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The Actuary The magazine of the Institute & Faculty of Actuaries

Pensions regulation: A bridge too far?

Why should the security of a pension promise from an occupational pension scheme be any different from that under an insurance policy? This is the central question to be addressed by the European Commission in the looming debate on whether and how a risk-based funding and capital adequacy requirement of the type applying to fi nancial services fi rms should also be applied to defined benefit pension schemes.

Opinions in Europe are currently polarised between those who view pension schemes as financial institutions not dissimilar to insurance companies, and others that view pensions as a cross between a strict financial product and a bestendeavour initiative to deliver certain social policy objectives. In a specific reference to pensions, the European Parliament has urged the Commission to explore ways of promoting better risk management, and the possibility of supplementing the Institutions for Occupational Retirement Provision (IORP) Directive with a harmonised solvency framework for pension funds in line with the Solvency II approach, taking into account the specific features of occupational retirement provision.

If the Solvency II requirements, as constructed for insurance (see box), are adopted for pension funds, the technical provisions and capital required could be considerable — well in excess of the amounts required for buy-out. The Commission is well aware that pensions are different from insurance and have acknowledged that a ‘cut and paste’ solution is therefore not the right answer and that a sharp increase in capitalisation could have serious consequences for members and sponsors. They will seek to identify the relevant issues before a ‘call for advice’ in 2008 as part of the due process for reviewing the operation of the IORP Directive. The blueprint for change, if any, is unlikely to emerge until 2009 and any timetable beyond that is speculative.

Insurance companies in the EU have been complying with EU-wide regulatory requirements since the 1990s. Thus, there is already a reasonable amount of homogeneity of markets and consistency across the EU on reserving and solvency for insurance companies. Solvency II may just be the logical next step on the road to removing regulatory arbitrage. The pension landscape, on the other hand, is fundamentally different, presenting some unique challenges if the admirable objective of harmonisation is to be converted into a practical set of principles acceptable across the EU.

There is already a high level of State provision in some member states and little or no tradition of occupational pensions, although the IORP Directive does not apply to the former. Then there are member states where a high proportion of occupational pensions traditionally come from defined contribution arrangements where solvency considerations only apply to embedded guarantees. Where pensions are funded, there is a wide range of funding practices across member states, often shaped by national legislation, much of which has only recently been put in place at great cost to comply with the IORP Directive.

Elsewhere, there is the curious situation whereby significant slices of defined-benefit pensions fall outside the scope of the IORP Directive, simply because they are unfunded or provided through book reserves. Further, the range and types of pension plan and the degree of risk-sharing between plan sponsors and members varies significantly between member states. In many cases, certain aspects of plan design are dictated by national legislation and are insensitive to changing fashion and conditions. Finally, differences in the tax treatment of pensions provide a further (and in many cases substantial) tilt to the playing field. This is not just confined to differences between member states but can also apply across the range of savings products in a single state.

Much of this diversity results from the principle of subsidiarity which recognises national sovereignty, allowing governments the freedom to arrange their internal affairs as they see fit. This is a much valued carve-out to accommodate different social and fi scal cultures and objectives. The IORP Directive does not (and probably cannot) seek to change it. The first task for the Commission is to find a practical way around what appears to be a conflict between the principle of subsidiarity and the objective of harmonisation. This in turn should have an important bearing on whether the regulatory emphasis between Pillar I (capital) and Pillars II and III (supervisory process and market discipline) can be the same for pensions as it is for insurance.

These are not issues that can be easily resolved at the technical level. Difficult choices will need to be made at the highest political level to reconcile the objectives of free competition with the disproportionate impact on capital requirements between differing member states:
» States with generously funded private-sector benefi ts (who would bear the brunt of any new requirements)
» States with unfunded pensions (who would also face substantial new capital requirements unless the concept of harmonisation is severely compromised so that they continue to be exempted from the IORP)
» States with little or no private sector pension provision (who escape regulation altogether).

Some commentators would argue that any initial pain, however harsh or uneven, is a necessary price for a more competitive European Community in the long term. That said, the financing implications and their potential impact on capital markets, as well as competition in the short term, could be very large unless the effects are allowed to emerge over very long periods. Equally important in any solution that follows would be the potential impact on employers’ appetite for occupational pensions involving any form of guarantee, the consequential level of future pension provision and its implications for social policy objectives.

Modified Solvency II?
The European Parliament is known to favour the principle of ‘same risk, same capital’, so regardless of how the problems of harmonisation are resolved, it is conceivable that a capital-focused approach might be developed around the high-level principles of Solvency II, but with the detailed rules specifically tailored for pensions. For individual pension plans, the capital adequacy bar would most probably be raised to reflect more specifi cally the risks taken, particularly in the design of the pension plan, its demographic profile and its assets and funding strategies. Successful implementation would depend on the flexibility retained in the rules for risk mitigation through management actions — for example, benefit reductions, conditional indexation, long lead times for education and planning, and a gradual phasing-in of any substantial new financial commitments.

Some thought would also need to be given to the nature and quality of assets backing the solvency capital. Here it would be necessary to recognise differences between insurance company and pension scheme balance sheets. With the latter, the assets you see on the balance sheet are just part of the capital backing the promise, since in most cases (excluding the so-called ‘regulatory own funds’) there is a lifeline back to the sponsoring employer. In practice, therefore, the employer’s business is already providing solvency capital. In a uniformly quantitative approach, however, there would be questions about the quality of the employer’s covenant and the extent to which it can be enforced by the pension scheme. Any attempts to put a value on this ‘credit’ would raise complex, but not insurmountable, problems.

It might be tempting to bypass these problems by requiring all solvency capital to be held on the pension scheme’s balance sheet. In countries like the UK, this would raise the spectre of trapped capital which would be fundamentally unsound, since solvency capital is not the same as liabilities, and shareholders do need to have access to it without penalty.

A further credit to consider would be against security ‘purchased’ from external institutions such as the Pension Protection Fund, although the arguments here may not be so clear cut.

Something different?
It has been said that Solvency II is not just about capital adequacy, but also about changing behaviours. Evidence from the UK insurance industry shows that the risksensitive individual capital assessment regime has indeed led to better decision-making, better engagement with company boards, better quantification and allocation of capital, more innovation, and generally better risk management. The pensions industry could certainly benefi t from more of this if it came with an affordable price tag.

If promoting the right behaviour is the primary objective, then a Solvency II-type approach may not be the only way. Take the example of the UK pensions industry two years ago. It does not have any hard quantitative prescription, but sponsors across the country will tell you that it is no pushover. Trustees and actuaries will tell you that it has led to a better awareness of the risks taken, including the employer’s credit risk, with funding and investment strategies set in tandem to balance the risks involved, and their affordability, with member security. And the Pensions Regulator will tell you that it is in the business of risk-based supervision with clearly articulated expectations and checks, aimed at promoting the right behaviours. Indeed, evidence is also emerging of funding targets which are at times higher than those which might have otherwise prevailed.

All this has been achieved through strong regulatory and scheme-based governance, with appropriate guidance and checks. While not a recipe for a uniform level of security, it does provide some lessons on how the high-level objectives of Solvency II might be encapsulated within a principles-based funding and solvency framework — one that recognises the essential differences between insurance and pensions, as well as the different styles and structures for pension provision within EU countries. The detailed rules could then be devised on a bespoke basis to comply with the principles but at the same time to suit the particular features of pension provision in the country concerned (or the relevant pension vehicle). Governance would assume a strong role, both at regulatory and at a scheme-specific level. This would be more consistent with the regulatory approach embedded in the IORP Directive and less divisive.

What is Solvency II?
Solvency II is a three-pillar framework setting out the funding and capital requirements, supervisory process and disclosure for insurance companies. Objectives
» A more risk-sensitive approach with incentives for proper risk management
» Consistency between financial sectors (insurance v banking)
» Harmonisation of regulatory standards across the EU, developing in parallel with international accounting standards. Pillar I (capital) requirements
» Technical provisions equal to the value at risk-free rates of best-estimate cash fl ows, plus an explicit risk margin
» Additional solvency capital, set by reference to the company’s true risk profile, sufficient to cover technical provisions and other liabilities at the following year-end with 99.5% confidence
» Supervisory action triggered automatically if available solvency capital falls below an objective baseline.

Pensions forum
The International Committee of the Pensions Board will be holding a Solvency II pensions open forum at 6pm on 4 March at Staple Inn, at which Chinu Patel will be giving a presentation. Registration is from 5.30pm. Please visit wam.actuaries.org.uk/wam/confbooking.exe to reserve a place.