Regulation overload 2013
Written by Ilonka Oudenampsen
Ilonka Oudenampsen examines what impact different legislative changes over the coming year will have on the European pensions industry
After the financial crisis, governments have been wanting to ensure that the opaque financial world is better regulated so that crashes such as in 2008 will not happen again.
But although the increasing regulatory burden on the financial industry is ultimately for the benefit of the investor and the economy as a whole, all those additional requirements are also likely to have some negative impacts.
One regulatory change that will mainly affect pension funds is of course the revision of the IORP Directive. Most responses from the European pensions industry with regards to the review have been on ‘Solvency II for pensions’, the European Commission’s proposal for revised solvability requirements.
Most is to do with the huge negative impact it will have on DB schemes, increasing their deficits even further, but some have also pointed out that these solvability requirements will discourage equity investments and encourage bond investment, despite some equities being less risky than certain government bonds.
Inrev director of public affairs Jeff Rupp adds that it will have a negative impact on real estate investments, which would incur a 25 per cent standard solvency capital charge.
In order to avoid the standard charge, every pension fund would be free to develop its own internal model, but the problem with that route is that it is a very time-consuming and expensive procedure.
Rupp explains: “We would expect most pension funds, certainly the large pension funds, to start developing internal models in order to get lower solvency capital charges, at least for their real estate portfolios.”
However, he notes that, although theoretically every scheme could build their own internal model, this is not a viable option for all schemes. “There are a lot of small pension funds, particularly in Germany and Austria, that would find the process of developing an internal model to be extremely expensive and burdensome, and disproportionate perhaps to the relative advantage that they would gain from having a lower solvency charge applied to their real estate portfolios, especially knowing that real estate is typically somewhere around 10 per cent of a pension fund’s portfolio."
So while bigger schemes can benefit from economies of scale, Rupp says, small schemes will need to make “an unpleasant choice” of spending a lot of money on developing an internal model, simply paying a higher solvency charge on their real estate portfolio, or quit investing in real estate altogether.
However, the UK’s Investment Management Association (IMA) points out that the IORP Directive entails more than just the Solvency II-type proposals and encourages the European pensions industry to also look at the other two main points in the directive, namely DC governance and information provision.
The association is interested in these topics because it believes there is a great opportunity, both domestically and at European level, to lay out a framework for DC which can work to the benefit of consumers, no matter what member state their scheme happens to be in.
In its home country, the IMA chaired the DC group within the investment governance group (IGG), which produced a series of best practice principles with respect to DC investment governance.
“Starting with the outline of roles and responsibilities, moving through the need to set clear objectives, how to implement those objectives in investment terms, how you monitor your investment process, how you review, how you communicate, a whole collection of governance questions,” its director of public policy Jonathan Lipkin explains.
“We see an opportunity potentially to develop that approach in the context of the wider European debate on the regulation of DC. You live in a world where there is no right answer, but what you can put in place is a framework so that you can demonstrate either 5, 10 or 15 years hence, why you took the decisions that you did and demonstrate that the governance processes are robust.”
On information disclosure, Lipkin says that, despite the diverse European pensions landscape, it is possible to develop a reasonably consistent methodology that will help consumers. “We don’t think that you can magically create a common document across a range of different pension and long-term investment products. We do think that you can set yourself the aspiration of working towards consistency in certain key areas, such as the way in which you describe and calculate charges.”
While the IORP review will directly impact all European pension funds, pensions have been given an exemption under most other regulations. However, schemes might still notice the effects of other financial legislative changes.
One obvious consequence would be a cost increase, as the financial industry deals with complying with new regulation and passes on the costs to their investors, but Throgmorton managing director Roger Ganpatsingh believes that this is unlikely to happen.
“The market is currently experiencing significant downward pressure on management fees. In this environment, it is unlikely that the additional costs experienced by managers as a result of increased regulation will be passed on to investors. Fees are being pushed and pulled by various factors but I still think that the net effect will be downward pressure, because that’s what markets are dictating.”
With regards to specific regulations, the European Market Infrastructure Regulation (EMIR) and the Alternative Investment Fund Managers Directive (AIFMD) are likely to cause the most impact.
Under EMIR, pension schemes have been granted a three-year exemption, which can be extended once for two years and another time for one year.
However, they will still be subject to the risk management rules, which will have an effect on pension funds who are directly trading OTC derivatives. More indirectly, LDI funds will also be impacted by the regulation, as they do a lot of long-dated inflation-linked swaps and interest-rate swaps.
Dillon Eustace partner Donnacha O’Connor explains: “If a pension fund is investing in an LDI fund product, while the pension fund itself may benefit from the exemption, it is likely that the fund won’t be exempt unless it is a dedicated investment vehicle for one pension fund and the purpose of the derivatives are exclusively to hedge the pension fund’s risk of insolvency, and, importantly, the relevant EU regulator agrees to it. So, LDI funds may in this way cause pension funds’ costs of implementing LDI strategies to increase, assuming the fund passes on those costs to the pension fund, which we expect would be the case.”
There is a parallel with the consequences the AIFMD will have. O’Connor says: “Pension funds that invest in AIFMD-compliant investment funds will almost certainly bear higher costs associated with compliance with that directive. For some pension funds, it may be a question of: are the costs to invest in AIFMD-compliant funds going to be so prohibitively high that they switch to off-shore funds or managed accounts, or, on the other hand, as a matter of policy or of risk management, will they want to invest in AIFMD-compliant funds because of the additional protections and enhanced levels of investor disclosure that the directive will bring.”
However, State Street Corporation director EMEA, regulatory, industry and government affairs Sven Kasper adds that in certain European countries, some pension vehicles are still unsure whether they are exempt. “In certain member states there are still questions about where certain managers of pension money might fall, within the scope of the AIFMD or not. There is a general pension fund exemption in the AIFMD, but there are questions about how does it exactly apply, which entities are included and which are outside the exemption. In particular in the Netherlands that is of course highly contested, given the industry there.”
Apart from the IORP review, there is not one bit of legislation that will have a big impact on the European pensions landscape. The challenge for pension funds does not lie in the individual regulations but in the wider, enhanced regulatory environment and staying on top of all the legislative changes as and when they come in.