Pension funds are one of the most regulated financial investment vehicles in the world. Pension funds all over the world are subject to various types of restrictions. These restrictions affect every part of the pension funds operations. The governance mechanisms have to rigorously be followed while funds are being taken in, invested, accounted for, and disbursed.
However, it also needs to be understood that pension funds all over the funds are not subject to the same type of regulation. The rules that govern the regulation of pension funds are quite different in almost every country. However, these rules emanate from two basic systems of pension governance.
These two systems are called the prudent person rule and the quantitative restrictions system In this article, we will have a closer look at these two systems of pension governance.
The Two Types of Pension Regulations
- The prudent person rule is the most widely followed system when it comes to the governance of pension funds worldwide. This is because this rule is followed in Anglo-Saxon countries such as the United States as well as nations of Western Europe. The pension funds of these regions control large sums of money which is what makes this system the most widely followed.
The prudent person principle is a set of rules which attempts to control the way in which decisions are made when it comes to pension fund investments. This means that the regulations do not require the trustees to have exceptional expertise or to follow a particular schedule. Rather the trustees are expected to behave in a manner that would enable them to preserve the capital which grows at a reasonable rate.
The prudent person rule does not levy any explicit restrictions on the type of investments that the fund managers choose. However, since they are legally required to be prudent, it is safe to assume that questionable investments such as penny stocks or cryptocurrency are not considered an option while making investment decisions. The prudent person principle provides a lot of freedom to trustees and fund managers while expecting them to be rational and ethical.
- The quantitative restriction method is very different as compared to the prudent person rule. The prudent person rule is based on trust whereas the quantitative restriction method imposes very tangible restrictions.
As a part of the quantitative restriction method, there is an explicit list of instruments that pension fund managers can choose from. There is a clear and tangible demarcation between the types of investments that are allowed and the ones that are not allowed. Also, there are rules governing the types of financial instruments which are allowed.
There is a maximum percentage of the funds in the portfolio that can be allocated towards asset classes. For instance, governments can mandate that not more than 40% of the funds assets can be held in equity assets. This means that the portfolio managers will be required to continuously rebalance their portfolios to ensure that they are complying with the law.
Factors Governing the Choice of Regulatory Principle
It has been observed that countries that have relatively well-developed economies and financial markets choose the prudent person rule as their regulatory principle. However, countries that are not as developed rely more on the quantitative restrictions system. This choice is governed by certain factors which have been listed below:
- Nature of Financial Markets: It has been observed that countries that have well-developed financial markets prefer the prudent person rule. This is because their markets are so well developed that any investments which are being sold to the people have been thoroughly vetted. Hence, the odds of professionally managed pension funds making questionable investments are very less. On the other hand, countries that do not have well-developed financial markets are at the risk of questionable investments being sold to a large number of pensioners. Some of these countries are also suffering from large-scale corruption. Hence, there is a possibility of collusion between fund managers and sellers of questionable investments.
- Involvement of The Government: In many parts of the world, pension funds are managed by the government whereas in other parts of the world pension funds are privately managed. Countries in which funds are privately managed prefer the prudent person rule. On the other hand, countries in which the government is involved in the management of pension funds follow the quantitative restriction system. This is because if private players are responsible for providing pensions, the government wants to give them a free hand.
- Nature of Pension Plan: The type of regulation also depends upon the type of pension plans which are common in that part of the world. For instance, if a large number of pension funds follow the defined benefit method, then the government is more likely to impose a quantitative restriction system. This is because the government indirectly becomes responsible for guaranteeing pension payments. On the other hand, if defined contribution plans are commonly followed, then the government is more likely to follow the prudent person rule.
Hence, it can be said that there are two main types of governance systems when it comes to the regulation of pension funds. The choice of the governance system depends upon a wide variety of factors. This choice has a significant implication on the performance of pension funds worldwide.