Blueprint for Europe
Hugh Whelan examines ‘De Ryck’
One of the main thrusts of the recently published keynote recommendation report to the European Commission – ‘Rebuilding Pensions’ by Belgian consultant Koen De Ryck – is an attempt to underline the legal separation of the pension fund and its assets from the plan sponsor.
Calling for a clear structure to be implemented within funds defining the executive body (management) and the control body (board of directors), De Ryck says the board should be the fund’s highest authority and should be set up to operate independently and critically. It should be accountable to the members and beneficiaries, the plan sponsor and the supervisory authority.
A Statement of Investment Principles (SIP) would, under De Ryck’s recommendations, also be drawn up by the fund containing details of risk perception, tolerance, monitoring and the board’s own prudential investment principles.
This would include the fund’s strategic asset allocation and return objectives considering current liabilities and market environment, on a three-year time horizon.
De Ryck also proposes that funds be licensed by member state supervisory authorities and that any external providers used be licensed by their prospective supervisory bodies.
For defined benefit plans (DB), proof ought to be given that liabilities are properly valued and for all plans, sponsors should be committed by a contractual obligation to fund the plan, De Ryck argues.
Ideally, these should be calculated annually with a technical note from the actuary to state any changes influencing the previous valuation. A triennial valuation is suggested as a minimum requirement.
Members of defined contribution (DC) schemes should also be provided with evidence of asset allocation, investment fund choices and risk, which must be well documented by the lead sponsor, the report says. Independent qualified actuaries must be called upon to calculate pension liabilities or to certify any internal reports made.
The report says the actuary also has a duty to report irregularities, malpractice or regulatory breaches to the supervisory authority, but should be free to select calculation methods within national regulation and professional standards, using assumptions deemed to be appropriate. These should be prospective as well as retrospective and explicable to the board.
The fund’s technical provisions should be calculated for the time period equal to liability duration with mortality tables used being the latest available, group, and if possible sector specific and prospective.
The interest rate assumption/discount rate should be based on the liability duration, government bond yield curve and on the asset allocation risk profile. The inflation rate should be the current one, unless the actuary decides average rates should be applied. And ideally, the report suggests, the actuary should develop several coherent actuarial scenarios from optimistic to pessimistic, to be submitted to the board.
Actuarial prudence and realism are the keywords here for the actuary to arrive at the most probable estimate of the financial integrity plan and prevent over or underfunding.
Future benefit valuations related to employee past service should be expressed in monetary terms (Accrued Benefit Obligation – ABO) to determine whether liabilities are sufficiently funded. Future service or underfunding valuations should be expressed as a contribution level/premium, says De Ryck.
The fund’s assets should be valued on the basis of marked-to-market to allow comparison of funds, transfer calculations on a like-for-like basis and easier transfers between funds and providers – both nationally and cross-border.
Overall though, actuarial valuation methods – excluding those which are country, industry or group specific – should be uniform at EU level, thus promoting a basis for mutual actuarial recognition and facilitating cross-border mobility and transfer within the union.
A significant element of the report is the proposal of a dynamic minimum funding requirement (DMFR), allowing for a scheme overfunding buffer or underfunding margin. This, the report says, would allow greater investment flexibility and cut down on unnecessary short-term fluctuations in the premium level.
Depending on the asset structure/ risk profile of the plan, as well as the long-term nature of the scheme and the liability structure/age profile of the members, DMFR means, where applicable, that a fund’s technical reserves need not be fully funded. The report suggests this shortfall could be to a maximum of half the buffer.
De Ryck argues that the advantage of DMFR is that, being fund specific, the shortfall can be determined objectively in such a way that it can be followed by supervisory and tax authorities.
In cases where a scheme is underfunded below the shortfall maximum, the actuary should propose a refunding programme, De Ryck says. For insufficient contributions or a slow pace of funding, this refunding should be immediate.
But if the shortfall is due to market volatility, refunding could be spread over a market period of three to five years or accelerated according to market conditions, the report suggests. In all cases a recovery plan should be submitted to the supervisory body.
As a going concern allowing for plan improvements such as indexation or premium level reduction, DMFR may over time allow for contribution holidays and reimbursement of surplus assets to the entity taking the risk on any shortfall, the report says.
A similar situation should occur in the event of a fund winding-up situation, but only after all entitlements have been accounted for, or conditions state otherwise. The supervisory authority should also be closely involved to ensure all necessary action is taken in the interest of members and beneficiaries.
Notably, the report suggests that insolvency insurance contracts should not be obligatory for funded pension plans, as this could cause moral hazards and encourage excessive risk taking. In the event of bankruptcy or financial problems the supervisory body should take charge of the plan or, if necessary, assets could be transferred to another provider or an insurance company. Alternatively, a central discontinuance fund could be set up alongside a national or EU-wide compensation scheme.
Legal solvency margins for schemes could be required if the fund is engaged in a ‘firm commitment’, such as a guaranteed minimum interest rate or biometrical risk benefits.
Quantitative investment restrictions and local country requirements, which may lower returns and raise risk and fund inflexibility, should also be abolished, the report says.
And company self investment by the fund should be discouraged, or limited to 4% of the scheme’s equity investment – which should also apply to any individual share holding.
Currency matching requirements should be dropped throughout the EU, although investments outside the EU should carry a distinction between convertible and non-convertible currencies, with holdings of the latter left to the prudency of the board of directors.
For custody, best practice would be to appoint entities not linked to the fund’s money management, however the report notes no mandatory need for this. Indemnity insurance for custody should, however, be a standard prerequisite.
Disclosure to scheme members would include an annual report and a copy of the plan rules with charges on joining the fund. Target levels for members’ contributions and benefits should be included, with all information provided in the most user-friendly manner and available on request.
On retirement or death in service, clear information must be provided on all pension and benefit entitlements due, including capital and theoretical annuity benefits in the case of lump-sum payments. Members should also receive details of vested rights and any options available, the report argues.
For DC plans, members should also be party to a net individual benefit statement on capital build up in the fund, split out between contributions and investment income plus capital gains or losses. Future growth expectations as a percentage of current salary should also be included. And the report also recommends that details on portfolio investment including valuation, performance, benchmark comparison, risk and costs incurred, should be added.
From an EU perspective, the report recommends a light regulatory touch, allowing freedom and flexibility within a framework of responsibility and accountability.
This, De Ryck says, makes regulation easier to harmonise between member states and would be a step forward on the question of mutual recognition of pension funds, and thus cross border membership and pan-European pension funds.
The supervisory authority should, for DB plans, have at its disposal all actuarial valuations – which the report suggests should be done at least every three years – ALM study details and SIP and prudential compliance data.
In the case of scheme bankruptcy, the supervisory authority should work as closely as possible with the sponsor or take control of the fund to enact the least damaging measures, the report says. The regulator itself should also publish an annual report with relevant statistical information and a general overview of the funds it supervises.
Finally, the report recommends the development of EU-wide databases publishing relevant information on the pension fund sector – possibly in collaboration with representative trade organisations of pension schemes and other providers.