Solvency II directive has European DB plans seeing red

Opposition is intensifying against a European Commission proposal to apply to defined benefit funds a set of regulations originally targeting insurance companies, as the initiative moved a step closer to becoming reality.

“This is the No. 1 regulatory threat to U.K. pension schemes,” said James Walsh, London-based EU and international senior policy adviser at the National Association of Pension Funds.

Released earlier this month, a quantitative impact study on the affect of Solvency II regulations on pension funds estimated that combined U.K. defined benefit deficits alone would rise to about £450 billion ($689.5 billion), or a 24% shortfall measured against risk-free liabilities. In comparison, the current aggregate deficit of about 6,300 plans tracked by the Pension Protection Fund is estimated around £237 billion as of March 31.

Other major DB markets such as the Netherlands, Ireland, Germany and Belgium would also be worse off, although not likely to the extent of the U.K. All five nations are opposing the EC proposal, which aims to use at least portions of the Solvency II regulations as a blueprint for the new Holistic Balance Sheet provision within the Institutions for Occupational Retirement Provision II Directive.

Critics point to the increase in costs to companies at a time when the European economy is already in the doldrums. Furthermore, any additional pressure on pension plans will likely result in a quicker pace of DB plan closures, sources said.

“This confirms that any such new rules would harm businesses' ability to invest, grow and create jobs, and many more schemes could be forced to close,” U.K. Pensions Minister Steve Webb said in a statement following the publication of the report, titled “Preliminary Results for the European Commission.”

The commission previously estimated the cost of implementing Solvency II for the European insurance sector to be between e2 billion ($2.6 billion) to 3 billion over a period of five years, partly because of the cost of meeting new data requirements.

“If applied to the pension industry, there will be the same problems of recalibrating the data in order to report back to the regulators, and the cost associated with that,” said Mark Westwell, London-based senior vice president and regional client management executive in Europe, the Middle East and Africa for State Street Global Services who advises clients on Solvency II.

Another “real concern” is that the proposed regulations would accelerate the shift of plan investments to bonds from equities, potentially harming economic growth in the region, Mr. Walsh added. “The left and right hands of (the EC) are not working together. On the one hand, the commission just published last week a green paper encouraging pension schemes to have a bigger role in helping the European economy to grow through investments.”

Under Solvency II, one of the key elements is the valuation of capital requirements based on the level of investment risk taken, adjusted for various factors such as portfolio diversification. According to data provided by Russell Investments, the average equity allocation among European pension funds is about 40%, compared with about 5% among insurance companies in the region. As a result, insurers have much larger exposures to low-risk government bonds.

“Pension funds and insurance companies might have some similarities but are really different animals,” according to Farid Kabbaj, director of investment strategy and solutions at Russell Investments, Amsterdam. “The investment management and regulation of insurance companies is based on the idea that the company should provide an absolute guaranteed benefit to the policyholders. Therefore solvency buffers should be high and the amount invested in risky assets such as equity should be low.”

“It does not make sense to copy this approach directly to pension funds,” Mr. Kabbaj said. Firstly, pension funds do not have to provide an absolute guarantee as the sponsor covenant. Furthermore, the returns needed by pension funds to close the deficits are substantially higher than the risk-free rate of return.

“This means that a high proportion of assets should be allocated to equity, currently over 40% on average, which the high Solvency II buffers do not support,” he added.

The intent of the European Commission's proposal is to act as a basis for the IORP II Directive regulating European defined benefit plans in an effort to improve risk management and governance as well as to add consistency in the valuation of assets and liabilities across the region.

For example, discount rates used to calculate pension liabilities vary widely, with the Netherlands using an adjusted swap curve that comes closest to the rate prescribed under Solvency II. The U.K., Germany, Ireland and Belgium use various interpretations of an expected rate of return on assets, according to the study, conducted by the European Insurance and Occupational Pensions Authority.

Other countries included in the study are Norway, Sweden and Portugal.

As a result, the impact of Solvency II also varies. For example, the deficits of Dutch pension funds would deepen to 21% of liabilities, compared with the current 17%. The Netherlands is the second largest DB market in Europe by assets, behind the U.K. The two countries account for about 75% of total DB assets in Europe.

The study did not take into account the ability for Dutch pension funds to cut benefits, which would improve both funding ratio and solvency requirements, according to Niels Kortleve, member of the committee on international affairs in the Federation of Dutch Pension Funds.

“This is a severe misrepresentation. Including the benefit cuts would lead to a more sustainable situations,” said Mr. Kortleve, who is also innovation manager at PGGM, fiduciary manager of the e129 billion Pensioenfonds Zorg en Welzijn, Zeist, Netherlands.

But not all countries would be worse off. The surplus for Swedish pension funds, for example, would likely rise to 13% from 8% of liabilities.

Mark Dowsey, senior consultant at Towers Watson in London, said the EC's “notion of getting to a position in which there is more consistent valuation of pension liabilities between pension schemes from one country to another is sound.” However, the commission might potentially rush through a new set of regulations without considering its full impact.

“It's a difficult balancing act,” Mr. Dowsey said. “In the attempt to mitigate risk, (the commission) needs to be careful not to introduce a whole new set of systemic risk.”

The results within the study itself might need to be revised, sources said. Jane Beverley, principal and head of research at consultant Punter Southall in London, pointed out, for example, that the EIOPA's results are based on data from about 100 individual IORPs, or pension funds, out of an estimated 140,000 funds within the EU. “The IORPs that provided data tended to be the largest schemes and may therefore not represent true experience across all scheme sizes,” she added.

The EIOPA also warned that its results must be treated with caution and “a number of issues had not been resolved yet and further work needs to be undertaken,” according to the study. The organization is scheduled to publish its final report by the end of June.

A wholesale application of Solvency II to pension funds remains unlikely, sources said, but they fear any additional regulations will further damage an already wounded DB system. With yields in government bonds being particularly low, regulations that drive pension funds to shift even more assets into the asset class would potentially require companies to increase contributions as real returns diminish amid widening deficit levels, said Lena Tochtermann, principal policy adviser at the Confederation of British Industry, a lobbying group representing U.K. businesses based in London. As a result, companies would have less to invest in their businesses.

“It's more risky for pension schemes and their sponsors,” Ms. Tochtermann said.

The EC could either postpone the introduction of Solvency II for pension funds until deficits have been closed, or change the regulation to reflect the specifics of pension funds. Mr. Kabbaj of Russell added: “More should be done to tailor the regulation to pension funds. “