial reviews to assess the financial capacity of the scheme to meet the accrued pension benefits in the event of the scheme being wound up on the review date. If the scheme's assets are inadequate to meet the liabilities, then there must be a stipulation to pay in the contributions that are required to bridge the shortfall over a specific timeframe (this requirement is referred to as the Minimum Funding Requirement in the U.K.).

Contractual commitment on the part of the employer to meet any deficiency in the scheme (shortfall of assets relative to the liabilities of the scheme) in the event of the scheme being wound up.

Framing an appropriate investment policy: As on date the approved superannuation funds in the Indian context need to adhere to the investment pattern mandated by Rule 67 of Income-tax Rules. But then quantitative restrictions on asset choice have their own limitations. While these investment restrictions are concerned solely with the risk characteristics of the investments themselves, they do not capture the risks associated with mismatching of assets and liabilities, including embedded liabilities due to contractual guarantees. Hence assessment of the risk of mismatching needs to be considered by the regulatory authority while formulating regulations on investment policy.

In countries such as the U.K. and the U.S. there has been a shift from detailed quantitative restrictions on asset choice toward more general ``prudent-man'' rules. In the Indian context, there is likely to be a progressive liberalisation of the investment pattern which will eventually require the trustees of occupational pension schemes to formulate investment strategies which are consistent with the nature, term and cash flow profile of the liabilities of the scheme.

Under such circumstances there is a need to ensure that the prudent-man rules are met. In the U.K., this is achieved by requiring the trustees to prepare a ``Statement of Investment Principles'' (SIP) and adhere to this statement. Among other things, SIP must cover the rationale underlying the investment policy adopted by the scheme, the risk and expected return of the investment policy and the minimum and the maximum percentages of funds to be held in different asset classes.

There is still a case for some forms of quantitative restrictions on asset choice as an additional safeguard to prudent-man rules, for example: limits on self-investment being an obvious example. In the Indian context, there is also a case for stipulating minimum percentage of investment in securities issued by government and quasi-governmental bodies to meet the funding requirements of the core sectors of the economy.

Portability of accrued pension benefits: From an employee's point of view a key issue concerning defined benefit schemes has been portability of accrued pension rights from one scheme to another. There is need for regulatory intervention to ensure that individuals are able to transfer their entitlements from one pension scheme to another as they change employment without undue penalties being attached to the transfer. One possible regulatory response to this would be to ensure that the employees legally own the pension assets within the scheme that are attributable to them and that there is adequate portability of pension assets within the system.

Defined contribution schemes

There are regulatory concerns that are common to both DB and defined contribution (DC) schemes. However, the unique regulatory concern in the context of a DC scheme is in terms of providing investment advice to secure a reasonable level of retirement income.

Investment advice: As stated earlier, the investment risks in a DC scheme is borne by the employee, which means that the retirement income of the employee is at risk. It is difficult for the ``man in the street'' to judge the level of contributions required to secure an adequate retirement income. Anecdotal evidence to date suggests that participants in DC arrangements have little understanding of the cost of delivering adequate pensions or of the implications of different investment choices on the likely level of benefits in real terms.

Hence, the role of regulation in this regard will be to ensure that the employee understands the retirement benefits properly through appropriate professional advice. Much of this advice is financial and actuarial in nature and the actuary is well placed to give it. It needs to be made mandatory for DC schemes to obtain professional advice with regard to scheme design by demonstrating how different designs can meet different objectives through suitable investment vehicles.

For example, there may be a need for investments to be automatically switched from an equity basis to a gilt basis as members approach retirement and continued ability of the scheme to meet its original objectives. If the scheme is aiming to provide broad levels of (target) benefits, these can be reviewed in the light of the changing economic circumstances and changing scheme demographics.

Since there can be a range of investment options made available under DC arrangement, it is also important to ensure that the investment charges (investment management expenses) are reasonable in relation to the investment vehicle. For example, an equity-based investment vehicle where added value is being sought through active management can have higher charges than an index tracking investment vehicle. There is a need for regulatory intervention to monitor and regulate investment charges.

Consumer education

A core issue in the context of retirement provision in general is the issue of consumer education on pension matters. Regulatory intervention is required to bring about a radical improvement in the quality and accessibility of information on pensions - both in general and in the information employees are given about their pension provision.

For example, there can be a mandatory requirement on DB schemes that such schemes should provide their members with an annual statement on how much pension has been accrued to date; and forecast how much members can expect to accrue by the time they reach pension age, if they continue in the same job.

There can be a corresponding requirement on all DC schemes that such schemes should provide their members with annual statements that disclose the projected value of the individual's fund at retirement age and the amount of pension it can buy at today's annuity rates and clarify that the financial and demographic assumption used in the projections can inevitably change over time.

Pension Regulatory Board

With a growing number of occupational pension schemes, there arises a need for a dedicated regulatory board to monitor the working of the occupational pension schemes. This board needs to be vested with adequate powers to conduct investigations and impose penalties for non-compliance with legislation. This board can be modelled along the lines of the occupational pensions regulatory authority in the U.K.

To enhance the effectiveness of the board in supervising occupational pension schemes, it can be made mandatory on the scheme auditor and actuary to ``blow the whistle'' by immediately sending a written report to the board where they have reasonable cause to believe that there has been a breach of legislative requirements which is likely to be of material significance in the context of the board's supervisory role.

To investigate disputes and complaints concerning occupational pension schemes and redress the grievances expeditiously, the board can operate through a Pensions Ombudsman (appointed by the board) who will have the necessary statutory authority for resolution of disputes and complaints.

With growing awareness about the importance of pension benefits there is a need for a comprehensive dedicated legislation governing occupational pension schemes such as the Pensions Act 1995 in the U.K. and the Employees' Retirement Income Security Act, 1974 in the U.S. There is a need to distinguish between DB and DC schemes because the regulatory concerns associated with the two types are different.

The important regulatory concerns associated with DB schemes include: ensuring security of accrued benefits; framing an appropriate investment policy; portability of accrued pension benefits.

While DC schemes share the regulatory concerns of the DB schemes, the most important concern is about providing appropriate investment advice that will ensure a reasonable level of retirement income.

Regulatory intervention is required in the area of consumer education on pensions matters. There is an immediate need to bring about a radical improvement in the quality and accessibility of information on pensions - both in general and in the information employees are given about their pension provision.

To enhance the effectiveness of the board in supervising occupational pension schemes, the scheme auditor and actuary can be made accountable to the board. The board can operate through the mechanism of Pension Ombudsman for expeditious resolution of disputes and complaints concerning the occupational schemes.

K. Sriram

Visiting Faculty - Finance, Indian Institute of Management (B)

(Concluded): (The First Part was published on Dec.14)

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