Media Briefing Note: Changes to the IORP Directive – What Does it Mean for UK Pension Schemes?
27 January 2012
The European Commission is planning changes to the Institutions for Occupational Retirement Provision (IORP) Directive. The IORP Directive is the European legislation which provides a framework for the regulation of funded occupational pension schemes in Europe. The Commission's view is that the current form of the Directive is a key barrier to the growth of cross-border pension schemes and that funding requirements should be harmonised across Europe, under a similar regime to that being introduced for insurance companies under the Solvency II Directive. This could have very significant implications for the funding of occupational pension schemes in the UK. There are also proposed changes to scheme investment rules.
Although it is unlikely that any new rules will come in for several years, experience shows that once a European proposal develops a head of steam, it is difficult to arrest or divert its progress.
The idea behind the revisions to the IORP Directive is to ensure that the level of security offered by all pension schemes backed by a sponsoring employer (in other words, defined benefit schemes in the UK) is similar. One option being considered on funding is a “Holistic balance sheet" (HBS) approach: a single regulatory framework with security mechanisms recognised explicitly.
Implications for UK schemes
There are concerns that in effect Solvency II will be applied "by the back door" as the factors underpinning the HBS approach may end up resembling those that will apply under Solvency II.
Although there is very little detail on how important components of the HBS would be valued, it seems almost certain that the approach would dramatically raise funding requirements. Knock-on effects would include weaker sponsor covenants; more scheme closures and increased risks for members. In addition, the proposal would increase the complexity involved in assessing scheme liabilities, thereby increasing actuarial costs.
Particular questions include:
- Will schemes be required to fund to a higher level than is currently the case?
- Will defined contribution schemes also be affected? There is a possibility that there could be a requirement to have in place additional capital to cover "operational risk"
- Benefits under defined benefit pension schemes in the UK are already protected by the employer covenant and the Regulator/Pension Protection Fund regime; how would this be taken into account under a new regime?
On the proposed new investment rules, the main worry is that the new rule would place responsibility for all aspects of investment on the scheme trustees. How would this work where investment is outsourced or assets pooled or where the members make the decisions?
On 25 October 2011, the European Insurance and Occupational Pensions Authority (EIOPA) launched a consultation (over 500 pages) on its draft advice to the European Commission on changes to the Institutions for Occupational Retirement Provision (IORP) Directive. The IORP Directive is the European legislation which provides a framework for the regulation of funded occupational pension schemes in Europe. The scheme specific funding requirements of the Pensions Act 2004 derived from the IORP Directive.
The review of the Directive is a wide-ranging one. The most controversial aspects relate to funding and technical provisions but there are also contentious proposals around scheme investment.
The European Commission's view is that the current form of the IORP Directive is a key barrier to the growth of cross-border pension schemes. The Commission has asked EIOPA how funding requirements should be harmonised, not whether they should be harmonised, so there is likely to be some form of legislation coming from Europe and impacting on the funding requirements of UK occupational pension schemes. The review could have very significant implications for the funding of DB pensions schemes in the UK if it results in a funding regime similar to the Solvency II Directive for insurers.
The immediate time scale is short: consultation closed on 2 January 2012 and EIOPA is now expected to give its final advice to the Commission. EIOPA has indicated that there will need to be a detailed impact assessment for each country and type of pension fund affected, so it is unlikely that any new rules will come in for several years. However, experience shows that once a European proposal develops a head of steam, it is difficult to arrest or divert its progress.
Background: Solvency II
Solvency II is a European initiative to toughen the capital requirements for insurance companies in a bid to make them more secure and better able to withstand significant market shocks. The intended effect is that assets of insurance companies would become more conservatively held.
Solvency II will apply to insurers from the beginning of 2014. It will affect their pension products, including stakeholder pensions; pensions savings vehicles that use insurance as a wrapper - such as self-invested personal pensions, with-profit policies and unit-linked policies; and annuities.
There has been an on-going debate about whether Solvency II's capital requirements should apply to occupational pension schemes. Most in the UK, including the Government and the NAPF, argue that it would be inappropriate to apply a Solvency II regime to pension funds in the UK where benefits are already protected by the employer covenant and the Regulator/PPF regime.
Revision of the IORP Directive
The Directive currently covers two main types of IORP, which are subject to different solvency requirements:
- Article 17(1) schemes ("own funds" IORPs) - the IORP provides guarantees to cover certain risks. They are required to hold additional capital. There are no such schemes in the UK
- Sponsor-backed IORPs - the sponsoring employer bears the risks, eg UK DB schemes.
EIOPA is charged with ensuring that the level of security offered by all IORPs is similar. In the consultation paper EIOPA considers two policy options:
- Keep the current approach in the Directive; security mechanisms are recognised implicitly
- "Holistic balance sheet" (HBS): a single regulatory framework for both types of IORP; security mechanisms recognised explicitly.
EIOPA favours the HBS approach, many of the components of which are drawn from the Solvency II Directive.
What is the "holistic balance sheet approach"?
The HBS approach would provide "a high-level overview of all the elements that would make up the development of a risk based supervisory framework for IORPs".
For a UK DB scheme, it might take into account the following assets:
- Financial assets valued at market value
- Financial contingent assets eg charges over property
- Non-financial contingent assets: value of the sponsor covenant; possible recourse to PPF; recovery plans (up to around 15 years)
and the following liabilities:
- "Best estimate" of liabilities (possibly a market-consistent risk-free rate) with risk buffer for risks beyond this level. Together, they would form the technical provisions.
- Capital requirements: additional solvency capital calculated on risk-based basis.
There are two options for the interest rate used to establish technical provisions:
- Risk-free discount rate
- Two- level approach: Level A based on risk-free interest rate and Level B calculated using an interest rate based on expected return.
The HBS proposal has alleviated fears that Solvency II-style capital requirements would be applied to occupational pension schemes. However, there are concerns that in effect Solvency II will be applied "by the back door" as the factors underpinning the HBS approach may end up resembling those that will apply under Solvency II. Particular questions include:
- Will schemes be required to fund to a higher level than is currently the case because the introduction of "best estimate" of liabilities might mean that the technical provisions need to be set at a level similar to full buy-out?
- Will money purchase schemes be affected? The consultation suggests the possibility that in pure DC plans there could be a requirement (as there is under Solvency II) to have in place additional capital to cover "operational risk" (such as contributions and investment returns allocated to an incorrect account). Not only would this add considerably to costs but it would inevitably lead to a shift to contract-based DC schemes.
- How will the strength of the employer covenant and PPF guarantees be measured?
Although there is very little detail on how important components of the HBS would be valued, it seems almost certain that the approach would dramatically raise funding requirements. NAPF estimates that the likely switch to a risk-free discount rate to value the best estimate of liabilities could increase technical provisions by an average of about 27%. Knock-on effects would include weaker sponsor covenants; more scheme closures and increased risks for members. In addition, the proposal would increase complexity involved in assessing technical provisions, thereby increasing actuarial costs.
EIOPA also recommends some changes to investment rules and risk assessment for IORPs, introducing elements of Solvency II wording, notably a general restriction on investing in assets whose risks IORPs cannot identify or control, instead of the current "prudent person" rule. Alternative wording recognises that some investment functions may be outsourced but puts responsibility for all aspects of investment on the IORP. Both these options are unwelcome, not only because the real dangers they would protect against are already covered by the existing IORP Directive but also:
- the new principle would not be appropriate for DC schemes where members make the investment decisions and the IORP has no discretion, or for IORPs which pool their assets
- the idea of all responsibility for investment remaining with the IORP is inconsistent with any form of outsourcing; apart from anything else, the risk of litigation against directors/trustees would be an important disincentive for pension provision
- allowance is not made for lay trustees
- a requirement for geographical diversification of investments would be dangerous - it could increase the risk of a currency mismatch between the scheme's assets and liabilities
- the revised principles do not deal with issues that do need amendment or clarification: for example, the prohibition on borrowing (the recommendation is to retain this in its current absolute form) and the extent to which trustees can enter into transactions to control longevity and other non-investment risk.