VaR limits for pension funds: an evaluation

Abstract

A risk-based approach for supervision and regulation of the financial sector is gaining ground in both emerging and industrialized countries. As part of this approach, regulators need to measure, monitor, and mitigate market risk. Value at Risk (VaR) is one measure being explored for this purpose. One of the most important sectors in which this practice has been adopted is the pension fund industry.§ § For example, Mexico has adopted a regulation that combines quantitative limits and a VaR limit for the case of pension funds. Other countries with a defined contribution system are considering adopting a similar framework. View all notes As the recent financial crisis has shown, risks are generally difficult to measure and mitigate. This becomes crucial in the case of pensions, where people rely on their savings to finance their old age.

As longevity increases, defined benefit pension systems may no longer be sustainable, and defined contribution systems are more likely to be considered. In defined benefit schemes, retirement income is a function of labor income during the last years before retirement, and the investment and longevity risks are taken by the sponsor of the plan (namely, the company or government). In defined contribution schemes, the retiree's pension depends on the amount accumulated during the working life, so the investment and longevity risks are taken by the individual.

Measuring risk adequately is important for individuals, because their portfolio decisions have an impact on their future pensions. This is particularly important for countries that have adopted a mandatory defined contribution pension system, as is the case in most of Latin America and Eastern Europe.¶ ¶ In Latin America: Bolivia, Chile, Colombia, Costa Rica, Dominican Republic, El Salvador, Mexico, Peru, and Uruguay. In Eastern Europe: Bulgaria, Croatia, Estonia, Hungary, Kosovo, Latvia, Lithuania, Macedonia, Poland, Russia, Slovak Republic, and Sweden. View all notes Most of these countries have adopted stringent quantitative restrictions which, in practice, imply a very narrow set of instruments in which pensions funds can invest. However, there is increasing interest in adopting risk measures to complement or substitute the quantitative restrictions.

This paper discusses some of the effects of imposing VaR limits and quantitative restrictions on portfolio choices. The paper relates results on conventional portfolio optimization and VaR portfolio optimization with the imposition of regulatory constraints (such as volatility constraints, VaR limits, or quantitative constraints). It also provides guidelines with respect to the conditions under which VaR limits are preferable to quantitative limits. Finally, it also discusses some empirical issues that regulators should consider prior to imposing VaR limits or adopting a risk-based supervision framework for the case of defined contribution pension systems.

The paper is organized as follows. Section 2 describes the main rationale for imposing regulations based on VaR limits or quantitative restrictions for pension funds in defined contribution systems. Section 3 presents some equivalences between VaR limits and conventional risk measures and the conditions required to meet them. Section 4 uses the equivalences of the previous section to analyse the effects of imposing VaR limits and discusses specific aspects that should be considered prior to imposing a VaR-based supervision. Finally, section 5 presents some concluding remarks.