This briefing looks at the proposals for a new European risk-based supervisory regime for institutions for occupational retirement provisions (IORPs), or funded pension schemes.
Commissioner Barnier recently announced that the European Commission intends to publish a proposal for a new Directive to improve governance and disclosure standards of pension funds by autumn 2013.1
Plans to address the solvency of pension funds have been postponed indefinitely (following widespread criticism from across the pensions industry, and opposition from the UK, Netherlands, Germany and Ireland).
However, both employers and trustees should remain alert to the increased costs and compliance burden which could result from the remaining proposals.
The European Commission is carrying out a review of the 2003 IORP Directive (Directive 2003/41/EC on the activities and supervision of institutions for occupational retirement provision). The review follows the publication of the Commission’s White Paper on ‘adequate, safe and sustainable pensions’ in February 2012.2
Following detailed advice from the European Insurance and Occupational Pensions Authority (EIOPA) in February 2012, a revised draft of the directive (IORP II) is now expected in autumn 2013 (twice delayed from earlier due dates of December 2012 and summer 2013).
The current IORP Directive provides a European framework for pension scheme funding and, in particular, underpins how employers fund defined benefit (DB) occupational pension schemes. It was implemented in the UK by the Pensions Act 2004.
The initial aims of the review were to:
- complete the Single Market for occupational retirement provision, by harmonising the solvency and valuation rules of defined benefit pension funds in European member states;
- strengthen protection for scheme members;
- facilitate cross-border activity; and
- ensure a level playing field between institutions for occupational retirement provision (IORPs), or funded pension schemes, and insurers (in light of Solvency II insurance regime).
EIOPA Advice (February 2012)
The Commission proposes to establish a Europe-wide risk-based supervisory regime for institutions for IORPs.
EIOPA’s advice proposed that this could be achieved by adopting a three pillar approach for IORP II, which is drawn from the approach to banking regulation set out in the Basel II and III accords and from the forthcoming requirements for insurance companies set out in Solvency II Directive (2009/138/EC):3
Pillar I: quantitative requirements. Including the valuation of assets and liabilities, technical provisions, and the treatment of security mechanisms and investment rules. Central to the Pillar I proposals is a ‘holistic balance sheet’ approach.4
Pillar II: qualitative requirements. Including the supervision of IORPs, requirements for key individuals and outsourced functions, risk management, internal controls and internal audit and actuarial functions.
Pillar III: disclosure requirements. Including the provision of information from IORPs to supervisors, members and beneficiaries.
Following the May 2013 announcement, the proposal for IORP II will now focus on Pillars II and III, following concerns that the solvency standards under review would inflate pension deficits and restrict the availability of long term investment finance (eg through altering incentives to hold long term assets). Commissioner Barnier has made assurances that he has:
‘no desire to penalise national systems which work well. And especially [does] not want, in the current fragile economic situation, to harm the ability of pension funds to play their role as long-term investors.’
However, given the extensive interaction between the governance standards and solvency requirements outlined in EIOPA’s advice, the European reforms could still have an impact on the deficits reported by pension funds.
The governance requirements of Solvency II provided the starting point for EIOPA’s advice. Solvency II includes a two stage process by which insurance firms will be (i) required to show compliance with funding requirements and (ii) monitored by supervisors.
Governance Requirements under Solvency II
Stage 1 – the Own Risk and Solvency Assessment (ORSA): The firm undertakes an internal assessment, known as the ORSA, in which it evaluates its solvency needs and its compliance with technical provisions. Firms are required to perform and ORSA ‘regularly and without any delay following any significant change in their risk profile’.5 EIOPA has suggested that this would be a useful way for pension funds to assess their risk profile, given that pension funds operate on a long term cycle and the ORSA provides a forward looking approach.
Stage 2 – the Supervisory Review Process (SRP): Supervisors review the firm’s ORSA as part of its SRP. This process is a means by which supervisors review the firms’ procedures for complying with the Solvency II regime and is a means for them to identify any deteriorating financial circumstances. As a result of this SRP, the supervisor may point out material weaknesses and deficiencies in that undertaking (eg in its governance requirements or in the amount of capital held). Solvency II provides for the SRP to be conducted ‘regularly’, but gives supervisors discretion to establish the minimum frequency and scope of these reviews having regard to the nature, scale and complexity of the activities of the undertaking concerned.6
As with the ORSA, EIOPA have indicated that they think that the SRP is a useful starting point for a new supervisory regime for pension funds. Although EIOPA suggests that supervisors will also need to take account of the security mechanisms open to pension funds (such as the employer covenant).
This approach indicates how the Commission could continue to pursue its aim of maintaining a level playing field between insurance companies and pension funds. However, the current proposals fail to appreciate how IORPs differ from the regulated insurance community. In the UK, the differences are stark: there are more than ten times as many DB pension schemes than insurers, they are regulated by different entities, have different relationships with investors, and perform different social functions.
The insurance regulatory regime (including the forthcoming Solvency II requirements) assumes intensive regulator involvement and oversight. The relatively small number of UK insurers (fewer than 600) makes it feasible for the UK’s Prudential Regulatory Authority to do this. But it is difficult to see how the Pensions Regulator (TPR) could take a similar approach with the much greater number of DB occupational pension schemes.
This approach to governance also demonstrates how the IORP II proposals could still have an impact on scheme funding—even if the new Directive does not prescribe new solvency standards. Under Solvency II the supervisor can address deficiencies in an insurer’s financial position by requiring it to hold extra capital, known as a capital add-on. Member States also have discretion to require the amount of the add-on to be published—that is, to disclose to the market that it does not approve of the firm’s risk management and/or governance. The new governance regime under IORP II could therefore strengthen TPR’s powers to intervene in pension scheme funding, if TPR has identified weaknesses.
Other Governance Requirements
EIOPA has set out further recommendations for the governance systems of pension funds, particularly in relation to how they manage risk:
Risk management: Pension funds could be required to put in place a more rigorous system for identifying and responding to risks.
Internal control systems: These could include obligations to undertake regular assessments of compliance and meet whistle-blowing requirements.
Fit and proper persons: Fit and proper criteria (eg for adequate qualifications and good reputation) will apply to personnel who run, or have key functions in pension funds.
- Internal audit
- Actuarial function
- Appointment of depositories and safekeeping of assets
EIOPA made three recommendations concerning the outsourcing of key functions of pension funds:
- Service providers should face greater obligations to co-operate with supervisors, and provide information and access to their premises, particularly in the case of cross border schemes.
- Pension funds should be required to monitor the provision of outsourced functions, to ensure that service to members is maintained and that this did not lead to an increase in operational risk.
- Any outsourcing of key functions should be formally documented in a legally enforceable written document.
The third pillar of EIOPA’s advice considered the disclosure requirements of pension funds to (i) supervisors, and (ii) members and beneficiaries.
Disclosure to Supervisors
Supervisory authorities already have substantial powers to require information from pension funds, supervise their relationships with service providers and carry out on-site inspections.
For this reason, EIOPA suggested that there may not be any need to grant greater powers to supervisors. If any reforms were to be made, these would aim to harmonise the form and type of information which pension funds are required to provide.
Disclosure to Members
EIOPA’s advice on disclosure to members has received a more positive response than most of their proposals—perhaps because it addressed concerns particular to DB and DC pension funds, rather than insurance firms. EIOPA emphasised that their main objective was to help members understand issues which are both important and difficult for members and to equip them to make the decisions needed to plan for their retirement.
‘People generally find retirement planning a difficult issue. At the same time, saving for retirement is one of the most important elements of lifetime financial planning. Information requirements are an essential element of the protection of IORP members, especially when they bear the investment risk. Current and potential members/beneficiaries need information to ‘understand’ and make judgments about on the one hand the functioning of an IORP and its scheme, and if applicable to make informed decisions (concerning the provider, different investment options, opting-in or out). On the other hand, people need information to make choices about their broader retirement planning, the IORP scheme being only one element of it. Finally, information requirements contribute to trust in the pension sector, in this case specifically in IORPs.’
Source: EIOPA’s advice to European Commission
EIOPA proposed introducing six principles for reforming the disclosure regime:
- Information should be provided in all phases of members’ participation in the scheme, proportionally to the choices to be made.
- Information should be (i) correct, (ii) understandable and (iii) not misleading.
- Information overload should be avoided.
- Information has to make clear the risks to which they are exposed.
- In the case of DB schemes, it should be made clear that any benefit adjustment mechanism (ie any possibility to reduce pension rights) should be part of the description of the risk-sharing mechanisms in place (ie which of the main stakeholders, such as members, beneficiaries, employers, bears the risk of a funding deficit). This will be less relevant in the United Kingdom, where there are statutory restrictions on changing or reducing accrued rights.
- The potential of digital devices in delivering and making available information efficiently and effectively should be taken into account.
Solvency standards (Pillar I): postponed but not forgotten
There was widespread criticism from across the pensions industry and public opposition from the UK, Netherlands, Germany and Ireland to the original proposals for solvency standards. Despite this, Commissioner Barnier has confirmed that solvency rules for pension funds remain an ‘open issue’, declaring that ‘we must face up to the weaknesses in some occupational pension funds’.
In February 2013, Pensions Europe, a representative of national associations of pension funds, advised the Commission to shift the focus of its proposals towards governance and disclosure requirements.7 The European Parliament’s Committee on economic and monetary affairs similarly stated that it is not convinced that Europe-wide requirements concerning own capital or balance-sheet valuation would be appropriate.8 Criticisms of Pillar I include:
- It is unworkable, as security and adjustment mechanisms cannot be valued on a consistent basis with balance sheet items with a current value, and are particularly sensitive to the assumptions based on current economic conditions.
- It does not appreciate the difficulty of valuing a sponsor covenant.
- Implementing the holistic balance sheet would be a complex and costly exercise, and could lead to increased labour costs.
- The introduction of explicit valuations could increase the level of the deficits reported by IORPs and the onus on employers to make up the shortfall in funding, which would divert capital and encourage the closure of further DB schemes in favour of defined contribution schemes.
- Insurers are not an appropriate comparator for pension funds.
- The introduction of assumption-driven capital requirements might affect the strategic asset allocation of IORPs and discourage investment in long-term financing.
- The possible requirement to use a risk-free discount rate (such as gilts flat) is inconsistent with UK governmental policy.
These concerns were reinforced in April 2013 when EIOPA published the preliminary results of its quantitative impact study (QIS) on the effects of applying the ‘holistic balance sheet’ approach to pension funds (see below).9 The QIS was conducted in autumn 2012 in eight European countries: Belgium, Germany, Ireland, Netherlands, Norway, Portugal, Sweden and the United Kingdom. The results estimated that pension funds in the United Kingdom would have a deficit of 527 billion Euros under the new solvency regime (an increase from what has been estimated to be 350 billion Euros under the current regime).
Holistic balance sheet
The holistic balance sheet would require IORPs to produce valuations that, in addition to stating actual assets and liabilities, would take into account various adjustment mechanisms (such as conditional indexation and benefit reductions) and, in a major departure from current UK practice, count as assets security mechanisms, sponsor support and pension guarantee schemes. It would also be used to assess whether IORPs have met two new sets of minimum and solvency capital requirements, and to set further restrictions on the discount rate to be used when calculating a best estimate of an IORP’s liabilities.