EIOPA will be looking to assess defined benefit (DB) and defined contribution (DC) pension schemes together in future stress tests of the European pension fund sector, it has indicated.
The outlined move echoes a call from specialists in the Dutch pension fund industry that has also found take-up at the European level via umbrella association PensionsEurope.
Publishing the results of the 2019 stress tests yesterday evening, EIOPA said that in future, it wants to “further improve its analytical toolset for stress testing IORPs, extending the horizontal approach and with that assessing the common exposures and vulnerabilities of the DB and DC sectors together”.
Niels Kortleve, chair of PensionsEurope’s working group on stress testing, said this year’s results of the DB and DC stress tests were in each case strongly influenced by one country: the Netherlands for the DB analysis and Italy for the DC segment.
“Considering the continuing shift from DB to DC, a horizontal approach aligning DB and DC parts of the stress test is warranted in order to make the future IORP stress tests more relevant,” he said.
PensionsEurope also indicated that in its view there were still improvements to be made to the stress test methodology despite a new cash flow analysis approach. The Dutch regulator and pension funds pressed for this.
PensionsEurope said it stood ready “to provide its expertise to EIOPA to further define its stress testing methodology in order to address all specificities of the IORPs sector.”
EIOPA said the extended cash flow analysis provided important insights, showing that “IORPs’ financial situation would be heavily affected in the short term, leading to substantial strains on sponsoring undertakings within a few years after the shock and resulting in potential long-term effects on the retirement income of members and beneficiaries over decades (should the short-term effects become permanent)”.
Financial stability questions
The DB and DC sectors were for the first time assessed together with regard to investment behaviour and the integration of environmental, social and corporate governance (ESG) factors, which EIOPA said were two important analytical areas complementing the stress test.
“The interesting results of that horizontal assessment will be very good starting points for further research in terms of sustainability and understanding the particularities of IORPs’ investment allocation and investment behaviour,” the supervisor said.
Assessing potential conjoint investment behaviour by pension funds after the stress test – a sudden reassessment of risk premia and shocks to interest rates on short maturities – EIOPA said it observed “an expected tendency to re-balance to pre-stress investment allocations within 12 months after the shock”.
“That may indicate counter-cyclical aspects of the expected investment behaviour, yet would also come at a risk,” it added.
According to Janwillem Bouma, chair of PensionsEurope, the results confirmed IORPs’ countercyclical behaviour and important role in stabilising financial markets.
“It is important that legislation continues to allow IORPs’ countercyclical behaviour,” he said.
Results ‘not surprising’
According to EIOPA’s analysis, the materialisation of its adverse market scenario would result in an aggregate shortfall between total assets and total liabilities of €180bn under national frameworks and €216bn under the stress’s common methodology.
Under the assumptions of the latter, the shortfalls in the adverse scenario would have triggered aggregate benefit reductions of €173bn and sponsors would have to provide €49bn in financial support.
PensionsEurope said the results of this year’s stress test were not surprising. It argued that it was clear funding ratios would drop in EIOPA’s “severe” stress scenario.
“If this unlikely severe scenario would happen, it would of course have impact on stakeholders in the form of higher contributions and (possibly) lower benefits,” it continued.
According to the industry association, this year’s stress test used the “relatively challenging” reference date of 31 December 2018 – after a sharp fall in some major stock markets that month – and applied a “substantial” shock on assets, especially on equity-related investments, on top of that.
The Dutch regulator said that EIOPA’s analysis showed that the materialisation of the adverse stress scenario would have a lasting impact on the Dutch economy.
In total, 176 IORPs participated from across 19 countries. French IORPs – mainly new vehicles set up by insurance-based providers – participated for the first time, only a few Irish pension funds took part because of the delayed transposition of the IORP II directive in Ireland, and, as previously reported, there was no participation from the UK, the biggest pension fund market in the European Union.
EIOPA said the level of participation meant that in most countries more than 60% of the national DB and 50% of the national DC sectors were covered in terms of assets. Gabriel Bernardino, chair of EIOPA, described the coverage as “quite good”.
ESG first
For the first time, the stress test exercise was complemented by an analysis of environmental, social and corporate governance (ESG) factors for pension funds.
EIOPA analysed in a qualitative manner the extent to which pension funds contributed to mitigating ESG risks in society and the extent to which they reduced their own exposure to ESG risks.
A quantitative analysis provided a rough indication of pension funds’ exposure to “brown” assets and the overall carbon footprint of their investment portfolios.
“This quantitative part can be viewed as a first step towards a stress test analysis, assessing the impact of transition scenarios towards a low-carbon economy,” the supervisor said.
It found that the majority of pension funds in its sample had taken appropriate steps to identify sustainability factors and ESG risks for their investment decisions, but only 30% of them had processes in place to manage ESG risks.
The quantitative analysis indicated a relatively high carbon footprint of the sample’s equity investments and, concentrated in a few member states, of the pension funds’ debt investments. The comparisons were with the average EU economy.
Bernardino said: “Long-term obligations and long investment horizons arguably require IORPs to consider ESG factors and enable IORPs to sustain short-term volatility and market downturns for longer periods than other financial institutions.
“The supervisory monitoring and the applied supervisory tools need to be capable of detecting adverse market trends and market developments that can have long-term negative effects.”
Speaking to journalists, he said EIOPA considered pension funds’ stewardship role to be “fundamental”.
“You need to engage with the companies in which you invest to make sure they reduce their risk and by doing that you can also reduce your own risk as an investor,” he said.
Comprehensive information about EIOPA’s 2019 stress test exercise can be found here.
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