Pension schemes face increased solvency stakes
In October the European Insurance and Occupational Pensions Authority (EIOPA) published the consultation ‘Response to Call for Advice on the review of Directive 2003/41/EC: second consultation’. The consultation covered EIOPA’s draft advice to the European Commission on the review of the Institutions for Occupational Retirement Provision (IORP – Directive 2003/41/EC). The Directive applies to occupational pension schemes, which unlike insurance-based pension schemes do so on a not-for-profit basis.
EIOPA will give their final advice to the Commission in mid-February on the reform of the IORP Directive, with a view to publishing a draft Directive later in the year. While this may sound very technical, the outcome of the consultation could be pivotal – and extremely adverse –for UK defined benefit (DB) pension schemes and the wider European Union economy. It is an issue that significantly concerns the TUC.
Various studies have estimated that the outcome of the proposals in the EIOPA consultation could significantly increase the costs of DB pension scheme liabilities and ultimately result in scheme closures. DWP estimate that total UK pension scheme liabilities could increase by over £100billion. Others put the cost much higher, for example JP Asset Management put the figure at £600billion. This is very worrying for scheme members who may have no alternative source of pension saving, or if they do are likely to have a less generous replacement defined contribution (DC) scheme where members are exposed to risks.
So why is the Commission looking to review the IORP Directive? A key theme running through the consultation is that there is a desire for consistency across IORPs and financial institutions, and for harmonisation in the regulation of funded occupational pension schemes and insurance.
As the EU authority for both occupational pensions and insurance, EIOPA will adopt a consistent approach to both sectors. Differences in approach between both sectors will need to be justified. (p. 9)
We are very concerned that the European Commission has asked EIOPA how scheme funding requirements should be further harmonised, not whether they should be harmonisation. The Solvency II Directive (2009/138/EC) applies to annuities and the management of contract-based pension schemes provided by insurance schemes. The Solvency II Directive fundamentally reforms capital requirements for insurers and reinsurers across the EU, and it is currently expected to come into force in 2014. Solvency II places a lot higher funding requirements on insurance schemes than on pension schemes as they operate on a short-term basis.
There are major concerns regarding the implications of Solvency II for occupational pension schemes. Harmonisation of regulation for occupational pension schemes and insurance, and Solvency II being the default regulatory framework except where justified could have very serious implications for DB schemes. We do not think it is appropriate to apply a solvency regime relevant to financial service companies providing insurance to occupational pension schemes. Occupational pension schemes have long term predictable liabilities. The application of a Solvency-II inspired regime would increase DB occupational pension scheme liabilities by 20-30%.
While the EIOPA consultation did not propose the direct application of Solvency II capital requirements to DB schemes it presented the idea of a ‘holistic balance sheet’. The EC’s intention of the holistic balance sheet is to record on a consistent basis both assets and security mechanisms, including both on and off balance sheet items. For example in the UK this would include the employer covenant and the Pension Protection Fund alongside pension scheme assets and liabilities. However, we are concerned that this idea is inspired by Solvency II and would significantly increase scheme’s technical provisions (liabilities for past service pension benefits as they fall due). Furthermore, it is not a tried and tested approach.
Under the current IORP Directive schemes are not required to value a scheme’s technical provisions at a risk-free discount rate (discounting is the amount of future payments, expressed in today’s terms). However, the consultation examines valuing a scheme’s technical provisions on a risk-free rate basis.
The Commission would like the valuation of assets, technical provisions and other liabilities to be market consistent and based on sound economic principles ie. made according to the ‘fair value’ principles adopted for Solvency II ie. that both assets and liabilities would have to be assessed on market consistency principles (p.76).
Market consistency to value liabilities and assets means that market prices are used where available on a mark-to-market, or fair value basis, to indicate their current market value. The downside of market-consistent valuation is that it generally leads to a high volatility of results. Furthermore, market-consistent risk-free rates do not sit well with the long-term nature of IORPs. The use of a market consistent risk-free rate to calculate technical provisions (which is central to the idea of a Holistic Balance Sheet) would place greater pressure on schemes and ultimately lead to a high level of DB closure.
Given the diversity of pension provision across the EU, the application of a harmonised Solvency II-derived regulatory framework to insurers and funded occupational pension schemes is both undeliverable and undesirable. The UK already has a robust system of member protection in place for DB schemes underpinned by the employer covenant, the work of the Pensions Regulator and the Pension Protection Fund.
We are also concerned about the adverse impact a revised IORP Directive could have on the EU economy. Given the current European economic situation the potential impact of a revised IORP Directive could be particularly unwelcome. De-risking of investment portfolios, as pension schemes move from equities to risk-free investments could negatively affect economic growth, investment and destabilise capital markets.
The consultation also had no accompanying full impact assessment and evidence setting out the detailed case on the need for the reforms. For example, at present there are only 84 cross-border IORPs of around 140,000 IORPs in the EU and the Commission would like there to be more. The Commission and EIOPA have provided no detailed evidence demonstrating why the regulatory framework should be amended. Our view is that the low number of cross-border schemes is not due to the wording of the Directive needing to be changed. Instead, it is due to lack of demand, and the different pension systems and tax regimes that exist in Member States. It is very concerning that decisions may be taken without a full impact assessment and evidence being provided. Indeed, when an impact assessment is published it is understood it will not examine all aspects of the consultation.