Study “Private Pension Funds: Balancing Sound Operational Principles”

In 1999 the Lithuanian Free Market Institute conducted a Freedom House-sponsored project “Private Pension Funds: Balancing Sound Operational Principles and Prudent Supervision”.

The goal of the project was to promote sound and effective supervision of pension funds by developing a conceptual framework that would create a proper balance between self-regulatory market mechanisms and state control in pension fund supervision.

The work on the project was based on a comprehensive approach in which supervision was understood as a complex of factors that determine a smooth operation of pension funds. These include, first and foremost, a favourable environment for self-regulatory market mechanisms, activities of professional organisations, existing business standards, codes of ethics, and state control.

The first step was to compile a comprehensive list of risks involved in PF activity and to define measures that can be used to handle these risks. An evaluation was made to define which risks, and management thereof, could be left to the discretion of pension funds and which should be delegated to professional organizations and supervisory authorities.

The results of the analysis, coupled with an evaluation of the functioning pension fund legislation and foreign experience, provided a solid basis for formulating a conceptual framework for prudent supervision of pension funds.

The conceptual framework elaborates the notion and goals of pension fund supervision and explores its main areas from the perspective of how to balance self-regulation with other forms of supervision. The conception can serve as a guide for building a supervisory system for different types of pension funds.

The conceptual provisions were used to formulate recommendations for PF supervision in Lithuania. A package of policy proposals were submitted to the Securities Commission, the Ministry of Social Welfare and Labour, the Ministry of Finances, the Board for Insurance Affairs, parliamentary committees, and the State Social Insurance Board.

Partners to this project were the Centre for the Study of Democracy (Bulgaria), the CASE Foundation (Poland), and the Jaan Tonisson Institute (Estonia).

The following presents the list of PF risks and risk management instruments and the conceptual framework for prudent supervision of pension funds developed as a result of the project.


Pension fund supervision is necessary for two reasons: to ensure effective competition within the pension fund industry, and to promote public confidence in the industry by protecting the interests of pension fund participants. When considering various approaches to pension fund supervision, it is critical to keep in mind that state regulation should only be applied in those areas where conditions for market self-regulation are non-existent. Therefore, it is necessary to define the relationship between self-regulation and state control in all aspects of the pension fund industry.

A licensing system currently exists to ensure that pension funds are compliant with established requirements and to prevent a loss of pension assets. However, licensing is not necessary as compliance can be verified during the process of registration, and the safety of pension assets can be secured by legally segregating pension assets from the assets of the pension fund itself.

In order to safeguard participant’s interests, the supervisory authority may oversee the establishment of general principles regarding mergers, acquisitions, liquidations, or bankruptcies. In the case of the latter, if pension fund assets are properly separated from the fund’s assets, they will be free from creditor’s claims.

Under the current licensing system, supervisory institutions require a business plan and information on executives’ qualifications; however, neither can ensure proper operation of the pension fund. Increased self-regulation would better insure proper operation because pension fund members would have the freedom to transfer assets between funds based upon the fund’s reputation. Mismanagement would result in lost customers.

Investment restrictions should be kept to an absolute minimum. If conditions are proper, investments should be governed by the prudent man rule, though investment supervision may resort to placing restrictions and limiting the scope of investments if market relationships and financial institutions are underdeveloped. There should be no restrictions to investment abroad, as this would reduce portfolio diversification and thus the safety of investments.

General principles and methods of asset valuation are useful in comparative analysis of pension funds. Asset valuation poses no problems regarding the appraisal of value of liquid assets; however, illiquid assets may be valued using methods the pension funds develop themselves. Detailed regulation is unnecessary, though funds should report to the supervisory institutions what method of valuation was used.

Creating a competitive environment for pension funds is critical. Therefore, marketing and administrative costs should be regulated by market forces rather than by the supervisory authority.

The supervisory authority need not establish uniform accounting procedures. Pension funds should be allowed to define their internal accounting procedures themselves, though any changes to these procedures should be recorded and explanations should be given, along with financial accountability, to the supervisory institution.

Protecting the interests of pension fund members is one of the most important objectives of pension fund supervision. For this reason, the law should dictate requirements concerning the contents of participation rules. Any changes to these rules should be approved by the supervisory institution and members should be notified. However, members should have the right to withdraw from the fund if they find any changes to participation rules to be unacceptable. Further, the law should define principles by which assets continue to be accumulated, and the future pension calculated, if a participant changes pension funds.

In order to ensure that pension fund members’ assets are protected, the law should prohibit pension funds from using pension assets for mortgaging or guaranteeing without members’ consent. Further, pension assets should be kept in an independent depository, whose responsibility should be to ensure that transactions are concluded in accordance with statutory requirements.

Mandatory guarantees should not be used, as they do not meet the purpose of protecting member interests. They are intended to protect members, but in most cases are financed by the members themselves. By imposing guarantees on minimum investment return, fund managers are restricted in the types of investments they make. Therefore, riskier investments, which potentially could generate higher rates of return, are discouraged or prohibited by the supervisory institutions as any shortfalls must be covered by the fund itself. By eliminating guarantees, fund managers have more freedom in controlling members’ investments.

Information disclosure is one of the key factors of market self-regulation. Availability of information facilitates individual choice by allowing market participants to make well-considered decisions. Standardized information disclosure procedures make it much easier to present and understand information. The state supervisory authority should define what information should be disclosed; however, pension funds or professional associations may establish the specific standards. Annual statements should be made available to fund members, as should annual reports on the management and financial status of the pension fund. In short, the more information that is made available, the smaller the need for state regulation.

In establishing a supervisory institution, there are several factors that must be considered. The role of the supervisory institution will be further modified depending on changes made in the financial market as a whole. The institution’s level of independence, scope of authority, management, and its position amongst other supervisory institutions of the financial market must all be taken into consideration.

If consolidation of the financial market as a whole takes place, pension funds should be included in this system. This consolidation will impact the supervisory institutions, and the responsibility for supervising pension funds may be performed by a specialized institution or by an existing agency.

The budget of the supervisory institution may be formed either through allocations from the state budget or a special fee charged on market participants. The latter would ensure a greater level of independence.

In defining the powers of the supervisory authority, it is important to decide in what cases it will have the power to impose sanctions on market participants and when this will be done by court.

State supervision of pension funds should be:

  • Market oriented. That which can be regulated by market forces should not be regulated by the state. The state should only ensure equal opportunities for competition, obtaining information, etc.
  • Independent. Supervision should be free from political interference and transparent in its decision-making.
  • Accountability driven. Pension fund executives should be held accountable for prudent management of pension funds. Likewise, the supervisory institution itself should be held accountable for its activity to the pension fund industry and society at large.
  • Efficient and effective. Suitable power should be granted to the supervisory authority so it can monitor the industry. Further, it should have adequate resources and qualified staff and should use them in the most effective way possible.
  • Discretionary. A proper balance should be found between clearly defined supervision rules and opportunities to make discretionary decisions in the application and enforcement of these rules.
  • Open and consultative. There should be constant communication between the supervisory institution, market participants, professional associations, and consumer groups in order to obtain information about the market and community views on policy proposals and administrative measures. This will give room for entrusting more supervisory functions to self-regulation.