Provision of Voluntary Private Pension Schemes in Ukraine: Review & Recommendations

1. Provision of Voluntary Private Pension Schemes in Ukraine:Review & Recommendations February – March 2008

2. Content • Background • Market Structure • Risk Management • Non-transparent Competition • Governance and Transparency of NSPFs • Asset Valuation and Calculation of Pension Unit Value • Consumer Protection • Regulatory Practice and Policy

3. infancy stage – low volumes raise the issue of long-term sustainability and risk related with fast entry and possible consolidation: • - expected rapid growth of assets (370% 12/05 – 09/07) • - low minimum capital requirement (200K+300K €) • - potential in related activities (2nd pillar reform?) • supervision devided between two regulators • funds – incorporated entities founded not for profit (for founders) Low volumes – high fees pushes for growth and aggresive promotion of schemes (good) and creates risk apetite (not necessarily good)

4. Channel 1 Non-transparent Competition Growth? - Kyivmiskbud Experiment - Special scheme for government empl. - Special scheme for NBU employees 2 Governance and Transparency Growth? - Role of founders and affiliated entities - Information disemmination 3 Asset Valuation Growth? - Accounting and audit - Prices used for valuation - Responsibilities of custodians 4 Pension Unit Value Calculation Growth? 5 Optimum portfolio of NSPFs Growth? 6 Consumer protection Growth? List of Problems / Areas for Improvement

5. Market Structure One asset manager manages funds with 100,000 members and average assets per member of around 90 UAH. Age of a fund explains only a smaller fraction of differences in terms of size (assets) – sales strategy matters!

6. Recommendation no. 1 • Become interested in large funds in terms of number of members but small in terms of assets • OK if growth comes • Contributions not strictly regulated • What are potential risks? – think about spill-over effects

7. Risk Management Recommendation no. 2 • Eliminate potential conflict of interest on the side of founders - direct investment - investment via affiliated entities Recommendation no. 21 • Increase regulatory powers, resources and coordination to track ultimate controllers and eliminate conflicts of interest

8. Risk Management Recommendation no. 20: more frequent and more flexible monitoring of limits on the basis of monthly averages – focus on substantial systematic breaches of limits

9. Risk Management Recommendation no. 3 • Lack of government securities increases risk (corporate bonds) – develop government bonds market • Illiquid securities markets increase risk, too – develop securities’ market • Delivery vs payment criteria

10. Risk Management Recommendation no. 4 • Well-defined legal limits • Absence of investment abroad (that may improve risk-return portfolio characteristics) • Disregard balance of payments considerations, allow foreign investment in liquied safe instruments

11. Risk Management Recommendation no. 5 • Other assets (up to 5%) – fuzzy definitions • More precision required from regulation Recommendation no. 6 • Gradually allow derivatives for hedging purposes Recommendation no. 7 & 8 • Limit NSPF’s share in equity or an issue • Gradually shift to “prudent man rule” (long-run)

12. Bank Arkada – Kyivmiskbud experiment Board composed of high government officials Asset Management and Arkada Bank administration by Arkada Bank Pension fund regulated by a special law Housing loans Cash 100% pct of UAH 180 Loan contract mln assets invested in assignment Arcada Fund 31,000 mortgage certificates members of Special purpose backed by 8,500 which 1,400 entity Arkada Fund housing loans begun to contracts receive pension payments out of which less Mortgage backed than 10% claim certificates : 50% of lifetime UAH 360 mln Arcada related annuities outstanding bought Insurance by the Pension insurance company against default Fund ), 50% by other investors ( credit enhancement ) This is a securitization scheme without actual transfer of There are 4 issues of certificates in Fund ’ s portfolio . 3 of risk . Arkada Bank is originator of housing loans insured by them have been private placements fully subscribed by mortgages . When the bank runs out of cash it sells the the Fund and 1 has been a public placement . Certificates loan contract to Arkada Fund which issues mortgage are issued with fixed coupon rates below parity and certificates and passess cash payments to the bank . revalued every three months according to prices of Payments of certificates are insured by the cash flow of benchmark bonds which are rising . So the total return is interest and principal at the basis of portfolio of assigned higher than the coupon rate in order to achieve housing loans . Arkada Bank continues to act as a servicer guaranteed return which is equal to inflation rate + 200 in this transaction . If the final obligor defaults Arkada Bank bps . Allegedly average return is 500 basis points above buys back bad loans ( “ clean up ” ) and tries to collect late inflation . payments effectivelly . Non-transparent Competition

13. Resolution for the Experiment Recommendation no. 9 • Equalize tax treatment • Define transition time period to comply with the Law on Non-Sate Pension Provisions • Change the Governance Structure (to eliminate false impression of public guarantee) • Provide legal solutions for abolition of guaranteed return • Facilitate orderly transformation

14. Non-transparent Competition Recommendation no. 10 • Public sector entities should refrain from designing new schemes under special legislation and/or under legal exemptions

15. Governance and Transparency Recommendation no. 11 • Clarify differentiation between banks’, insurance and pension products Recommendation no. 12 • Ensure the (independent and accountable) Board represents members’ interests • Investigate if SCRFSM has adequate resources and legal powers to act in case of conflict of interest discovered • Promote market discipline (information disemmination, prospectuses)

16. Asset Valuation and Unit Calculation – Most Urgent! Vicious Circle: • Lack of common accounting practices • Uneven practice of profits distribution to members’ accounts • Long time intervals for calculations of unit values • Lack of reliable prices for securities’ valuations • Role of custodians in valuations is not strong enough

17. Asset Valuation and Unit Calculation Recommendation no. 13 • Implement common accounting principles in all asset classes – IFRS + education + industry association efforts Recommendation no. 14 • Technical solutions for valuations in illiquid markets (not closing but weighted average prices etc.) • Common valuation guidelines based on public-private dialogue

18. Asset Valuation and Unit Calculation Recommendation no. 15 • Daily calculation of unit values (daily distribution of profits and losses to unitholders’ accounts) Recommendations no. 16&17 • Is it necessary to increase bankruptcy remoteness of assets with custodians? • Declare custodians legaly responsible for valuations

19. Consumer Protection Recommendation no. 18 • Cross-selling and forced-selling • Cooperation with labor and consumer protection authorities

20. Policy Recommendation no. 19 • Despite small value of assets, 3rd pillar pensions deserve full policy attention • Provide strong political support (and require responsibility) to (from) regulators • Make implementing recommendations a part of the capital markets development plan