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Change for the worse?

Written by Ilonka Oudenampsen
December 2012

Ilonka Oudenampsen speaks to Belgian Association of Pension Funds chairman Philip Neyt about the revision of the IORP Directive and what impacts a Solvency II framework would have on the Belgian pension system

Belgian pension funds have had a decent year so far, compared to 2011. Returns last year stood at -0.74 per cent, whereas in the first half of 2012 pension funds recorded returns of 4.58 per cent. However, like every other country in Europe, the Belgian pension system is facing several challenges, such as an ageing population and turbulence on the financial markets.

One regulatory issue that is keeping the industry busy is the revision of the IORP Directive and a possible Solvency II framework for pensions. Currently consultations are being held to assess what impact such a framework would have, but Philip Neyt believes that it would have the opposite effect of what the European Commission hopes to achieve.

The chairman of the Belgian Association of Pension Funds (BVPI) and managing director of the Belgacom pension fund notes: “Pensions are a social-legal matter that differs from country to country. If you look at prudential legislation and especially the framework of Solvency II regulations, then I think that will be very counterproductive. Moreover it does not increase transparency and comparability, which was the main goal of Solvency II. On the contrary, it adds complexity and in the end it will make insurance more expensive and less innovative.”

As retirement ages across the continent increase and Europeans are living longer, pension funds’ durations are increased to cover several more years. However, the Solvency II regulations will require pension funds to be fully funded at any given moment in time. But Neyt disagrees with that principle and says: “Pension funds are not like banks. With long durations, you can be partly illiquid, because you know you don’t need the money immediately. And at the moment we need that illiquidity premium to get returns. Bond yields are low, so the illiquidity premium is needed to get some extra yield.”

Moreover, the framework disregards economic reality, Neyt says, as government bonds are no longer risk-free and not all equities are as risky as the solvency frame-work suggests. “It’s very unhealthy to manage portfolios based on a quantitatively fixed framework. This would mean that investors will disinvest in equities, because the required buffers are too high. This would result in an equities outflow of around €1,000-€1,300 billion, which would have dire consequences. That money flows out of the equity market, is not reinvested in the economy, equity markets will fall even further, and the money will flow back into the bond market, which will turn into a self-fulfilling prophecy, with even lower yields.”

He adds that the financing of businesses will be jeopardised as well, because, when banks encoun-ter the major impacts of Basel III, pension funds will have to step in as long-term financers of companies. However, if they need to have huge buffers to invest in company shares, equity investments will even further decline and businesses will struggle to find financing.

A Solvency II type framework would encourage pension funds to invest in government bonds, but at the moment these are not achieving the required and much needed returns either. Neyt explains: “I can invest in German bonds and get a yield of 1.5 per cent, which is lower than inflation. But in the long term I need to pay out pensions, and I don’t pay those with nominal yields but with real money.

“Secondly, if I’d invest in Portuguese bonds, they had a return of +40 per cent since the beginning of the year, but last year that was -40 per cent. That is no longer economically driven, but all based on political decisions in the eurozone.”

He notes that an additional disadvantage is that it is impossible to evaluate asset managers who manage a bond portfolio, because these returns are no longer solely based on economical foundations or manager skill but mainly on political decisions.

“Eurobonds used to be a safe haven, but they no longer are. Either I’m no longer rewarded for the risks I take, which is also the case with German bonds, because in case things go wrong in the eurozone, Germany will not be saved either, or I get a yield but the volatility is huge and driven by political decisions that are difficult to anticipate. So I don’t want to have that as the core of my portfolio,” he explains.

“Pension funds need to ensure they have real returns which still remain positive in the long term. Investing in German bonds is a definite death sentence.”

Furthermore, one always regulates the past and never the future, Neyt says. “While the extra bond investments insurance companies have made have largely been used to finance the euro government debt, I believe this approach involves severe systematic risks for both equity and bond markets.” There will be no more long-term investors for equity markets, he warns, while the bond market turns into one big melting pot, which will result in low diversified portfolios and a big correlation risk.

Neyt says that, if Europe really wants to go through with these regu-lations, a shutdown of Belgacom’s pension fund is certainly an option. “Then I will go to the unions, we’ll do something else, then we might even consider setting up a Branch23 in Luxemburg. It’s a must to have a well-diversified portfolio; it’s the best guarantee for an acceptable return-risk profile in the long term.

If we need too much capital or we are forced to put too much money in a non-diversified EU-government bond portfolio, since it’s the only asset according to the EU that does not eat capital, it’s unhealthy for the long-term continuity of the pension plan.”

The European Commission has not yet made a decision on the new IORP Directive and its advisory body EIOPA is currently conducting quantitative impact studies (QIS) into the consequences the directive, and in particular a Solvency II framework, would have on pension systems across Europe.

Although the problem is not present at the moment, Neyt says that, if the day would come, he will indeed be consistent and looking for other options for funding our pension promise. “I think Europe is absolutely not working on a balanced risk framework.” Appropriate risk management is key, he explains, but not “forcing pension schemes into a quantitative frame-work which does not require any buffer for euro sovereign bonds and for equity, regardless the quality of the rating of the company, requires a buffer of 40 cent for each euro invested. No buffer for owing a Greek bond cannot be justified and the EU should take into account the changed reality of the sovereign risk within the Union.”

According to the BVPI chairman, pension funds and regulators should be realistic, both about the economic climate and the duration of pension funds. It’s a given that yields will be lower than in the 80-90’s, which were historically speaking exceptional, but in the 50-60’s it was the same as now.

“If Europe says, if you’re invested in equities you always need to be 100 per cent funded, then I say that that is unnecessary, because I have net cash inflows the next 10 to 15 years, while my duration is about 17 years and a run on the pension fund is not possible since people need to have been retired to be entitled and the chance of lowering the retirement age is close to zero.”

Regulators should be tough on governance, he adds, as it’s up to the board of directors to have an appropriate risk framework and management. “Good governance and very tough ‘fit and proper’ tests on the board members are the best guarantee for good risk management and the solvency of the fund. And in the case of pension funds, the contributing employers and representatives of the beneficiaries are present.”

Neyt still hopes the EU will change its mind. “Giving the changing economic environment, a new risk-based framework is necessary, but a more qualitative approach taking into account the specifics of each fund and not the one size fits all approach. I hope the pendulum goes back to the middle. This would also give oxygen to the European economy and its future growth.”



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