Introduction

The European Commission (EC) has introduced ambitious proposals to align European pensions’ regulation with Solvency II. But despite encompassing some sensible long-term objectives such as improving risk management and governance, these proposals appear hurried in development and flawed in concept. They fail to recognize fundamental differences between insurance and pensions, and the practical impact on pension funds and their sponsors.

The complexity of local arrangements and their interaction with state pension provision mean that changes to occupational pensions are best addressed at the member state level. In our view, a good outcome would be a dilution of, and more pragmatism in, the EC’s agenda.

Background

In 2011, the EC asked the European Insurance and Occupational Pensions Authority (EIOPA) for advice on how the Institutions for Occupational Retirement Provision (IORP) Directive could be amended to make occupational pensions’ regulation more consistent throughout member states. Compared to Solvency II, the current IORP Directive gives individual member states considerable discretion in regulating pensions, in line with the subsidiarity principle enshrined in EU law.

In its Call for Advice, the EC set out its ambition to harmonize the regulatory structure between member states and across financial service sectors, believing that, against the backdrop of demographic aging and the recent financial crisis, intelligent and effective regulation of pensions would:

• Level the playing field across insurers and IORPs as competitors
• Contribute to European growth and employment by increasing consumer confidence and economies of scale
• Take full advantage of the European Single Market by increasing the prevalence of cross-border funds, improving labor mobility and reducing complexity for businesses
• Promote long-term investment through risk-based regulation
• Contribute to the sustainability of member state finances through strengthening of the occupational pensions pillar

The EC has also issued a white paper, setting out actions to support member states in the provision of safe and sustainable pension systems. This includes reform of the IORP Directive.

Through setting EIOPA the narrow task of considering how Solvency II could be adapted to pensions, the EC has perhaps missed an opportunity to optimally address European pensions’ regulation. Constrained by its mandate, EIOPA has recommended that the overarching governance principles associated with Solvency II should also be applied to all IORPs within the scope of the Directive, but allowing for both proportionality and heterogeneity in EU pension arrangements.

The holistic balance sheet and member security

A key recommendation addressing the differences in pension arrangements across different member states is that IORP managers should prepare a “holistic balance sheet.” This balance sheet would look at the security of the pension promise from a member perspective. It is intended as a risk management tool rather than as a statement of account. It would determine the liabilities of the scheme and its potential risk exposure while assessing the value of financial assets and other contingent support, such as the covenant of the sponsoring employer and pensions insolvency funds. The EC proposes that all items on this balance sheet be measured in a market-consistent manner, though this is likely to be extremely challenging for items such as the value of sponsor covenant.

A much-articulated concern is the requirement that defined benefit schemes are fully funded on a “risk-free” basis and that additional funding may be needed to cover inherent risks. Such insurance-like funding requirements would drive many corporate sponsors into insolvency − an issue that the EC recognizes. In fact, current proposals are undermined somewhat by their failure to consider the “political” issue of what would be required of an employer sponsoring a scheme in deficit. However, based on the information available today, these concerns could prove misguided.

Figure 1: A sample holistic balance sheet

A new quantitative impact study will assess whether a uniform measure of security across member states can be achieved through an amended IORP Directive in conjunction with the financial impact of different funding regimes. Such uniform security is likely to be challenging, if not impossible, since scheme benefits are fundamentally different, with softer or harder benefit “targets” in individual states often interacting with state Pillar 1 and 2 provision.

The holistic balance sheet framework may lead to richer risk management and funding discussions between IORP managers and defined benefit scheme sponsors − particularly as reliance on sponsor covenant is clarified. But theoretical benefits should be balanced against hard costs and likely practical benefits.

Governance and transparency

Proposals around supervisory review and governance echo Solvency II. They impose responsibilities on IORP managers, including meeting “fit and proper” standards for membership of governing boards, maintaining explicit risk management policies, carrying out an “Own Risk and Solvency Assessment,” and having policies to ensure internal controls over outsourcing and other financial and compliance processes.

These proposals will also affect defined contribution arrangements, where more comprehensive disclosure requirements, such as the provision of “key information documents” for members, are likely to be imposed.

IORPs versus insurers

Under Solvency II, insurers are subject to risk-based capital requirements. They differ from IORPs both in the hardness of their liabilities and in that they can usually raise capital when in financial difficulty. IORPs, on the other hand, must either reduce benefits or seek finances, which might not be forthcoming, from a sponsoring employer. To the extent that quantitative requirements are harmonized, the potential interaction between IORPs, insurers and the broader capital markets is a legitimate concern. Harmonization of regulation is likely to lead to harmonization of investment behavior, potentially exacerbating supply and demand imbalances. For these reasons, harmonization of regulation across sectors should be approached with caution.

What next?

On the basis of industry feedback, sourced through two consultations, and subject to a quantitative impact study, EIOPA has sent its final advice to the EC. The EC will now consider how the IORP Directive should be amended. While EIOPA has said that a revised IORP Directive could be ready for consultation before the end of 2012, precedent from the lead-up to Solvency II would suggest that implementation is likely to take several years: The Directive will have to be translated into member state legislation, and local regulators will have to consider how they will operate under the new regime. At present, the proposals pose as many questions as answers, and it is difficult to gauge their impact on IORPs and their stakeholders. Inevitably, political compromise will have to be reached, particularly on measures that would increase the financial strain on employers. At least over the short term, a lightly amended Directive focused on disclosure and governance might seem a more pragmatic possibility.