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Convergence still a mirage

The European pensions directive, the ‘single passport' for funded occupational pensions, was designed to provide a consistent set of requirements that would ensure, among other things, a pension fund's solvency.

One of these was the requirement for pension funds to calculate and cover what the directive called ‘technical provisions' The term ‘technical provisions' means the assets a pension scheme must hold now if it is to be able to pay its liabilities, its pensions commitments, in the future.

The simplest way for pension funds to calculate and cover their technical provisions in a consistent way is to use discount rates. Yet there is evidence that discount rates tell only part of the story. Differences in the way different European Union members states operate their occupational pension systems provide a tactical ‘underlay' to the directive - much as differences in the strengths of national economies provide a tactical overlay to single European currency trading.

There is now concern that this could lead to a situation where the corporate sponsors of pan-European pension schemes move their schemes to the least demanding regulatory environment.

In particular, Ivo Van Es, the European Commission administrator in the insurance and pensions unit of the internal markets directorate-general has warned about ‘supervisory arbitrage' a situation where companies move their pension funds to legislations with the lowest funding requirements.

The most compelling evidence for a national ‘underlay', below the requirements of the pension directive, has emerged from a survey by the pensions committee of the Groupe Consultataif Actuariel Européen: ‘Minimum Technical Provisions for defined benefit occupational pensions in the EU'.

The principal conclusion from this survey is that a comparison of the discount rates in isolation is not enough to give an indication of the strength or consistency of reserving for technical provisions. Different practices produce different levels of pension security and a lack of consistency between countries.

One of the main factors governing the level of technical provisions is the type of benefit promise - whether this is fixed, linked to final salary or something in between and whether pensions, once in payment, remain fixed or need to be increased.

Another factor is the reserving method and its consistency with the benefits promised, as well as statutory indexation and preservation requirements.

The survey also makes the point that social policy differences in members state are bound to be reflected in their pension plans. The level of pension provision, and therefore of the plan design, is a function of social policy, it says. As a result a unit of pension in each country will be different and have different values.

The results, they say, indicate a very wide variation between countries in the methods and assumptions for assessing minimum technical provisions.

The aim of the Groupe Consultatif survey was to identify the status quo ante - the main differences in methodology for calculating minimum technical reserves before the European pensions directive came into force.

The survey was carried out between November 2004 and November 2006 and covered pensions schemes in Belgium, Finland, Germany, Ireland, Luxembourg Netherlands, Portugal, Spain and the UK. It excluded Austria because it provided no data; Denmark and Italy because pension provision is mainly defined contribution (DC); Sweden because defined benefit (DB) schemes are mainly insured; France because there are no pre-funding requirements for employer sponsored DB schemes, and therefore they are exempt from the pension directives funding requirements; and Greece because no DB schemes existed in the country at the time of the survey.

The Groupe Consultatif survey found that one of the main factors governing the level of technical provisions (other than demographics, which were beyond its remit) was the type of benefit promise - fixed, linked to final salary or something in between - and whether pensions in payment remain fixed or need to be increased.

The main forms of DB in the EU member states are fixed monetary amounts; benefits based on career average earnings and CARE schemes - career average schemes revalued further to pension age in line with inflation or an index; and benefits based on final salary at pension age.

The Groupe Consultatif survey responses suggest that it is up to individual schemes to decide the level of pension increase. Increases can range from none through increases at a fixed rate to increases in line with an index of inflation.

Vesting periods are another variable. In the UK and Ireland, for example, a deferred pension must be revalued at a minimum level between the dates of leaving service and retirement.

This diversity in DB promises means that a unit of pension - defined, say, as the pension accruing from a single year's service - will have different capital values in different countries.

The Groupe Consultatif concedes that the differences between EU countries are inevitable, but says they must be acknowledged: "These differences are a function of social policy and flexibility available to individual schemes. It is important that they are recognised in any comparison of technical provisions."

Notably, there are differences between the methods by which financial assumptions are set. The Groupe Consultatif survey indicated that, before the implementation of the IORP directive, there were varying practices across EU countries on how the financial assumptions were determined.

The survey distinguishes two groupings of countries within the EU, each with , with different approaches to linking financial assumptions to equity or bond markets.

In one grouping, comprising the UK and Ireland, financial assumptions for minimum technical reserves have been set with reference to market yields. They are therefore capable of complying with the requirements of the European pensions directive.

In the other, larger grouping of EU countries, financial assumptions have been prescribed as fixed rates without any direct link to stock market indices or yields. Fixed discount rates have been prescribed in Belgium, Finland, Germany, Luxembourg, Netherlands and Portugal, where the rate has varied from 2.75% to 6%. This approach will need to be modified if countries are to comply with the pensions directive.

The survey finds that it is generally uncommon for EU countries to link financial assumptions to either a pension fund's actual asset profile - the split between equities, bonds and other assets - or to its liability profile - the split between pensioners and non-pensioners.

The Groupe Consultatif expects the second, larger grouping of countries to migrate to the first in its approach to financial assumptions. "As individual countries begin to implement the directive we may see more convergence towards the first group in order to comply with the European pensions directive," it notes.

One of the main factors governing the level of technical provisions is the reserving method. The survey suggests that this at least is as important as the financial assumptions in calculating the technical provisions. Yet the Groupe Consultatif warns that a simple comparison of reserving methods, by itself, will not indicate where there is strong or weak reserving. The nature of the underlying benefits, guarantees and options must also be taken into consideration, it says.

 

o make a consistent comparison between countries, the Groupe Consultatif looked at the strength of the reserving method relative to the ‘accrued' liabilities established by the scheme rules and any legislation regarding indexation and preservation. Again, the Groupe Consultatif identified two distinct groupings of reserving methods for the purpose of minimum funding.

The first grouping, which includes Belgium, Finland, Portugal , Luxembourg, Ireland and the UK, uses what is called accumulated benefit obligation (ABO) methods. This defines technical provisions as the value of the pensions accrued to date, allowing for any statutory revaluation between the date of accrual and retirement.

In addition, two countries, German and Netherlands, use a variant of the ABO , the vested benefit obligation (VBO) which excludes benefits that had not vested at the valuation date.

The second grouping uses projected benefit obligation methods (PBO). This defines technical provisions as the value of the pensions accrued to date but based on projected salaries at retirement. Of the countries with final salary pensions only Spain has followed this method.

The survey divides ABOs into two types. In the first type, ABO1, the minimum technical reserve is based on current salaries. This is the case in all countries except Ireland, UK and Spain. In the second type, ABO2, the minimum technical reserve allows for statutory revaluation of the accrued pension between the dates of accrual and retirement. This is the type used in Ireland and the UK.

The Groupe Consultif sought to discover whether one type gave more scope for regulatory flexibility and prudence than the other. For example, they suggest that in countries with strong preservation and pension indexation laws there should be less pressure for implicit funding margins from which to finance discretionary benefits.

They conclude that the reserving method and benefit promises should be considered together, since the strength of the reserving method is relative to the benefits promised. Thus the reserving method in Spain is the strongest in those countries where the benefit is linked to final salary close to retirement.

They estimate that the difference between the reserves established under different methods can be substantial - 50% to 60% between ABO1 and PBO, and 20% to 25% between ABO2 and PBO. They suggest that the difference might be equivalent to a discount rate differential of up to 3% a year between ABO1 and PBO and 1% a year between ABO2 and PBO.

The PBO method provides protection against future shocks, the survey notes. "Since future salary increases are not guaranteed, the reserve in respect of the expected salary increases serves to smooth future contributions requirements, as well as to provide a safety net against adverse experience,"

In contrast, the ABO method of reserving is more susceptible to volatility from adverse experience. To counter this, countries have bolted on additional reserving factors in the minimum technical provisions:

q In Germany, Ireland, Netherlands, Portugal, and the UK, for example, these additional reserving factors include requirements to exclude the possibility of future withdrawal from service;

q In Belgium , Ireland Spain and the UK there are requirements to assume that member controlled options, such as early retirement on generous terms, will be exercised against the scheme;

q In the Netherlands, Germany and Spain there are requirements to establish explicit solvency cushions or buffers;

q In Germany, Ireland, Netherlands, and the UK there are requirements to establish reserves for expenses of winding up where these have to be met from the pension scheme These can be an explicit addition to the technical reserves , as in Germany, Netherlands and the UK, or a deduction against the scheme's asset, as in Ireland.

The Groupe Consultatif survey found no uniformity of practice across the additional reserving factors, although it suggests that that some of them may be less important when the funding method is strong.

For example, early retirement benefits or pension increases that are given at the discretion of the plan sponsor are not explicitly required to be taken into account in any country for establishing minimum technical provisions.

The Group Consultatif concludes that "consistency between countries will be affected by the extent to which the technical provisions allow for explicit solvency margins, options exercisable by members, risk benefits, expenses of winding up and direct or indirect margins for prudence.

"In addition, the manner in which such allowances are made will also affect consistency between countries."

Whether EU member states' implementation of the of the minimum solvency requirements of the European pensions directive will lead to greater consistency is arguable. The Groupe Consultatif says there is no reason to expect convergence of methods and assumptions.

The group sees three distinct approaches to minimum solvency requirements. The first is the Irish approach. Here the intention is to continue with the minimum funding requirement (MFR) for all schemes, with a strengthened reserving base because of financial market changes.

The second is the approach of the Netherlands. This is a fully prescriptive approach with market-based technical reserves, additional risk based solvency capital and strictly enforced periods for correcting deficits.

The third is the UK's ‘scheme-specific' approach, where each scheme decides for itself . There is no rigid minimum or maximum funding requirement, but a strong emphasis on principles, governance and disclosure with a regulator intervening if trustees and sponsors cannot agree a funding strategy.

Although implementation of the European pensions directive is unlikely to lead to greater consistency between member states in the way they apply minimum technical provisions, there is likely to be change. The authors of the Groupe Consultatif report say they expect to see "significant changes in the way discount rates and other assumptions are determined as EU states begin to implement the directive.

Yet these changes will reflect the tactical ‘underlay' of countries applying a pan-European template to their national pension systems. "There are signs that minimum technical provisions will in future be characterised by differing balances in member states between scheme collateral, regulatory powers and disclosure." the Group Consultatif report concludes. Convergence is still some way off, and the opportunities for supervisory arbitrage remain.

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