EIOPA's advice to the European Commission does little to allay concerns about the outlook for defined benefit pensions in Europe
-It continues to focus on individual scheme solvency as the only way of securing members' benefits, failing to acknowledge the role that compensation schemes such as the Pension Protection Fund (PPF) could play
-The recommendations on valuing assets against liabilities comes across as an attempt to force pension schemes into a framework designed for insurance companies
-The most concerning points are the valuation principles proposed- if the risk free rate were used, the difference between financial assets and best estimate liabilities would be GBP 700bn in the UK alone according to J.P. Morgan Asset Management calculations
-This difference could be offset by a commitment to future contributions, but it still implies that full buyout funding is the ultimate aim
-The structure of the additional capital buffer - the Solvency Capital Requirement - would not only add GBP 600bn to the liabilities, but could encourage pension schemes to move out of equities and other risk assets
-If the recommendations are adopted, the impact on defined benefit pension schemes, not to mention the broader economy, will be profound.
"The paper from EIOPA on the IORP directive - commonly referred to as "Solvency II for Pensions" - does little to allay concerns about the outlook for defined benefit pensions in Europe. EIOPA state that they do not consider the question of whether or not Solvency II is the correct starting point for the revised IOPR directive, noting that many respondents believe Solvency II is the wrong initial framework. However, market consistency is used as the basis for valuation, leading to potentially huge deficits. Furthermore, the Solvency Capital Requirement (SCR) - an additional capital buffer - follows the corresponding design in Solvency II very closely.
"The paper is based on the philosophy that all pension funds should be able to secure all benefits for members at all times. This view was also put forward by Commissioner Barnier a few days ago. However, this implies that pension schemes should be treated in the same way as insurance companies. There are good reasons to try to ensure that all insurance companies remain solvent. Compared to pension schemes, insurance companies are generally larger and certainly fewer in number, and so merit the close scrutiny proposed in Solvency II. However, individual pension funds are very rarely systemically important. If a firm becomes insolvent and leaves behind an insolvent pension scheme, this event rarely threatens the broader financial infrastructure.
"In other words, the aim for pension schemes should instead be to ensure that all members receive their benefits when those benefits are due. The difference here is subtle. The focus should be on members receiving their benefits, but this does not mean that those benefits should necessarily by paid by their schemes. In other words, there should be some pooling of risks across pension schemes, such as can be provided by compensation arrangements like the Pension Protection Fund (PPF).
"It is unnecessary to force companies to over-capitalise their pension arrangements when security can also be provided by pooling. Of course, minimum capital requirements should be in place for pension schemes in order to avoid weaker companies from taking advantage of their pension scheme members, but not at the level implied by the EIOPA paper.
"The paper recommends the use of the holistic balance sheet for pension schemes, albeit as a supervisory rather than a funding tool. Indeed, EIOPA stress that any deficit on this balance sheet should not necessarily imply a need for additional contributions. The holistic balance sheet includes sponsor support and contingent assets alongside financial assets, whilst the liabilities include not only the value of benefits due but also an additional capital buffer in the form of the SCR. Whilst this provides a neat way of valuing all assets against all liabilities, it does come across as an attempt to force pension schemes into a framework designed for insurance companies. The desire, also stated by Commissioner Barnier, is to ensure that similar products and activities are subject to the same requirements regardless of the structure of the provider. But the structure of the provider does matter - pension schemes, particularly in the UK, have access to sponsor capital, whilst insurance companies do not have access to the additional capital of their shareholders.
"The use of a holistic balance sheet also implies that there needs to be some quantification of the ability of a sponsor to support its pension scheme. When combined with the additional governance requirements proposed in the paper, this would add another layer of costs to pension provision. Rather than spending money on compliance, these costs could be directed towards greater coverage by pension protection schemes.
"Most concerning, however, are the valuation principles. It is assumed that assets will be taken at market value, which is reasonable, but also that liability valuations should be market consistent. Market consistency is not defined, though the idea of two separate liability discount rates is proposed: a risk-free rate and some higher discount rate such as the expected return on assets. If the risk-free rate were used, then the difference between financial assets and best estimate liabilities would be over GBP 700bn in the UK alone, according to JP Morgan Asset Management calculations based on recently-released data from the Pension Protection Fund [1]. EIOPA suggest that this deficit could be offset by the ability of the sponsor to cover any shortfall. However, this could be interpreted as meaning that only a commitment to future contributions could be used to offset any deficit - at least this is what examples in the paper of the holistic balance sheet seems to suggest. There is, though, no indication of the period over which additional contributions would be made, and a longer period could ease the pain. However, this still implies that pension schemes are ultimately expected to have sufficient assets to secure their liabilities with insurance companies.
"The concept of a Solvency Capital Requirement (SCR) has also been included in EIOPA's recommendations, although the prospect of a counter-cyclicality adjustment is also raised. The SCR is an additional capital buffer that pension funds would need to hold to reflect short-term risks. So, for example, the higher the allocation to equities, the larger the SCR. We estimate that the aggregate SCR would be of the order of GBP 600bn. If this were to be implemented it could lead to pension schemes moving out of long term investments such as equities and into short-term matching investments such as bonds. As well as lowering the expected return that schemes could hope to achieve, this could have a broader impact on the cost of capital for companies, encouraging them to be more highly leveraged as the cost of borrowing fell relative to the cost of equity capital. EIOPA propose a counter-cyclicality adjustment to counter this, and there is also the prospect that the sponsor covenant could be regarded as adequate to cover the additional risk, although this is not clear from the proposals.
"This paper gives useful additional insights into the planned changes to European pensions legislation. However, if the recommendations are adopted - and it is still an "if" rather than a "when" - the impact on defined benefit pension schemes, not to mention the broader economy, will be profound."
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