From our perspective: Armour-plating won’t do
Many criticisms of the quantitative impact study consultation of the European Insurance and Occupational Pensions Authority (EIOPA) on its holistic balance sheet proposal focused on the exercise itself - that it is too complex and opaque, and only large pension funds have the resources to do it.
But there are fundamental reasons why very foundations of the EU’s favoured solvency capital-based approach for pension funds is plain wrong. It risks armour-plating pensions for a lucky few, at the expense of the many who won’t enjoy funded retirement provision at all.
Unfortunately, in explaining the very reason why its approach is wrong, it also becomes apparent why it cannot rectify its fundamental error without revisiting the assumptions that underly the general approach to financial supervision.
Risk-based capital requirements are now embedded in our financial system, a little like outdated legacy software. Adapted from the 1988 Basel Accord on banking capital adequacy, the same approach was adopted for the Solvency II and, despite the assurances of the EU Internal Market Commissioner Michel Barnier, have apparently been copied and pasted in EIOPA’s QIS consultation exercise.
The first flaw in all this is the notion of risk-free assets, adopted in the Basel Accord on banking (since superseded by Basel II and now Basel III), because the notion of risk-free has clearly changed since 2008. Who in the real world thinks all euro-denominated sovereign debt should carry a zero-risk weighting? Fortunately, many pensions funds have run their own common-sense credit risk check over their euro bond holdings and sold peripheral debt en masse several years ago.
Second, an overly crude risk-weighting approach for asset classes is counterproductive. This approach is based on an ex-post observation of credit risks and historic returns of asset classes. Further, it fails to recognise the benefits of asset diversification (pension fund balance sheets hold a much broader range of asset classes, in particular equities, than banks) at the overall portfolio level or the ability of the institution, as a long-term investor, to absorb (and benefit from) long-term behaviour. Not to mention the need for institutional investors to provide patient long-term capital to fund innovation and prosperity.
In conjunction with a value-at-risk calculation and a target certainty ratio, which in Solvency II is 99.5%, a wholly false sense of security is engendered which is likely to mislead beneficiaries. In the Netherlands a 97.5% certainty ratio under the FTK has not prevented widespread benefit cuts. The concept of value-at-risk was invented as a measure of the short-term (ie, one-month) volatility of investment banks’ proprietary trading books, with the emphasis firmly on the ‘short term’.
The result is a toxic mix of outdated economic theory and a confusion of credit and market risks and a thoroughly wrong-headed approach to supervision.
No-one challenges the need for banks to be properly capitalised according to an internationally recognised framework. Likewise, insurers have proved themselves to be systemically important to the financial system.
Fortunately, as Peter Kraneveld argues in this month’s Guest Viewpoint on page 24, there is a different approach to pension regulation and supervision. This involves taking into account the quality of pension provision, as well as the overall funding level of the institution concerned. The two are symbiotic, since de-risking to meet short-term regulatory requirements likely means underweighting assets, such as equities, that could better ensure the long-term quality and adequacy of the pensions promise.
Yet unpicking this supervisory knot would need the EC to unthink some of its assumptions. The most important and controversial of these is that European occupational pensions need a harmonised risk-based supervision framework in order to facilitate a single market in pensions.
There is and never will be a functioning cross-border market in defined benefit pensions; such a market will only ever exist for defined contribution provision.
The very fact that the Dutch pension system is undergoing benefits cuts proves the pensions contract to be flexible. Unlike banking and insurance liabilities, pension funds in many countries have an inbuilt safety valve and present wider systemic risk to governments or the taxpayer.
If the EU succeeds in armour-plating European defined benefit pensions it will only succeed in diminishing funded pension provision overall.