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The Actuary The magazine of the Institute & Faculty of Actuaries

Big bang in European pensions?

The UK pension system and financial industry are increasingly being affected by European legislation, jurisdiction, and reform. This article highlights some of the key features of the European pension system as well as recent attempts at reform, both at national and EU level.

Overall features
Retirement provision in Europe has several striking features.
– Multiplicity and heterogeneity of systems operating in parallel. Pensions are still very much a national affair, despite the Treaty of Rome, which established the principle of free movement of goods, labour, and capital.
– The EU has finally started to move, albeit slowly, towards a common framework. With the recent action by the European Commission and the rulings of the European Court of Justice, a future regulatory framework for pensions may have started to take shape. This is likely to facilitate a wider application of qualitative or prudence regimes in Europe and the introduction of the prudent expert concept in pension scheme governance.
– The speed of reform in most individual countries. The demographic time-bomb is already among the top political issues in many countries. The older generation fear for their pensions while younger people realise that they may have to pay for pensions twice: for their parents, and for themselves.
– A clear recent trend towards globalisation of pension investment business as more pension plans are looking for international providers of asset management, custody, and other financial services.

Multiplicity, diversity, complexity
Legislation and practice in retirement systems have evolved in fundamentally different ways in the various European nation states over more than a century. There are key differences in many respects:
– balance of first pillar (state pension provision), second pillar (occupational pension funds), and third pillar (individual accounts) provision;
– size of funded pensions (see figure 1);
– legal and regulatory framework (eg supervision, investment restrictions);
– benefit arrangements (eg defined benefit, defined contribution);
– constitution of pension funds (as trusts, foundations, mutual assurance companies, book reserves);
– governance of pension plans (eg workers’ representation);
– funding system and solvency rules;
– the use of ‘guaranteed returns’;
– tax treatment of contributions and benefits;
– role of financial institutions (eg insurance companies) in the provision of pension products;
– differences in investment culture and attitudes towards risk.

A new European regulatory framework?
Unlike banks, insurance companies, and investment funds, pension funds are still outside a common EU framework. However, the European Commission feels that ‘a fully functioning single market for occupational pensions is essential to ensure that citizens are able to exercise their rights to free movement enshrined in the EC Treaty and thus to enhance labour mobility’.
After a failed attempt in 1994, the European Commission proposed a new pension fund directive in October 2000 designed to allow cross-border pension provision and investment while ensuring adequate prudential supervision. The main proposals are:
– Prudential supervision to protect members and beneficiaries.
– Investment rules intended to facilitate higher long-term returns and cost-effective investment.
– Rules enabling cross-border management of occupational schemes.
– The need for professionalism in pension scheme governance.
Effectively, this is a compromise between demands and practices in different countries. Given earlier failures, ambitions are limited. For example, PAYG (pay-as-you-go) systems are excluded from the draft directive. The same is true for book reserve systems as well as private pension arrangements. This may open the door to significant competitive and regulatory imbalances.

Uncertainty over solvency regulation
From a UK pensions perspective, most of the requirements would already be met. However, the regulator is likely to have a bigger and more proactive role to play, and the administrative workload on pension schemes, in particular disclosure, may increase as a result of the strong emphasis on security and transparency.
Much of the responsibility in legislation and implementation remains in the hands of EU member states. However, several provisions in the draft are still unclear. In particular, a major uncertainty has been generated by the proposed introduction of general funding rules via a directive, at the time when the UK’s minimum funding requirement is on the way out as a result of the Myners review.
After a series of amendments by the European Parliament this summer, adding some social security elements, discussions are likely to heat up further when European Council and the member states get more deeply involved. Given the strong differences in views across the political and national spectrum, and the failures in the past, it remains uncertain whether and in what form the draft directive will succeed.

‘Mediæval’ tax discrimination
The draft pension directive was complemented in April 2001 by a European Commission communication, ‘The elimination of tax obstacles to the cross-border provision of occupational pensions’. The objective is to remove tax discrimination for individuals wishing to contribute to pension schemes outside their home country, but also for pension plans that wish to provide pensions across borders.
The Commission intends to examine the various national rules and to press for the removal of discriminatory rules, for instance those that favour domestic schemes in terms of deductibility of contributions or taxation of benefits. It also recommends a new system of automatic cross-border information. Finally, it urges members states that deviate from the ‘EET’ system (Exempt contributions, Exempt investment income and capital gains, Taxed benefits as used in 11 member states, including the UK) to converge towards EET.
The Commission believes that these measures are in line with the Treaty and the rulings of the ECJ in recent years. It has yet to be seen to what extent this ‘soft’ approach will be successful in removing a fundamental obstacle for the increasing number of companies and people operating multinationally.

National pension reforms
Meanwhile, pension reforms are under way in literally every single European country. This development is not driven by European harmonisation plans but by the pressure on public budgets resulting from demographic and social changes. Pension reform has become a highly contentious issue in the political debate, particularly in countries with big unfunded PAYG systems such as Germany and Italy.
This is not the place to comment on the various reform attempts in detail. Some countries prefer to move directly from first to third pillar provision so that occupational pension funds will continue to play a very limited role. Steps are being taken to relieve the burden of first pillar provision through various measures, eg the increase in contributions, raising the pensions age, or new ways of funding state pensions (Ireland, Sweden, or Belgium).
In summary, the conclusions drawn differ strongly across Europe and are often the result of year-long domestic political haggling (see the recent German pension reform). It is not at all clear how the various recent national reform attempts will be compatible with a future European pensions directive or with any possible future tax harmonisation attempt.

Pensions governance
Moving down from the governance of whole pension systems to the governance of single pension funds, the scene is changing. There is a move away from highly prescriptive law towards putting the ‘prudent person’ principle centre-stage in the direction and control of pension funds.
This is about behavioural rules: the regulation of the decision-making process and the suitability of people involved, rather than telling people what exactly to do. More recently, there have been further requests for greater technical competence, in addition to general prudence. The draft directive requires pension funds to be ‘effectively run by persons of good repute who must themselves have appropriate professional qualifications and experience’. Similar conclusions were reached by the Myners review in the UK that puts the investment decision-making process by trustee boards centre-stage. Independently, the Dutch regulator has introduced suitability tests (professionalism, reliability, independence) for those responsible for pensions.
The demand for more professionalism in pension fund governance will be driven by other factors, too:
– increasing complexity in investing and risk management;
– size and strategic importance of pension plans for many sponsoring companies;
– more freedom for pension board directors from less restrictive legislation.

Pension investing is going global
Only partly influenced by political changes, some key economic and financial trends in European pensions can be observed.
– The trend towards the separation of pension assets, better funding, and outsourcing of investment management.
– Globalisation of service provision: the increasing use of international custodians, fund managers, investment consultants, risk and performance services.
– Increasing international exposure, strongly influenced by the introduction of the euro and the disappearance of currency risk within a major economic area.
– In the late 1990s, increasing equity weightings were observed (in contrast to the UK), favoured by strong equity returns, a change to investment culture, and the fall of strict investment restrictions.
– The range of investment instruments has been widened, including private equity, emerging markets,
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hedge funds, corporate bonds, etc. Also, the awareness of investment process, performance, and risk control issues is growing.
– Increasing numbers and competition among pension product providers, such as insurance companies, banks, and asset management houses, in connection with the growth of new defined contribution and personal pension vehicles.

In short
– The big bang is still waiting to happen in European pensions. Even if some people like to talk about it, there is no such thing as a single European pension system.
– Faced with similar harsh social and political realities, national governments are taking their own often non-convergent routes to reform.
– In contrast, Brussels is trying to open up the pensions market one of the most backward industries in the EU and give a common approach to European pensions regulation, and some sort of shape to taxation. All this is still to face the real political test.
– Meanwhile, and underneath the political sphere, we can observe some important economic trends in pension provision across Europe, eg the globalisation of pension investing, the rising business of commercial pension products, and the introduction of the prudent expert in pension plan governance.