Media Briefing Note: What Does the IORP Directive Mean for UK Pension Schemes?
24 February 2012
LONDON, 24 February 2012 - Commenting on the final Advice to the European Commission on changes to the IORP Directive published by EIOPA on 15 February, Jane Samsworth, head of pensions at Hogan Lovells, said:
"The proposed changes to the IORP Directive will not lead to more secure pensions but to fewer pensions schemes. Increased costs will kill them off. "
On 15 February 2012, the European Insurance and Occupational Pensions Authority (EIOPA) published its final 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 review of the Directive is a wide-ranging one. The most controversial aspects relate to funding and capital requirements 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 very likely to be 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 defined benefit (DB) pension schemes in the UK if it results in a funding regime similar to the Solvency II Directive for insurers.
In its final Advice, EIOPA has at least recognised the diversity of IORPs across Europe and made its recommendations on funding conditional on a detailed impact assessment of the effects on pensions and the wider economy. 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.
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.
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, 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 Pensions Regulator/Pension Protection Fund (PPF) regime.
The "holistic balance sheet" approach
The Directive currently covers two main types of IORP, which are subject to different solvency requirements:
- Article 17(1) schemes ("own funds" IORPs) - IORPs provides guarantees to cover certain risks and are required to hold additional capital. There are no such schemes in the UK
- Sponsor-backed IORPs - the sponsoring employer bears the risks, as in UK DB schemes.
EIOPA is charged with ensuring that the level of security offered by all IORPs is similar. The key proposal in its Advice is the concept of a "holistic balance sheet" (HBS) as a Europe-wide risk-based supervisory regime. The HBS approach compares the value of obligations against resources on a consistent basis and takes into account various adjustment and security measures in an explicit way. Many of the components of the HBS are drawn from the Solvency II Directive.
For a UK DB scheme, this would involve valuing financial and contingent assets on a tiered basis, with sponsor covenants and pension protection schemes being given the lowest classification. Liabilities would be valued on a "best estimate" basis, using a risk-free interest rate and an additional "risk buffer".
The adoption of the HBS proposal would mean that, in effect, Solvency II is being 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 amount needed to cover liabilities will need to be set at a level similar to full buy-out?
- Will money purchase schemes be affected? The Advice recommends 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 capital requirements 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 funding, thereby increasing actuarial costs.
New rules on investments
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 recognising that some investment functions may be outsourced has been rejected. The changes 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.