Finding the right level
The question of whether defined benefit occupational pension plans in Europe should always be fully funded is on the agenda again, largely as a result of two concurrent developments.
The first is the attitude of the Spanish presidency of the European Union. The Spanish made it clear at the European Council meeting in Barcelona in March that they intend to accelerate the progress of the pensions directive, which had virtually stalled during the preceding presidency.
This has focused attention on a number of areas of the directive that remain to be resolved – notably the funding of technical provisions. The proposed pensions directive originally took an uncompromising line and insisted that technical provisions must be fully covered by appropriate assets at all times.
This hard line has since been softened by a series of amendments by the European Parliament last year. However, there are fears that the EP may have gone further than the European Commission would like and that the European Council will reject the amendments.
The second development is the UK government’s announcement that it intends to reform and eventually replace the minimum funding requirement (MFR) for occupational pensions.
The MFR, established after the entrepreneur Robert Maxwell plundered his companies’ pension schemes, is a discontinuance test designed to give scheme members a reasonable assurance that if the sponsoring employer becomes insolvent, the scheme will be able to deliver the accrued rights. It requires schemes to hold a minimum level of assets to meet their liabilities, and sets out time limits, known as ‘deficit correction periods’ within which any under funding must be made good.
The UK government is now introducing legislation to extend these periods. More controversially, it plans to replace a single minimum funding requirement with a system of ‘scheme-specific’ funding standards. This approach is based on the assumption that each plan has different characteristics in terms of liabilities and therefore requires different funding levels.
This is a reversal of previous government policy. The former Department of Social Security (now the Department for Work and Pensions) stated in 1999 that funding of defined benefit pensions should be “independent of the circumstances of each scheme.”
The move has also polarised the debate about technical provision. At one pole there is what the UK characterises as a ‘one size fits all’ approach to funding levels, typified by Germany. At the other pole is the ‘scheme-specific’ approach, whereby technical provisions are tailored to fit the characteristics of the pension plan, represented by The Netherlands
There is currently little consistency among EU member states on prudential rules. Pension funds are subject to solvency margins in Austria, Germany, Portugal and Spain. However, there are no solvency margins in Belgium, Greece, Luxembourg, The Netherlands or Sweden. In Italy, solvency margins are not required for new occupational plans since these are all defined contribution plans and therefore deemed to be fully funded.
However there is a consensus that some sort of minimum funding requirement is necessary. This emerged from a survey of 127 European pension institutions carried out for the EC-sponsored report ‘Rebuilding Pensions’, the blueprint for a pensions directive. The survey found that a large majority (94.2%) were in favour of having some sort of MFR. However, two out of three (63%) wanted a “flexible” MFR. They said that 100% funding at all times would be almost impossible and certainly not necessary. They argued that since a pension plan was a going concern, benefits need not be fully funded at all times.
The report that followed the survey, drafted by Koen De Ryck, managing director of Brussels-based Pragma Consulting, drew inspiration from the Dutch supervisory authority PVK, which takes a scheme-specific approach to the regulation of pension funds. It proposed a flexible ‘dynamic minimum funding requirement’ (DMFR) that could adapt to the asset structure and risk profile of every pension fund. It said that the advantages of such a scheme would be that it was fund-specific and would avoid unnecessary short-term fluctuations in the contribution level.
The European Parliament’s economic and monetary committee, headed by Austrian MEP Othmar Karas, took this point when it made a series of amendments to the pensions directive last July. The committee said that it would be impossible to manage a fund to achieve an exact match of assets and liabilities every day without “deliberate and excessive” overfunding – something that the tax authorities of member states generally prohibit.
The committee amended Article 16 of the directive to allow the level of assets necessary for the funding of technical provisions to be calculated, on average, over a year. It also amended Article 17 which requires institutions that guarantee an investment performance or a given level of benefits to hold a buffer fund of additional assets above the technical provisions.
The committee said the size of this fund would depend on the type of liability incurred. It therefore amended the article to enable plan sponsors to use their risk and asset base to determine the size of the buffer fund.
This injection of flexibility was timely, in the light of the Treasury-commissioned review of institutional investment in the UK by Paul Myners, former chairman of Gartmore. The review’s conclusions questioned the purpose of Article 16, which is to provide a minimum funding requirement along the lines of the UK MFR to protect European pensioners from another Robert Maxwell.
Myners reported that MFR had not only failed to protect pensioners but had distorted investment patterns in the UK. He warned that the funding requirement in the EU directive, as it stood, would have the same effect in Europe. “Like the MFR, it would risk harming pensioners by causing their pensions to be invested in a sub-optimal way without actually providing improved protection,” he concluded.
The UK Treasury and Department for Work and Pensions have accepted this conclusion. In February they announced plans to replace the ‘one size fits all’ funding requirements of the Minimum Funding Requirement (MFR) with a long-term scheme-specific funding standard that looks at the circumstances of each particular scheme.
The government believes this will still achieve the aims of the Pensions Act 1995 while removing the investment straitjacket from pensions funds. Ruth Kelly, economic secretary to the Treasury, told a National Association of Pension Funds (NAPF) conference recently: “A long-term funding standard, constructed around the characteristics of different schemes and supported by stringent requirements on transparency, will ensure an appropriate degree of protection whilst removing the damaging incentive to pursue a risk-averse investment strategy.”
In the interim, the government wants UK pension funds to be given more time to make good any deficits. Currently, law stipulates that any underfunding between 90% and 100% of the liabilities must be eliminated within five years and that any underfunding below 90% must be restored to at least 90% within a year.
New regulations, announced in February, will extend these periods to 10 and three years respectively. The regulations will also remove the requirement for annual re-certification for funds that have 100% MFR asset cover at the valuation and certification date.
These changes have come about largely a result of lobbying by UK
occupational pension schemes. The National Association of Pension Funds (NAPF) has been urging replacement of the MFR for some time, largely to take the pressure off company pension schemes.
David Astley, NAPF benefits director, said that the government proposals would help slow this process: “There are significant pressures on providers of defined benefit pension schemes, which have come sharply into focus during recent weeks. By extending the time limits for schemes to make good underfunding, and removing the requirement for annual de-certification, the new regulations will bring schemes some much needed relief from the burden of red tape”.
However, the changes may benefit employers rather more than scheme members. Consultants William M Mercer have pointed out that that the longer correction periods for scheme deficits and the reduction in funding levels will mean reduced immediate cash flow into schemes.
Whether the EU pensions directive will be elastic enough to accommodate this approach is not yet clear. Rosemary Bustin, senior manager of the international pensions team at PricewaterhouseCooper in the UK, points out that the technical provisions articles of the directive already allow member states considerable latitude: “Article 16 does, in fact, allow schemes not to be fully funded. As to what level of funding you should have, Article 15 says it is up to the member states to work out the basis on which to calculate it”.
Bustin says that the danger of a flexible approach, with member states free to impose their own prudential rules as they have always done, is that the resulting directive, far from being a straitjacket, will be too loose to be of any use.
“The UK hope is that the directive will be so woolly that that it can allow it to carry on doing what it wants to do. But you have to try look at it from the point of view of other countries who are concerned about some high profile cases of UK pension schemes being underfunded. The risk here is that we will end up with something that doesn’t break down barriers or move things forward”.
Whether the European Council will accept the more flexible approach to funding levels which the European Parliament introduced last year or revert to the harder line of the European Commission is not yet clear. However, the eagerness of the Spanish presidency to achieve progress in the pensions directive before its term ends in June is a guarantee that the issue will be decided sooner rather than later.