Niels Kortleve, Barthold Kuipers and Wilfried Mulder offer reasons why the European Commission should focus on convergence of EU pension regulation rather than harmonisation.

On 30 March 2011, the European Commission sent a call for advice to the European Insurance and Occupational Pensions Authority (EIOPA) for the review of the IORP Directive. The call for advice aims to achieve full harmonisation of pension fund regulations "where EU legislation does not need additional requirements at the national level". Basically, EIOPA is presented with almost 100 articles from Solvency II and requested to turn them into a regulatory framework for pension funds.

The IORP Directive was introduced in 2003 to enable the establishment of pan-European pension funds, among other objectives. Cross-border pension funds provide employers with the benefits of economies of scale and a simplification of governance. However, in June 2010, there were only 78 cross-border pension funds operating in the EU.

The Commission has identified the "lack of harmonisation of prudential regulation" as a barrier to cross-border activity of pension funds. However, it is hard to see how differences in national prudential regulation might negatively impact cross-border activity, since pan-European pension funds are only subject to the prudential rules of the home member state. In our view, differences in tax regimes are much more likely to pose an obstacle. Moreover, we wonder why the call for advice does not pay any heed to obstacles such as social and labour law issues. Furthermore, cross-border schemes are required to be fully funded at all times and are not permitted appropriate recovery periods. This makes it virtually impossible to establish cross-border defined benefit (DB) schemes, since it denies the possibility to smooth deficits/surpluses over generations.

We conclude with experts from OECD and Groupe Consultatif that the imposition of a harmonised solvency regime upon very diverse occupational pension systems is neither necessary nor desirable. Instead, the IORP Directive should be extended with a set of overarching principles to foster convergence of pension fund regulations. In the case of sufficiently common regulatory approaches, the principles may be elaborated with more detailed rules at the EU level. To justify such a non-harmonised approach, the scope of the IORP Directive should be restricted to not-for-profit pension funds where the risks are borne by employers and/or (future) plan members.

Redefine scope of IORP Directive
Overlap between EU regulation for insurance companies, investment funds and pension funds.

The IORP Directive takes a horizontal approach as it may be applied not only to traditional pension funds, but to all institutions for occupational retirement provision. This includes the pension activities of insurance companies and investment funds, which also have in place their own vertical regulations (Solvency II, UCITS IV). As a result, EU regulation is applied in an inconsistent manner as identical institutions are subject to different prudential rules in different member states. In addition, it gives rise to calls for an inappropriate extension of insurance and retail investment fund rules to pension funds as well as the opportunity of regulatory arbitrage.

The IORP Directive may be applied to insurers in two ways. First, Article 4 of the IORP Directive allows member states to subject the ring-fenced occupational retirement business of insurers to parts of the IORP Directive.

Second, member states have the option to establish IORPs as insurance-type vehicles or institutions that underwrite the liabilities themselves.

The aforementioned member state option to apply the IORP Directive to the pensions business of insurers has been an important source of tension. It is a source of competitive distortions as insurers in some member states will be subject to less strict capital requirements than insurers in other member states, which gives an opportunity for regulatory arbitrage. In addition, the IORP Directive also allows UCITS-type investment funds within its scope.

As a consequence, the IORP Directive could be used to circumvent restrictions in the UCITS Directive on illiquid investments - private equity, infrastructure, real estate - of retail investment funds.

Other occupational pension schemes
Some occupational pension schemes - as mentioned by the call for advice - are not covered by the IORP Directive. The question is whether and how to broaden the scope of the IORP Directive respecting social and labour law of the member states. For instance, should book reserves and pay-as-you-go pension schemes be included? For instance, both in Germany and the UK pension promises have to be backed by the plan sponsor and a protection fund is in place in case a company becomes insolvent. Similarly, industry-wide pay-as-you-go schemes in France do not have to be funded, while industry-wide pension funds in the Netherlands or the UK do.

Redefining scope
The overlap between EU regulation of insurers, investment funds and pension funds, as mentioned above, can be undone by restricting the scope to collective, not-for-profit pension funds in which the risks are borne by employers and/or employees. This would exclude from the IORP Directive insurance-type vehicles and pensions not provided through employers and/or social partners. Occupational pension schemes such as pay-as-you-go schemes would naturally fit this definition and their exemption could be abolished. This would not necessarily mean that these schemes would have to increase funding. The ability to raise future contributions - possibly backed up by insolvency protection - may be recognised as an asset, a possibility that is also put forward by the call for advice.

Different risks, different rules
The Commission is advocating a harmonised solvency regime for pension funds to avoid regulatory arbitrage between and within financial sectors. Pension schemes containing similar risks should be subject to similar regulatory requirements. However, these goals can also be achieved by limiting the IORP Directive to social institutions. This ensures that risks are borne solely by employers and employees and not by the shareholders, as is the case with insurance companies. In addition, not-for-profit pension funds have little incentive to engage in regulatory arbitrage as the costs and benefits of such activity are well aligned.

While the benefits of the Commission's plans seem unclear, the imposition of a harmonised solvency regime will be accompanied by substantial costs. The introduction of an alien prudential framework might be good news for actuarial consultants but will very likely pose a heavy burden for pension schemes and, as a consequence, their beneficiaries. Moreover, a short-term solvency regime with mark-to-market accounting will increase pro-cyclicality and - as happened with the introduction of the IFRS accounting rules - further discourage occupational pension provision. It will increase systemic risk and reduce the amount of long-term risk capital available to companies.

It is also questionable whether the EU should define an equitable intergenerational distribution of deficits/surpluses, which is an important objective of DB scheme supervision. Intergenerational risk-sharing provides substantial benefits to individual plan members, but there are limits to the level of deficits that can be shifted forward in time.Differences in demographic composition between countries should result in different limits, which means that harmonisation might not be desirable.

Therefore, we prefer that the IORP Directive be strength ened by extending it with the principles put forward by CEIOPS, Groupe Consultatif and the OECD. The detailed implementation of those principles should be left to the member states to facilitate the diversity in national funding and valuation approaches.

The overarching principle should be that the future IORP Directive is balanced - in other words, ensure pension funds are able to deliver on expectations of plan members. This is a very strict requirement that ensures that pension funds possess sufficient (internal or external) capital to back up any pension promises. Pension funds that place risks predominantly with the plan members - as is the case with DC schemes - should be transparent about that.

The principles could be further elaborated when regulatory practices are similar in the member states. In particular, we see scope for reinforcing the IORP Directive with more detailed provisions in the area of communication, governance, risk management and outsourcing to external service providers.

Convergence should be leading principle for IORP II
The main aim of public policy in the area pensions is to ensure adequate and sustainable retirement income. The Commission wants to achieve this by completing the single market for occupational retirement provision through imposing a harmonised solvency regime upon pension funds.

Indeed, the second pillar of occupational pensions needs to be developed further in Europe. Many governments have been reforming state pay-as-you-go schemes, but only 40% of European workers are covered by a funded pension scheme to supplement declining public pensions. We fear that the imposition of a harmonised solvency regime will discourage rather than encourage workplace pension provision. In our view, the Commission needs to take a more pragmatic approach and aim for convergence of funding regulation by extending the IORP Directive with the core principles of pension fund supervision. EIOPA could stimulate this convergence by giving an overview of market and best practices. We can support this process by bringing in the experience of the Netherlands with risk based supervision (FTK) during the financial crisis.

Niels Kortleve is innovation manager at PGGM and Barthold Kuipers and Wilfried Mulder are senior policy advisers at All Pensions Group (APG)