Speech

Opening Remarks by Jaime Caruana, Counsellor and Director, Monetary and Capital Markets Department, IMF - At the Ageing, Pension Risk Management and Financial Stability Seminar

February 15, 2007

Welcome to the IMF! I am delighted to welcome such a distinguished group of experts here today to address issues related to ageing and pension risk management, which we see as increasingly important for global financial stability. I am also most grateful to De Nederlandsche Bank (DNB) for co-organizing this event with us, not least because of their leadership in the area of pension supervision, including their recent adoption of a risk-based regulatory framework for pensions in the Netherlands.

In a number of countries, there remains a need to better evaluate and manage risks related to ageing, which constitute what some observers describe as "long-term systemic risks," given the potential GDP impact. As such, improving how institutions and individuals manage a variety of ageing-related risks, such as longevity, health care costs inflation, real estate exposure, real (inflation adjusted) returns, and broader efforts to simply improve the level and quality of savings, are all important issues for policy makers. During the past several years, we have addressed many of these issues in the Global Financial Stability Report, and have repeatedly highlighted how the pension and insurance industries will play a key role in shaping new risk-sharing arrangements in this area. Let me briefly outline a few thoughts aimed at stimulating our discussion today.

Systemic importance. Traditionally, financial stability analysis and considerations have focused on banks. Increasingly, not least because of demographics and the financial implications of ageing, analysts, including the IMF, are focusing on the role of non-banks in financial markets. In this context, I will not repeat the well-documented facts related to the significant market presence of pension funds—indeed, together with their close cousins, life insurance companies, they are the largest asset gatherers and managers in almost all industrialized countries. I would only emphasize that the significance of their role, together with that of asset managers more generally, is only expected to grow in the future. As such, their risk management and investment strategies, and how policy makers influence these strategies through various policy levers, such as regulation, accounting, tax and related policies, have become increasingly important to financial stability analysis.

Evolving risk management and regulatory practices. Significant changes have been observed in the pension fund industry in recent years. For pension funds (and some insurance companies as well), many of these changes have been attributed to coinciding drops in interest rates and equity prices at the beginning of this decade. This market shock led to greater efforts by pension fund managers and their regulators to strengthen risk management and ALM practices. The market impact of these changes is still evolving. However, it clearly reflects a move toward more sophisticated risk and portfolio management practices, with a greater focus on ALM, in order to meet their projected obligations or liabilities. Going forward, as regulators seek to ensure the solvency of these institutions, a key objective should be to introduce incentives that are consistent with sustained improvements in risk management practices, and that limit the risk of unnecessary market volatility.

Challenges ahead. Let me briefly expand on this and a few other points from a financial stability perspective. I am sure many of you will have interesting and informed views to share in this regard. I would like to mention three sets of issues and questions that we may wish to consider during the day:

• First, the implications of risk transfer activity across the financial system need to be well understood. Pension funds play an increasingly important role, indeed a variety of roles, in risk transfer markets. Pensions are perhaps the most frequently cited institutions which are shifting risks to the household sector, often exemplified by the closure or freezing of defined benefit plans, and the establishment of defined contribution plans for new or existing employees. The transfer of risks to households may produce certain risk management and stability benefits, and may appear to address the needs of a more mobile workforce. However, we need to consider whether individuals are adequately equipped to manage more directly these complex risks, with sufficient financial knowledge, advice and market instruments available to them. Indeed, do we have the data or information available to properly understand the implications of such risk transfer activity, particularly as it relates to different age and income groups in our societies?

• Second, the potential for unintended consequences of regulatory changes. Regulatory changes affecting pension funds should be introduced carefully, and designed in a forward-looking manner. As noted, a key priority should be to promote incentives which are consistent with improved risk management practices, and which do not lead to unnecessary market volatility. For instance, there are clear benefits from increased use of mark-to-market accounting for pension funds. However, an excessive focus on single-point accounting measures may also unnecessarily influence pension fund behavior in the short-term. Therefore, may a way forward include a broader disclosure of pension assets and liabilities, including their maturity profile, or market and interest rate sensitivities? And, what of government accounting standards, and the fuller reporting of its liabilities?

• Finally, the management of long-term, ageing-related risks may require policymakers to seek new and creative policy solutions. Beyond the well-documented fiscal challenges, governments may wish to consider how financial markets can support efforts to manage these ageing-related risks. For instance, new financial instruments may be needed to support pension funds' and households' investment and risk management needs, but necessary data or incentives may be lacking. Do governments have a comparative advantage at gathering or disseminating such data, and how best may they influence market developments? In certain cases, governments may decide to assume certain risks, and act as an "insurer of last resort", perhaps temporarily. This has been suggested by some observers, and in a variety of areas this is not a new role for governments. However, this is a complicated question, and is likely to be approached differently across countries. More broadly, authorities may promote more risk-based regulatory frameworks, as exemplified by the new pension regime in the Netherlands. This may in turn encourage a variety of market-based solutions to emerge, including risk transfer activity, such as the development of the buyout market in the U.K. Other efforts to encourage market innovations and to attract further capital to these complex risks may be considered, and may contribute to public policy efforts to manage the risks and costs related to ageing.

I will stop here with my introductory remarks and questions for consideration. As mentioned, I believe that these issues will continue to be of critical importance to policy developments in the years to come. Let me thank you again for joining us today. I hope that we can together shed additional light on some of these challenges, building on experiences from private sector practitioners, significant academic work, and the multi-faceted challenges facing policy makers. At the end of the day, we will take stock of our discussions and try to identify certain important themes regarding the key issues facing the pension industry and financial markets, as well as related policy considerations, with an aim to strengthen economic and financial stability for the long term. Thank you.