Fighting the fear
Written by Ilonka Oudenampsen
Ilonka Oudenampsen explores pensions funds’ fears concerning upcoming European regulations, particularly the IORP Directive and Solvency II
Pension funds across Europe are living in unpredictable and challenging times. While the eurozone crisis continues, funding levels remain extremely volatile and safe havens are hard to find, the European Commission is adding to the workload by proposing and consulting on several regulation changes.
The sheer volume of legislation that might have an effect on pension funds is a concern for many, but one of the main pieces of legislation is the revision of the IORP Directive and in particular the possibility of the introduction of Solvency II for pension funds.
Solvency II, a set of EU-wide capital requirement rules, is already in place for the European insurance industry, and there has been talk about also introducing Solvency II or similar solvency requirement rules for pensions.
In early January new research by JP Morgan Asset Management stated that the implementation of such solvency rules could add an extra £600 billion to the funding of UK pension schemes.
However, F&C head of insurance advisory Derek McLean is slightly hesitant about such headlines.
“If you would simply apply the Solvency II regulations to UK pension schemes then it’s a matter of doing a different valuation, but in effect you’re not actually changing anything of substance.”
Actuaries do a whole series of calculations, McLean explains, and they are all done for different purposes. “Depending on what the purpose is, you might get a very different answer from the calculations that you do if you’re doing it for another purpose. If you’re using a much more conservative discount rate for the liabilities, because you’re doing more of a valuation rather than a planning exercise, then the size of the present value that you produce might change accordingly.”
He therefore feels the headlines about how much Solvency II will cost British industry are somewhat misleading. “Because at one level, the reality is, applying Solvency II will make no difference whatsoever to the payments that the pensioners are expecting to receive.”
The underlying thought of Solvency II is to create a level playing field between different pension providers, as pension promises made by insurance companies and those made via a company’s pension scheme directly now fall under different legislation, and to ensure these pension promises are met. However, the pensions industry is not the same as the insurance industry and therefore many are lobbying for a different solvency framework for pensions.
Linklater managing associate, investment management group Silke Bernard, and member of several working groups of the Association of the Luxembourg Fund Industry (ALFI), explains: “We can take ideas from Solvency II, but we should not take over the whole set of rules, because some of these would simply kill the pension funds business. We should really take what fits, what’s sensible and what can work in the pension funds environment, but not to simply overrule the whole pension funds business.”
Russell Investments consultant Crispin Lace notes that there is no doubt that the current specifics on Solvency II, like the idea of the risk-free basis for liabilities and needing a buffer for any assets that do not meet this longevity, non-risk-free or non-maturity match, look hideous on the surface.
“But even if it applies to DB pensions or the corporate pension promise, the sponsor will be allowed to say: ‘well, there’s the value of the company ultimately behind it’. It’s like saying we have the corporate covenant to support that buffer. And for most people even on a risk-free basis the corporate covenant is probably sufficient to cover these risk assets for a Solvency II basis.”
Although the UK is the main worry when it comes to the possible effects of Solvency II, another country where it might have an impact is the Netherlands. But McLean points out that there are significant differences between the UK and the Netherlands, mainly due to their respective histories.
He explains that, while the UK focuses on protecting pensioners against inflation risk, the Dutch focus on the security of the members’ guaranteed benefits, with an inflation uplift seen as less of a priority and more as a desirable extra.
Dutch pension schemes have consequently much less inflation protection than UK schemes, but start, notionally at least, from a position of being much more secure.
McLean says: “If we assume for example for simplicity that the value of protecting the nominal benefits is 100, the value of protecting inflation-linked benefits is 150 and the scheme has 125, then the Dutch solution to the problem is: ‘I’ve got 125 of assets, I need to guarantee a 100, let’s make sure we manage the scheme so that 125 never falls below a 100’. Whereas a UK scheme is very much the other way around: ‘Let’s try and manage just the 125 towards our ambition of 150’. That divergence is extremely important in trying to understand the impact of introducing Solvency II, because obviously Solvency II is driven around the 125 versus 100 question and is therefore very easily translated into the Dutch market.”
Apart from Solvency II, pension professionals across Europe have been looking at other parts of the IORP Directive as well. When deciding to review the IORP Directive, the European Commission had three goals in mind: how to help in the set up of cross-border pension schemes as currently only 84 out of around 140,000 pension schemes in Europe operate across borders; proposing risk mitigation mechanism for pensions to ensure individuals receive the benefits they are entitled to; and looking at the way regulation relates to DC schemes.
Aviva Investors global strategy director for the institutional channel Richard Warne says: “So when you’re looking at the three aims the EC has and what they’re trying to achieve, none of them seem unfair or ridiculous. But obviously, the problem that that poses is that you’re looking at a system that covers multiple countries with multiple tax regimes and very different ways of providing retirement. That is what really has created the problem. It’s trying to create uniform rules that apply to all countries in a way that doesn’t negatively impact the existing regimes and meet those goals.”
European Fund and Asset Management Association (Efama) director of economics and research Bernard Delbecque agrees and adds that the concept might be brilliant in some respects, but it has to be translated into a very precise, detailed framework.
“How are you going to take into account the diversity of mechanisms that exists? For instance the sponsor support or the benefit adjustment mechanism: are we going to suppress them and replace them by something that is just to harmonise rules across Europe? It’s not clear and we are therefore waiting for a serious quantitative impact study, so that we can see the detailed framework of criteria and what would be the impact, in particular the possible costs for DB schemes and for employers and long-term saving.”
He cautions that although in some countries there might be some problems when new legislation would be introduced, this should not mean that we should give up on new legislation all together.
“Maybe they have some issues that can be dealt with at the national level with a strong influence or involvement of the EC or EIOPA, based on some sound practices. And consequently, the other side of this coin, in countries where there is no obvious problem, what is going to be the benefit of the new rules? What will be the benefit for those countries compared to the costs that those countries will incur? We don’t want to prejudge what is going to be the final outcome, but we’d just like to see,” he says.
AIFMD and Ucits IV
Compared to the IORP Directive and the possibility of Solvency II for pensions, other legislation such as the Alternative Investment Fund Managers Directive (AIFMD) and Ucits IV will have very little impact on pension funds.
Warne says that the AIFMD is a good example of where people were very worried about some of the aspects during the early stages of negotiations, although most of it didn’t see the light of day at the end.
“For many European pensions the impact of AIFMD is less than they had feared, and their fear was more associated with restrictions on what they could invest in. There’s still some controversy around the AIFMD, areas around depository liability and equivalence that’s still being worked through, but I think those are secondary issues for many European pensions.”
Any consequences of Ucits IV would also be mainly indirectly and EFAMA deputy director general Jarkko Syyrila says: “[AIFMD and Ucits IV] might impact on construction and regulation, but hopefully provides more protection for pension funds investing in these products.”
However, the framework of the main piece of pension legislation, the IORP Directive including the possibility of Solvency II, is still uncertain. Together with other upcoming financial regulations that might potentially impact pensions, there will be a lot to discuss and review for pension professionals over the next year or so.
“This stuff is great to talk about because it’s all in discussion. None of it is decided and we can speculate all we want and we have no idea what is really going to happen. Solvency II is probably the worst of that, because there’s so much uncertainty about what might happen and what might come out of it,” Lace says.
Warne concludes: “Regulation is going to have much more of a central theme around what happens and I think there’s been some very, what people presumed was subtle, but actually profound change, both in approach and scope of regulation, that I think will have dramatic impacts on our industry as fund managers.
“The impact on the insurance industry is already being felt with Solvency II and I think pensions are beginning to really fear the impact and to get quite concerned with what might be negative impacts. Obviously there are also positive impacts and it is important to strike a balanced view.”