European
pension frameworks: diversity implies challenges
Aerdt Houben of De Nederlandsche Bank and Chair of the CEIOPS
OPC(1) Solvency Subcommittee explains
The European market for occupational pensions faces major
challenges. These are driven by four economic and institutional developments.
First, the European Pensions Directive(2) has widened the scope for cross-border
pension services, representing the first step towards an internal market
for occupational pensions. Second, companies, employees and pension funds
are becoming increasingly mobile across Europe. This is illustrated by
the recent launch of some pan-European pension schemes. Third, demographic
pressures are increasing the need for fully funded pension systems, while
pay-as-you-go systems are becoming increasingly difficult to sustain.
Fourth, harmonised and advanced risk-oriented prudential frameworks are
being introduced in other parts of the financial sector, in particular
the global Basle II accord for credit institutions and the European Solvency
II regime for insurance companies.
The current European framework for pension funds is not risk oriented.
As the Directive lays down only minimal solvency requirements it does
not give rise to any substantial convergence in supervisory approaches
in this
field. At the same time, however, comparable member protection for pension
plans is needed to ensure undistorted cross-border services. Substantial
differences in regulatory requirements may lead to regulatory arbitrage
by pension funds and supervisory competition between countries. This ultimately
is not in the interest of pension beneficiaries. Against this backdrop,
the Committee of European Insurance and Occupational Pensions Supervisors
(CEIOPS) has conducted a survey on the solvency requirements that the
different European countries currently apply to their pension sector(3).
In particular, the survey has provided a comprehensive overview of differences
in the valuation of technical provisions (the static element of pension
solvency) and of additional security mechanisms underpinning pension contracts
(the dynamic element of pension solvency).
Valuation of technical provisions
The existing prudential frame-works for pension funds in European countries
are very diverse. The differences have historical and cultural roots,
and at times reflect national Social and Labour Law. Under the Directive,
pension funds have to be ‘fully funded’, that is they have
to hold sufficient assets to cover technical provisions. Short periods
of under funding are only allowed as long as the pension fund has a concrete
and realistic plan to ensure funding is promptly restored. Pension funds
recognise as a liability in their balance sheet the present value of the
current
and future pension rights of all their members. These technical provisions
correspond to the minimum amount of assets that pension funds should have
to be able to pay pension benefits as and when they fall due. However,
the calculation of these technical provisions is complex and varies markedly
between countries. Elements to value the technical provisions are the
discount rate to determine the present value of future pension payments,
mort-ality assumptions and assump-tions with respect to future inflation
and salary increases in those cases where future inflation or salary trends
are factored in.
In practice, most countries calculate technical provisions on the basis
of a discount rate that follows market developments. Some countries use
current risk free market rates to determine their discount rates. Other
countries embed prudence in the technical provisions by setting the discount
rate below the risk free market rate. Some countries make use of officially
fixed maximum rates, implying that the impact of market rate changes on
the financial position of the pension fund is less visible. A few countriespermit
schemes to make a prudent allowance for the expected returns of the assets
held by the pension fund when setting the discount rate, providing lower
security
to beneficiaries unless greater emphasis is then placed on other security
mechanisms.
The general philosophy in EU countries is to use mortality assumptions
that accurately reflect pension members’ mortality and survival
probabilities. About half of the European countries apply current mortality
rates in their tables, while the other half incorporates an element of
prudence. The majority of countries also include a trend in the mortality
tables to reflect the improvement in life expectancy in Europe. Tables
which do not include a mortality trend typically underes-timate biometric
risks.
Inflation represents a significant risk to the ongoing purchasing power
of a beneficiary’s pension. In only a few European countries is
unconditional inflation (or wage) indexation applied, thereby securing
members’ purchasing power. This guaranteed protection then needs
to be taken into account in the calculation of technical provisions. Where
the guarantee is not capped, some risk is left with the pension fund as
actual inflation or wage growth may exceed the assumption underlying the
technical provision. Vice versa, where the guarantee is capped some inflation
risk is left with the member. This underscores the need to set realistic
inflation assumptions. Some countries provide only conditional inflation
protection or none at all, in which case respectively some or all inflation
risk is borne by the beneficiary.
Additional security mechanisms
In addition, countries apply various combinations of security mechanisms
that provide further protection to the full funding requirement regarding
technical provisions. Existing mechanisms include:
l - Solvency buffers
l - Subordinated loans
l - Sponsor commitment and increases to contractual premiums
l - Guarantee funds
l - Reductions of future conditional inflation
l - Reductions of accrued pension rights
Some of these mechanisms, such as solvency buffers, sub-ordinated loans
or a guarantee fund, are capitalised, which means that security is arranged
up front. Capitalised instruments do not have an important economic or
cyclical impact once an adverse adjustment needs to be compensated for.
They do, however, increase the upfront cost to employers and hence may
interfere in the balance between cost and pension provision where employer
sponsorship is entirely voluntary. Also, they may tie up employer capital
although they may be used to provide members with conditional indexation,
where no inflation indexation is offered.
Instruments providing ex post security, such as sponsor contri-butions
or premium rises, may have a less favourable economic and cyclical impact
as shortfall correction is usually needed in times of economic downturn
and this financial obligation may further deteriorate the economic health
of the sponsor. However, this impact can be reduced by the existence of
additional funds or assets as collateral on which a claim may be made
by the pension fund and also by allowing a longer recovery period that
spreads out the effects of adjustment measures over the cycle. The dependence
on a sponsor also implies some credit risk to the individual member. Apart
from their job, employees also stand to lose part of their future pension
benefits if their sponsor were to fail when the pension fund is under
funded. A well-designed guarantee fund however can further mitigate the
risks associated with this dependence on the sponsor.
Summing up
There is an apparent interaction between the different elements that make
up the pension frameworks. For example, emphasis on prudent valuation
principles, which results in extra reserves, reduces the need for additional
security mechanisms. The variance in valuation measures and security instruments
therefore does not necessarily imply substantially different security
levels between countries: in practice, the variances are linked and often
cancel each other out. By implication, as different methods can be used
to secure pension benefits, national pension supervision frameworks do
not necessarily have to be identical. Conclusions on the overall security
level provided to beneficiaries can therefore only be drawn from a comprehensive
analysis of all different elements, requiring a common language to encompass
all individual elements. Indeed, now that the European Directive has opened
the door to cross-border occupational pension provision, comparable protection
for pension scheme members is needed to ensure cross-border activity in
an undistorted manner.
1 OPC – Occupational Pensions Committee
2 Directive on the activities and supervision of Institutions for Occupational
Retirement Provisions (IORPs); Directive 2003/41/EC
3 CEIOPS, Survey on fully funded, technical provisions and security mechanisms
in the European occupational pension sector, April 2008 (see www.ceiops.eu)
Written by Aerdt Houben, Division Director Financial
Stability, De Nederlandsche Bank & Chair CEIOPS OPC Solvency Subcommittee
