Gert Verheij discusses new rules concerning structure and risk management at Portuguese pension companies

During the last few years, Portuguese regulators have increased their scrutiny on all aspects of pension fund risk management. While the Portuguese pension fund market is small in comparison with those in other European countries, there are the same concerns and questions.

Portuguese companies that sponsor pension funds are now much more concerned about the possibility of annual losses and the need to either avoid accounting losses or having to top up contributions to meet minimum solvency funding requirements. Also the advent of the revised international accounting standard IAS19 has made sponsors much more concerned about pension funding which has resulted, in most cases, in plans converting from defined benefit (DB) to defined contribution (DC). However, surprisingly, shifts to ‘safer’ asset allocations involving more bond-orientated, liability-driven strategies have not occurred to quite the same extent as in other countries with similar challenges.

International best practice in regulation and supervision of pension funds clearly identify the establishment of appropriate mechanisms for risk management and internal control as the key pillars of good governance systems, in particular for their contribution to a sound and prudent management system. It is now agreed that companies in the financial sector should have policies and means to identify, assess, mitigate, monitor and control the range of risks they are exposed to. In order to foster a culture orientated towards more effective risk management and to ensure the efficiency and effectiveness of these mechanisms, it is essential that the systems of risk management and internal control are supported by appropriate organisational structures and meet a set of minimum requirements. These are normally embodied in policies, procedures and controls to be developed, implemented and maintained by the responsible organisation’s management.

Following these trends, in June of this year Portuguese regulators introduced the requirement of pension fund management organisations to establish a set of rules and principles that must be met in the development of risk management systems and internal controls. The rules are divided into four key areas: organisational structure, risk management, internal controls and key functions.

The new regulations also require these rules to be formally addressed in all pension fund management organisations’ annual reports.

With respect to the four key areas, the following aspects should be highlighted:

Organisational structure The new rules stipulate that the organisational structure of the pension fund managing organisation should be proportionate to the size, nature and complexity of the risks inherent in their business and the pension funds it is managing. This structure should also reflect that it constitutes an appropriate capability for the implementation of risk management systems and internal control. The rules also set out the responsibilities of the members of the management committee and require information on the culture of the organisation, the standard of information systems and communication channels. Risk management The rules require the provision of a set of principles to be adopted when implementing a risk management system which, at a minimum, should include the investment and operational risks in relation to the pension funds under management. This should include the specific risks of the pension plan itself, market risks, credit risks, the risk of (over)concentration and liquidity risk. The regulations also set out the responsibilities of the management committee when managing these risks; stipulating they should not prejudice pension fund members in any way. Internal control The rules describe the principles of internal control systems as needing to cover the entire organisational structure and all activities of managing the pension funds. Also defined in them, are the responsibilities of the managementcommittee for the provision of mechanisms for monitoring and reviewing the internal control system. Key functions Given the need for these companies to have the requisite skills for the job and to be able to manage their activities well, certain functions are considered by regulators to be of key importance to good governance. As such they take into account the principle of adequacy in terms of scale, nature and complexity of the risks, including the role of risk management itself, the actuarial function, the function of compliance and the internal audit function.

The focus of these new regulations appears to address typical DB pension plan issues, however, with the number of DC plans now out-numbering DB plans (366 to 267 at the end of 2008 according to the latest annual report of the ISP) one would have expected more emphasis on ways of improving the management of DC plans too. On the other hand, because DC plans are relatively new they have only €320m invested in them, which is dwarfed by the almost €20bn currently invested in DB plans.

Investment among Portuguese pension funds still appears to be relatively simple, but these new regulations are likely to be a catalyst for new thinking on the subject. Defining an investment policy with reference to the liability profile is still only in its infancy, while questions about taking risk, creating value or, alternatively, focusing purely on risk minimisation are rarely heard. Monitoring still only focuses on assessing the investment managers relative to an asset-only benchmark or peer group. This indicates a significant lack of progress in investment thinking compared to the rest of Europe and presents its own risks.

While regulation has laudable motives, the unintended consequences can be added costs and a tick-box mentality, rather than an overall raising of standards. So instead of concentrating on supervisory regulation, we would argue that in the Portuguese environment the development of strong investment beliefs could make the biggest difference. This is because by developing sound investment beliefs, pension funds are able to address most of the fundamental issues they face. In addition, in the process of developing these beliefs, investment organisations will be well positioned to establish best governance practices, thereby raising industry standards generally. Furthermore, by establishing well-developed and well-documented investment beliefs - and the improved governance that follows - pension fund organisations are likely to secure a competitive advantage over other investors, which at the end of the day is at the heart of good investment.

Gert Verheij is an investment consultant at Watson Wyatt in Lisbon